Good business sense? Why ethical companies often outperform
There used to be a misconception that ethical investing came at the expense of decent financial returns. After all, by definition it involves investing in companies that put environmental and social considerations on a par with making profits. Yet in recent years, ethical companies and ethical investment funds have often outperformed their peers.
Earlier this year, for instance, Ethisphere, an institute that measures ethical business practices, drew up its annual list of the world’s most ethical businesses and found that their share price had on average outperformed a benchmark index of comparable large companies by 13.5% over the preceding five years.
So why do ethical companies and investment funds deliver by putting other concerns ahead of profits?
Part of their success can be attributed to increasingly ethically minded consumers who support these businesses by voting with their wallets. But there are other factors at play. Company actions that benefit the environment and society are often indicators of good corporate leadership.
“Many investors have regarded strong environmental, social and governance (ESG) practices to be proxies for good management,” says Julia Dreblow, founder of SRI Services and Fund EcoMarket, which both provide information on sustainable investment.
For instance, ethical concerns can reflect a manager’s attitude to long-term risk – particularly their ability to view social and environmental risks as financial risks. The global economic fallout this year from the Covid-19 pandemic has demonstrated just how interconnected social and financial risks can be.
“Ethical behaviours do not guarantee corporate success, and the performance of shares is notoriously complex,” says Dreblow. “But what is very clear is that poor ESG practices are risky and regularly bite investors.”
Put another way, when companies disregard ethical and social considerations, they are often also turning a blind eye to real world business risks. For example, a tobacco company could have its product restricted or even banned, while carmakers that drag their heels on emissions targets can find themselves caught by tightening regulations. Likewise, a fashion company that is revealed to have used child labour in its supply chain may face a damaging customer boycott.
In addition, ethical business practices typically imply that business managers take a longer-term view of their markets. Indeed, sustainable practices are by definition focused on the future of our planet.
“It could be that really talented [business] managers also have a cultural preference for ethical practices,” says Sarah Gordon, chief executive of the Impact Investing Institute, a non-profit organisation. “But it seems likely that certain ethical practices will be good for business over the longer term, and it is really in that longer-term time horizon that ethics and business success converge.”
Another factor is greater accountability and transparency. Ethical companies, such as the increasing number of certified sustainable businesses, commit to being open and accountable to investors, regulators and customers. These attributes can mean a more stable and considered type of management – which, in turn, can arguably make for more impactful businesses and therefore more opportunities for impact investors.
Similarly, social considerations can also make for more representative leaderships and workforces. Moody’s, the credit rating agency, recently judged a company’s ethnic diversity drive as being credit positive.
Dirk Hoozemans, fund manager at Triodos Investment Management, the impact investment arm of the sustainable bank Triodos, explains that good social practices mean “treating employees well, for instance resulting in less churn and associated training cost of replacement hires. [It also means] more loyalty from suppliers, clients and employees and a more productive workforce.”
Earlier this year, Ray Dhirani, head of sustainable finance at WWF-UK, the conservation charity, highlighted the crucial role played by the finance sector when speaking about a WWF film on the subject. “We can’t ignore the warnings from science when they’re flashing red,” he said. “It’s vital that the finance sector moves away from short-term interests and towards long-term value creation and sustainable recovery which benefits people, the economy, and the planet.”
Analysis by the financial services business Morningstar of more than 4,900 investment funds showed that over a 10-year period to 2019, 58.8% of sustainable funds had beaten their average surviving traditional peer. Its research also indicated that sustainable funds weathered the February-March 2020 market crash better than most. For example, in the three months ending March 2020, the FTSE Environmental Opportunities Index Series dropped 15.5%, compared with a 24.8% drop in the FTSE 100.
Whether it’s through good leadership, risk management or the adoption of a longer-term perspective, the result is that socially responsible and sustainable companies are often better placed to deal with crises and volatility.
Many of these strengths stem from having a more proactive approach to their business and their role in society. Likewise, when it comes to ethical or socially responsible investing, the more proactive end of the spectrum is known as impact investing – investments that not only avoid businesses that are damaging to the planet and people, but actively support companies bringing about positive change.
Hoozemans points to a number of companies in the Triodos Pioneer Impact Fund portfolio that have performed particularly strongly during this year’s crisis. For instance, Teladoc, which provides telehealth services, has seen strong growth as people avoided doctor visits, instead choosing to communicate with their doctors online from home, Hoozemans says.
Another company in the fund, GN Store Nord, has a hearing aid division that saw sales suffer initially during lockdown as fewer older people visited audiologists. However, sales boomed in a different division of the same company − office communications − as more people started working from home and needed equipment.
Meanwhile, DS Smith, which manufacturers sustainable cardboard packaging mainly from recycled material, epitomises how socially responsible considerations can tally with a longer term business perspective. By buying used cardboard and recycling it into new boxes, it saves around 360,000 trees from being cut down each year.
Having made the link between the rise in e-commerce over recent years and the increased demand for recycled packaging, DS Smith couldn’t have been better placed to respond when demand for home deliveries accelerated dramatically during the Covid-19 lockdowns. It was able to react quickly, even creating new products that made rapid deliveries easier. From an ethical base, it benefited commercially as the future arrived far more quickly than anyone expected.
Beyond this year’s crisis, John Fleetwood, director of responsible and sustainable investing at Square Mile, an investment research business, says companies with a good record on ESG will continue to benefit from long-term tailwinds and avoid long-term headwinds: “If you look at a 20-year view, that’s the way the world is going. It’s having to focus more on sustainability issues, and [sustainable] products will be more in demand both from legislation, from government and a [consumer] need for these things. A clear example is the move towards electric cars (EVs). That’s going to happen … You’re investing in the winners.”
Making a difference
Triodos Impact Investment Funds focus on driving positive environmental and societal change around the world and work hard to deliver competitive financial returns. You can invest in the funds directly or via the tax-efficient Triodos Stocks & Shares ISA.
Please note that with investments in ethical funds and companies, as with all investments, past performance is not a guide to future returns and you may not get back the amount that you originally invested.
The tax benefits of an ISA are subject to change and depend on individual circumstances.
