What is ESG Investing? The tri-cycle of businesses

With this piece, we take a look at What is ESG Investing? We then head on to take a look at the three criteria of ESG. We discuss an example to help you understand why maintaining this cycle is important and finally drive home the point by talking about a real-life stock, that is, of ITC.

So, what is ESG investing?

Almost all businesses in the World have an impact on the environment through greenhouse gas emissions, disposal of effluents, and use of natural resources. The environment in turn interacts with society and society interacts with businesses. Therefore, businesses are intertwined with the environment and society through governance.

What is ESG Investing? The tri-cycle of businesses

Now that we have set the context, let’s understand what ESG investing exactly means.

ESG comprises of three criteria:

Environmental criteria: As stated above, companies consume energy and natural resources, discharge waste, and leave carbon footprints, impacting the environment. 

Social criteria: It is concerned with the relationships that the company maintains with labour and communities at the place of business, diversity, and inclusion.

Governance: It is related to internal policies, rules, and regulations that a company establishes to comply with the laws of the land and ensure operational efficiency. ESG investors are focused on investing in companies that follow sustainable practices, maintain good relations with society, and show a high quality of corporate governance. They believe that companies that take ESG practices seriously give higher returns in the long run.

But how exactly? Let us take a look!

Is ESG really an Indicator?

Take the example of a chemical manufacturing company. It requires raw materials which it sources from nature (not directly of course :P). It has chimneys from which it emits greenhouse gases and releases effluents in the nearby river. The government has certain regulations with respect to emissions and waste disposal. So, if the company violates them, it is bound to be fined depending on the extent of the violation. The money will go out of the company’s treasury, reducing its profit and also tarnish its reputation.

Next, the local communities will also protest against the company if it releases excessive waste into the environment further entrenching the company in deeper legal trouble. A spoiled relationship with the local communities may also make the company lose access to certain resources.

However, if a company reduces its energy and water consumption, its costs will go down, increasing its profitability. Now, assume that the company has a poor relationship with its workforce and there are frequent strikes. The result will be decreased productivity, hence, decreased revenue. There will also be a long-term impact in terms of losing out on good talent and increased hiring cost due to higher attrition. Similarly, if a company upholds high standards of governance, it is less likely to be scrutinized by financial regulators for frauds, window dressing, money laundering or any other financial offence.

Following sustainable practices strengthens a company’s goodwill, which might also fetch the company some support from the government. All these factors combined increase profitability and revenues while decreasing the cost of capital for a company, resulting in higher returns for shareholders. Hence, the focus on ESG!

Understanding ESG with the example of ITC

Now let’s look (see the graph below) at what ESG investing does to company valuations. Consider ITC Ltd, a diversified conglomerate that has a presence in the cigarettes, FMCG, hotels, Agri-products and paper product segments.

What is ESG Investing? ITC-ltd-ESG-EPS-FCF
Figure 1: Comparison of ITC with FMCG peers; Source: Refinitiv

If we compare the Price/Earnings ratio of the company to its peers, it is drastically lower, despite generating more free cash flow and earnings per share than some of its peers. This is mainly because of ESG factors. About 84-85% of ITC’s operating profit (EBIT) comes from its cigarettes business. Cigarettes, as we all know, could be at the peril of being banned or put under certain regulations. Moreover, their social impact is highly negative and ITC’s heavy dependence on the segment for profits is what is holding back its valuation, despite being a fundamentally strong company.

Related: Take a look at Financial ratio analysis
Business SegmentEBIT (FY20)Share (%)EBIT (FY19)Share (%)
FMCG – Cigarettes1,58,38584%1,54,11885%
FMCG – Others4,2492%3,2562%
Hotels1,5401%1,8571%
Agri Business8,2974%7,9344%
Paperboards, Paper & Packaging13,0537%12,3927%
Other2,9102%1,7241%
Total1,88,434100%1,81,281100%
Table 1: Segment wise contribution to EBIT; Source: Refinitiv

But if we compare ITC with other cigarette producing companies, we see that it commands a higher PE ratio despite comparatively lower earnings and free cash flow per share. This is because ITC’s product portfolio is diversified with FMCG products, hotels business etc.

What is ESG Investing?
Source: Refinitiv

To conclude, the moral of the story is that one should invest in companies that follow sustainable practices and take ESG factors seriously if one wants to create wealth.

Author

The piece was written by Shivam Ghule, a co-author at Casereads. If the piece added value to you, how about you share this with your best friend on WhatsApp?

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