ESG: good companies can make good stocks, announces a recent release by Bank of America Merrill Lynch.

Here’s how it expands on that:

• It’s not just for tree-huggers – incorporating environmental, social and corporate governance (ESG) considerations into one’s framework is critical. First, these metrics have been strong indicators of future volatility, earnings risk, price declines and bankruptcies. Second, trends in the US investment landscape suggests that trillions of dollars could be allocated to ESG-oriented equity investments, to stocks that are attractive on these attributes, over the next few decades– inflows equivalent to the size of the S&P 500 today!

The release offers some substantive (if perhaps rather fragmented) examples of why these metrics might constitute such effective indicators:

• Many of the factors included in the ranking system that we analyzed would seem to have economic ramifications. For example, emissions standards, part of the Environmental score, may predict the likelihood of fines and costly litigation. Innovation, which is included in the Social score, can lead to competitive advantages and barriers to entry. Training hours translate into a skilled workforce; employee satisfaction not only should enhance productivity but mitigates costly turnover –where these factors are incorporated into the Social score. At a deeper level, costly mistakes and bankruptcies often happen when corporations lack adequate checks and balances. The diversity of thought leadership at the top is one way to assess this risk, and leadership diversity is incorporated into the Governance score.

A few months later, the writers returned to the topic in a follow-up release, ESG Part II: a deeper dive, noting

• Prior to our work on ESG, we found scant evidence of fundamental measures reliably predicting earnings quality. If anything, high quality stocks based on measures like Return on Equity (ROE) or earnings stability tended to deteriorate in quality, and low quality stocks tended to improve just on the principle of mean reversion. But ESG appears to isolate non-fundamental attributes that have real earnings impact: these attributes have been a better signal of future earnings volatility than any other measure we have found.

They also observe though that despite this empirical evidence (which they acknowledge is mixed, with a few sectors seeming to demonstrate a negative rather than positive correlation between ESG factors and performance), and despite growing interest among investors, “ESG is not drawing much enthusiasm from US corporates.” An article in The New York Times suggests this might be in part because the term ESG is “ugly…jargon,” and “misleading because it conflates two structurally different dimensions of corporate activity.” Indeed there seems to be no inherent reason (beyond, for now, convenience in generating progressive awareness) why governance so often has to be considered in the same breath as sustainability.

The Times article concludes by noting that it “will take more evidence — and perhaps more time — (for ESG) to prove itself as an investment thesis.” But I’m not sure a focus on ESG can or should amount to a comprehensive investment thesis in itself, any more than (say) focusing on companies with lots of revenues would necessarily be a sound way of identifying good investment opportunities. Plainly, achieving perfectly sustainable production methods won’t achieve much for anyone if the market for the company’s products is inherently contracting, and achieving a beautifully diverse board and transparent compensation structure might not help that much if the company’s prospects stand or fall based on a single global commodity price. But it should also make intuitive sense, for the reasons set out above and for others, that all other things being equal, attention to these issues will stand investors in incremental good stead when they consider a company’s long-term prospects, and that therefore companies would be well-advised to try to anticipate and address the needs of such attuned investors. Put another way perhaps, it’s not necessary to fight an ESG war; only to pick and win a few strategic battles.

One of the specific problems at the current time is no doubt that it’s hard to get one’s head around the data that actually underlies these findings and prescriptions. I did follow the link to the Thomson Reuters document that sets out the rules and methodologies for devising the ratings used in the report, but it’s hard to engage with it in much depth (and then some of the links within that document don’t seem to work – not that I’m saying it would have clarified everything if they had). Anyway, it seems plain that any measure of (to take an example) “a company’s management commitment and effectiveness toward maintaining the company’s reputation within the general community” will remain highly judgmental and subject to debate and challenge for the foreseeable future, with consequent implications for the reliability of any finding based on that measure.

This is where one might wish for a way to bring this kind of effort somehow under the broad umbrella of the IFRS Foundation – after all, what body has greater expertise in providing a widely-recognized basis of recognition, measurement and disclosure for things that wouldn’t otherwise be readily susceptible to them?…

The opinions expressed are solely those of the author