The Emergence of ESG Investing

Redwood believes that shareholder returns can be enhanced by combining Environmental, Societal and Governance (ESG) factors with traditional financial factors. While ESG integration is in the early stages of adoption, it is likely that ESG investing will become more prevalent and mainstream in the U.S., as it already has in Europe. Redwood is taking advantage of the inefficiencies in this market and strives to be an industry leader as ESG investing matures.

What is ESG?

ESG represents the next generation of Socially Responsible Investing (SRI). Historically, SRI portfolios used an exclusionary investment process that reflected the values of a plan sponsor. Most commonly, SRI mandates prohibited “sin” stocks such as gambling, tobacco and alcohol, defense contractors, or environmental violators. Data indicates, however, that SRI “exclusionary” strategies have not, in aggregate, resulted in superior returns. SRI Investing has thus not achieved widespread adoption as most investors are unwilling to sacrifice returns, even in order to invest consistently with their values.

Redwood’s ESG strategy improves upon traditional SRI investing. Redwood identifies companies that increase shareholder value by adopting and implementing business practices that focus on the principles of ESG. Redwood’s ESG strategy enhances returns by finding companies that excel on critical financial metrics as well as on important societal values.

As an example, Starbucks (SBUX) has invested significantly in the production and processing of premium coffee beans around the world. SBUX educates local coffee farmers about sustainable farming practices, and helps to support undercapitalized and often impoverished farmers. While there is an expense associated with supporting their supply chain, they have ensured that they will be able to access enough coffee to expand into new markets and to serve new populations. SBUX also mitigates the risk of supply chain disruption due to farmer and other producer underinvestment. These investments enabled SBUX to grow international retail coffee sales 183% over the last 3 years, and support continued rapid growth.

SBUX has also been a pioneer of the “Employee First” philosophy. This belief that happy employees will lead to happy customers led SBUX to offer all full and part-time employees access to health insurance, stock option purchase plans, and other benefits in the early 1990s. More recently, the company has tackled environmental waste by introducing a $1.00 reusable cup that consumers purchase and receive $0.10 off of every cup of coffee when they reuse it. This is a perfect example of management actions that both solve a societal problem (4 billion paper cups sold annually) and generate incremental profits. Customers who purchase the reusable cup will likely visit the store more frequently, which will save the company money on marketing and increase profit margins. These profits, plus the savings from purchasing and disposing of fewer cups will more than compensate SBUX for the discount on each cup of coffee.

These examples of value-creating practices are ESG focused corporate efforts that blend societal value with economic value and can lead to positive alpha generation. Over the last decade, Starbucks shareholders have enjoyed a 447% return compared to the S&P 500 at 66%.

How Does Redwood Manage ESG Portfolios?

Redwood Investments is a fundamentally driven investment firm that utilizes proprietary quantitative tools. While managing ESG portfolios, Redwood combines its proprietary financial factors and ESG factor models. All companies in the investment universe are ranked on a combination of financial factors that include Fundamentals, Valuation and Financial Quality and ESG factors such as Product Type, Corporate Governance, Environmental Impact, Human Rights and Community Involvement. The Redwood model differentiates between the stocks most likely to outperform and those that have the greatest risk of underperforming. Redwood designates the most highly ranked companies by the proprietary model as “Value Creators” and the lowest ranked companies as “High Risk” stocks. The investment team conducts in-depth fundamental research on the Value Creators and avoids the most risky stocks.

ESG considerations are an integral part of Redwood’s fundamental work. The research process includes meeting with company managements, talking with competitors, reading trade publications, and consulting with Wall Street analysts. From these sources, as well as a detailed evaluation of sustainability reports and financial statements and corporate filings, the Redwood team identifies those companies most likely to report earnings that exceed consensus expectations, have high quality financials, take steps to increase shareholder value by creating societal value, and that trade with attractive valuations.

ESG is Growing

There is growing recognition that investors can enhance returns by integrating ESG into the investment process. As asset managers demonstrate that ESG portfolios can outperform, more ERISA plans, Endowments, Foundations, and private investors will seek managers that integrate ESG into their investment processes. Assets managed by signatories of the UN Principles of Responsible Investment (UNPRI) have grown from less than $5 trillion in 2006 to over $30 trillion in 2012.

As with investors, an increasing number of corporate leaders and their boards understand that by addressing societal and environmental needs, they are able to improve their financial returns. Accordingly, more companies are embracing the concept that building “societal value” can incrementally contribute to shareholder value.

The emergence of ESG factors parallels the emergence of positive earnings revisions and surprises as alpha factors in the mid-1980s. As more investors became aware of the factors and began to utilize them, they became increasingly predictive of stock price performance. Redwood anticipates a similar opportunity to capitalize on the inefficiencies of the ESG factors.

Redwood Seeks to be a Leader in ESG Investing

Redwood recognizes the importance and growth potential of ESG investing. As a result, the firm has developed a proprietary quantitative model and fundamental research process for ESG investing. Redwood has almost three years of experience managing ESG portfolios for ERISA, foundation, and individual investors. Redwood has signed the UNPRI as an expression of the firm’s commitment to the emerging industry, and operates with an ESG-minded focus.

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