ESG’s implications for investors

Alex Edmans

a man smiling for the camera

London Business School’s Professor of Finance Alex Edmans argues why investors need to change their pie-splitting mentality to a piegrowing one and why only certain types of ESG factors lead to outperformance.

Capitalism is in crisis. The consensus among politicians, citizens, and even executives themselves – on both sides of the political spectrum and throughout the world – is that business just is not working for ordinary people. It enriches the elites, playing scant attention to worker wages, customer welfare, or climate change.

Citizens, and the politicians that represent them, are fighting back. The precise reaction varies – Occupy movements, Brexit, electing populist leaders, restricting trade and immigration, and revolting against CEO pay. But the sentiment is the same. “They” are benefiting at the expense of “us”.

While radical calls to reform business drum up significant support, they risk throwing out the baby with the bathwater and ignore the crucial role that profits play in society. Profits are often portrayed as evil value extraction – but without profits, shareholders would not finance companies, companies could not finance investments, and investments could not finance shareholders’ needs.

Indeed, shareholders are not nameless, faceless capitalists, but include parents saving for their children’s education, pension schemes investing for their retirees, or insurance companies funding future claims. Investors are not “them”, they are “us”. So any serious proposal to reform business must work for investors as well as society.

Pie-growing or pie-splitting mentality?

Viewing investors as “them” and society as “us” is an example of the pie-splitting mentality. It sees the value that a company creates as a fixed pie. Therefore, any slice of the pie that goes to business reduces the slice enjoyed by society. Under this view, the best way to increase society’s take is to straitjacket business so that it does not make too much profit.

The pie-splitting mentality is practised by many investors also. They think the best way to increase profit is to reduce society’s slice, by price-gouging customers or exploiting workers, and view a company that takes stakeholder welfare seriously as “fluffy” and distracted from the bottom line.

For example, Costco paid its employees almost double the national average (until its competitors recently increased wages). It also gives 90% of them healthcare – in part due to making part-time employees eligible after just six months of service. Costco is shut on all major US public holidays, even though they may be particularly profitable days for business, to allow its employees to be with their families.

All these policies are expensive, and drive some stock analysts and investors crazy. An equity analyst, quoted in BusinessWeek, lamented that “[Costco’s] management is focused on… employees to the detriment of shareholders. To me, why would I want to buy a stock like that?” Similarly, the title of a Wall Street Journal article conveys the idea of a fixed pie: “Costco’s Dilemma: Be Kind To Its Workers, or Wall Street?” The crucial word is “or”.

But the pie is not fixed. The pie-growing mentality stresses, by investing in stakeholders, a company does not reduce investors’ slice of the pie. Instead, it grows the pie, ultimately benefiting investors.

A company may improve working conditions out of genuine concern for its employees, yet these employees become more motivated and productive. A company may develop a new drug to solve a public health crisis, without considering whether those affected are able to pay for it, yet end up successfully commercialising it. A company may reduce its emissions far beyond the level that would lead to a fine, due to its sense of responsibility to the environment, yet benefit because customers, employees, and investors are attracted to a firm with such values.

Under the pie-growing mentality, a company’s primary goal is to serve society rather than generate profits. Surprisingly, this approach typically ends up more profitable than if profits were the end goal. That is because it enables many investments to be made that end up delivering substantial long-term payoffs.

Now a profit-focused company will still invest in stakeholders – but only if it calculates that such an investment will increase profits by more than the cost of the investment. Indeed, comparing costs and benefits is how finance textbooks argue companies should decide whether or not to take an investment.

But real life is not a finance textbook. In practice, it is very difficult to calculate the future payoff of an investment. In the past, this was easier when investments were in tangible assets – if you build a new factory, you can estimate how many new widgets the factory will produce and how much you can sell them for.

Most of the value of a 21st century firm comes from intangible assets, such as brand and corporate culture. If a company improves working conditions, it is impossible to estimate how much more productive workers will be, and how much higher profit this greater productivity will translate into.

The same is true for the reputational benefits of a superior environmental record. A company that is free from the shackles of having to justify every investment by a calculation will invest more and may ultimately become more profitable.


Let’s turn to the evidence. The idea both business and society can benefit might seem to be a too-good-to-be-true pipedream. However, rigorous evidence suggests companies that treat their stakeholders well deliver superior long-term returns to investors.

For example, one of my own studies shows that companies with high employee satisfaction – measured by inclusion in the list of the 100 Best Companies to Work For in America – outperformed their peers by 2.3%-3.8% per year over a 28-year period. That is 8%9-184% compounded.

Further tests suggest it is employee satisfaction that leads to good performance, rather than the reverse. Other studies find customer satisfaction, environmental stewardship, and sustainability policies are also associated with higher stock returns.

Importantly, all of these measures of social responsibility are public information. So if the market were efficient, they would already be incorporated in the stock price and investors could not make money by trading on them. But, because many investors have the pie-splitting mentality – believing that these measures are at the expense of shareholder value – they ignore them.

Indeed, I found the Best Companies’ quarterly profits systematically beat analyst expectations. This suggests that employee satisfaction improved productivity, but the market did not previously take this into account and so underpredicted the Best Companies’ earnings.

Implications for investors

What does this all mean for investors? I will stress three points. The first is on the role of investors in business reform. As mentioned previously, investors are often viewed as the enemy, extracting profits at the expense of society.

One book claimed that “shareholder activists… are more like terrorists who manage through fear and strip the company of its underlying crucial assets,…extracting cash out of everything that would otherwise generate long-term value”, and politicians in both the UK and US have made proposals to restrict investor rights.

But such views are not backed up by the evidence. Rigorous studies show, while shareholder activism does indeed increase profits, this does not arise from pie-splitting but pie-growing – improved productivity and innovation, which in turn benefits society. So any repurposing of capitalism should place investor engagement front and centre, as the new UK Stewardship Code is aiming to do. The second is on the role of ESG factors in investment decisions. ESG investing is often viewed as a niche area, only to be pursued by investors with an explicitly social mission, under the view that social performance is at the expense of profits. Instead, integrating these dimensions is good practice for all investors, including those with purely financial goals.

ETF Insight: Can ESG investors do good and avoid underperforming?

Good companies are not always good investments. If a company is good, and everybody knows it is good, then an investor pays for what he gets. It makes no sense to buy Facebook because it is a leader in social media – everybody knows this, so its shares are expensive. A good investment is a company that is better than everyone else thinks. Stakeholder capital is a prime example of such hidden treasure: It ultimately leads to profits, but the market does not realise this, due to the piesplitting mentality.

The third implication is more nuanced. While ESG investing is not at the expense of profits, it is important not to go too far the other way. Some ESG advocates go to the other extreme and claim that ESG investing is a panacea. A Financial Times article argued “the outperformance of ESG strategies is beyond doubt” and a leading UK broker recently claimed that “study after study has shown that businesses with positive ESG characteristics have outperformed their lower ranking peers”.

These claims are often accepted uncritically given confirmation bias – the temptation to take “evidence” at face value if it confirms what we would like to be true. We would all like to live in a world in which ethical companies perform better, however, only certain types of ESG factors are linked to superior financial performance.

Which types? The ones that are founded on pie-growing. Some ESG investing is based on piesplitting – the idea that a responsible company is one that does not give too much profit to investors (or executives) and instead redistributes it to stakeholders. Indeed, some ESG investors use CEO-worker pay ratios as a criterion, believing that too high a ratio suggests that the CEO is taking too much of the pie from workers.

But the evidence suggests that pay ratios are actually positively correlated with long-term stock returns. Instead, pay reform should be centred around holding the CEO accountable for growing the pie. This depends not on the level of pay but its structure.

If she holds a substantial chunk of equity, she’s only rewarded if the pie grows; if it shrinks, so does her wealth. Indeed, research finds that companies with high CEO equity ownership outperform those with low CEO equity ownership by 4%-10% per year. Further tests suggest it is high CEO ownership that causes firms to outperform, rather rosy future prospects causing CEOs to voluntarily holding more stock today.

Business needs to be reformed to regain the public’s trust, however, the reforms should not involve regulating companies to make them less profitable. Instead, CEOs and investors must take their responsibility to stakeholders seriously and seek to create profits only as a by-product of serving society, rather than through exploiting customers, employees, and the environment. Creating social value is not simply “worthy” – it is good business. The highest-quality evidence, not wishful thinking, reaches this conclusion: To reach the land of profit, follow the road of purpose.

Alex Edmans is Professor of Finance at London Business School and author of Grow the Pie: How Great Companies Deliver Both Purpose and Profit

This article first appeared in the Q4 2019 edition of our new publication, Beyond Beta. To receive a full copy, click here.

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