Katherine Collins – Impact and ESG Investing - [Invest Like the Best, EP.129]

I know firsthand how complex the tech stack is for asset managers, and seemingly every new tool and data source makes the problem even worse, adding more complexity, more headcount, and more risk. Ridgeline offers a better way forward, one unified platform that automates away all that complexity across portfolio accounting, reconciliation, reporting, trading, compliance, and more, all at scale. Ridgeline is revolutionizing investment management, helping ambitious firms scale faster, operate smarter, and stay ahead of the curve. See what Ridgeline can unlock for your firm. Schedule a demo at ridgelineapps.com. Hello and welcome, everyone. I'm Patrick O'Shaughnessy, and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com. Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaughnessy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy Asset Management may maintain positions in the securities discussed in this podcast. My guest this week is Catherine Collins, who is the head of sustainable investing at Putnam Investments, a portfolio manager on two of Putnam's sustainable investing funds, and the author of the book, The Nature of Investing, Resilient Investment Strategies Through Biomimicry. Our conversation is on the ins and outs of ESG and impact investing, a young but increasingly common topic in the investing world. This is challenging ground for me as a quant because the data available is so new and limited. So Catherine's perspective was very helpful as we continue to learn. Given the importance of this topic, I'm also searching for guests with both positive and negative views on the role of ESG in an investing framework and welcome suggestions for future guests. Please enjoy my conversation with Catherine Collins. So we'll spend a lot of time on your current investment process thinking ESG, which is a topic that's become, I think, really important and interesting. Before we do that, I want to have this debate about mechanical versus human judgment processes. You already mentioned it earlier when you said, you know, everyone's asking about tracking error and sectors and not about what are you actually doing here? Maybe sum up your view on this. I think what you would characterize as an over mechanization of investing. I think it's easy to present this as an either or and it's.

equally important to emphasize there's a really powerful and that is at the center of this that we haven't yet reached, where you're taking the best of newer analytics and systems and structures that we've developed and matching them to a framework that is a little more adaptive or maybe a little bit broader in its objectives. Kind of uniting the art and the science is really the exciting part. And pretty often when I talk about looking at natural systems, it's perceived as like an either or, or that this is kind of a softer way to think about investing. It's kind of the opposite in my mind. So you want the best of both worlds to bring all those tools to bear. What I see that troubles me in finance, and I also see it shifting, which is pretty exciting, is for a really long time, we've sold people a pure utility function in many cases in finance. So, you know, money in, money out, that's it. When you make that your proposition and your only proposition, it's pretty easy for the towards what end kind of questions or how to actually get pushed to the side. And pretty frequently, I see long, long, complicated discussions about yet another version of a synthesized security going out into the world. And they're not bad things, but... They're not even the tail of the dog. They're like a couple hairs on the tail of the dog. And what's much more interesting to me is to connect that back. Like, okay. Here's how these relate to the underlying securities that these synthetic buckets are composed of. Here's how that then relates back to the stock market or the securities market you're investing in. Here's how that then relates to the economy. Here's how that then relates to society. Here's how that relates to the world. Like when you link all those things together, that's an exciting discussion and you can make the most of those mechanics. What I worry about is pretty often... those conversations and those decisions and those activities are happening in pretty great isolation from that broader setting. And yet they have tremendous impact, and they're impacted by that broader setting in a really important way. So one thing I love about the framework of biomimicry and the framework of sustainable investing in ESG as well is it gives us a little bit more.

tangible way baked into our processes to make sure that that linking happens. And when you do that, you can get the best of both worlds. So let's spend a bunch of time in ESG. I will admit that... my experience with it thus far. And I'd love to talk about the data sets and the math and all that kind of stuff. That's definitely more my world, but it definitely is through this utility lens that you described, which is like, okay, we've got a machine we put money into and hopefully more money comes out at some later data at a high rate of return. How does ESG relate to that equation? Am I going to get more? Is it going to be smoother? Am I going to take less risk? Like all very utility mindset stuff. So first I want to offer the alternative to the pure utility mindset through the ESG lens and the soil from which it spouts for you. So Divinity School sounds really interesting to me. I'm curious how that relates to this pursuit. But maybe describe the non-utility portion. What is the objective function outside of just getting more money that ESG offers? This gets back to a core biomimicry principle, which is always defining the function that you're after with great care. And if your function really is just money in, money out, you can go down a certain path for a certain period of time. But almost always. There's more to it than that in every setting. If you really get down to function, there's usually a couple different layers of things that you're trying to achieve. So if you said to someone, you know, you can get a 12% rate of return, but it will destroy the forest behind your own home, hardly anyone would take that, or it would hurt your own children in a very direct, pointed way. And yet, because we've put in all this opacity that we talked about before in the system, it's kind of easy to decouple. the investing and the effect. So what's intriguing about ESG investing and thinking about sustainability more broadly and deeply is it allows us to get back to all those questions we kind of set aside at the beginning of economics and finance, right? So really early on in neoclassical economic theory, we said teteris paribus, and then we shoved all these really important things over in the corner. And we knew we were doing it. You know, if you go back and read those early authors, they said, hey, by the way, don't forget, you want to get back to those things eventually, because you do want to.

have a more complete view. But we ran pretty far and pretty fast in this narrow direction. And now we finally have some more information, some more tools, some more insights to start bringing those things in the corner back in, right? To start thinking about implications on human well-being or climate or even good governance of organizations. And if you're an investor, what could be better, right? We're all looking to have the most complete view possible of what we're investing in. And yet all we've looked at for a really long period of time is this really narrow stream. of financial data. So who wouldn't want to know more than that, right? There's no one who thinks financial data tells you everything you want to know about what you're investing in. So at its core, all that this whole field is trying to do is to connect the dots that we kind of falsely severed long, long ago and give that more complete picture. And then you can do with it what you will. You know, you can use the information like any other data set, however you see fit. who wouldn't want to know more instead of less? So I want to hear about the data behind the objective function that's different than pure returns. So our work has always been, okay, you've got returns and some stuff that's associated with returns, and that's your target variable. And so when you apply, say, ESG data to that, what you get, at least in our experience, is kind of noisy, some tracking error, and some uncertainty. Maybe not better, maybe not worse, maybe a little worse because you're a small universe, all things equal. And so what I'd love to do is define a different kind of thinking here. So what is that data? If I was to completely change, I don't care about returns. I want to target something else in my research, companies that do XYZ, systems that result in ABC, whatever. What does that look like? So I want to pause before I answer this and say our premise in my work at Putnam is that actually tending to relevant sustainability-oriented issues at companies gives you a chance for higher returns. So our goal is not conciliatory returns or... You get some other form of return over here, and that should make you happy. It is that we think this can lead to meaningful long-term outperformance. And so we can talk about the empirical evidence for that. The key words that relate to that empirical evidence are relevant material sustainability issues. So if you have a huge checklist of 300 factors that you think are kind of interesting in the world.

Again, context specific for any given company at any given time. There's a small handful of those that are really, really important where the company is having a big impact on the world around it and vice versa. Their stewardship is going to make a big difference in terms of their long term potential. And so that's the core that we focus our work on. It might help to step back and talk about the evolution of ESG a little bit. And then that puts the current data in a little more context. So a lot of folks still assume that what we're talking about in terms of sustainable investing practice today. is a form of socially responsible investing, which started decades ago. Some folks talk about it in the past tense. It's not past. It's still very much alive and well, very important to a lot of investors. But the mindset with socially responsible investing is exactly what the name implies. It's, I don't want to be involved with certain types of companies for moral or ethical reasons. I'm going to secede from engagement with those organizations. And so it's a not that kind of mindset. And the key question is, what are you against? What are you fighting? kind of at the heart of socially responsible investing. When you do that, all the questions you mentioned about, you know, smaller investment universe, you have to compensate for that somehow definitely do come into play. But for some investors, that's the framework that they want to choose. Way at the other end of the spectrum in the last 10 plus years, now we've seen impact investing growing very significantly. Started really with philanthropists kind of moving backwards to use their investment capital in different ways. And now the term is broadening out just as the activity. broadening out. What impact investing is discipline where you have explicit financial returns and explicit goals for social or environmental impact at the same time. So they're living side by side, they coexist. Pretty often there too, there's a little bit of a trade-off, right? You want to have more gainful employment in a certain place or even better environmental outcomes, you might actually have an either or with your financial return. The big, huge middle is where it's really exciting. And that's where I'm living all day, every day now. This is the ESG integration category. It's a huge range of approaches. You've got quant approaches. You've got fundamental approaches. You've got all kinds of hybrid approaches. This is where we're trying to make the best use of this newer data, asking newer and different questions, getting newer and different insights. So the type of data that's available is...

growing really quickly. And thank goodness it is. The good news is 10 years ago, we had nothing even to complain about. And now we have a lot to complain about when it comes to the new data sets. So we're not yet looking at metrics that are always standardized. They're not yet fully disclosed by companies. There's a lot of judgment and estimation that goes into them, but there's something to work with. And so for anyone who has an analytical bent, this is a dream come true. Once you have something to work with, even if it's messy, you're willing to do the work and get to whatever is valuable within it. That's the stage we're at now for ESG data. And what's most important, particularly for fundamental investors who are engaging with this data, is to try to figure out What is it in any given setting that is relevant and material? Once you kind of skinny down that set of requirements, then you get this really cool loop where you probably have at least some data that gives you some clues about current performance, gives you a better set of questions to follow up on. You have the chance in our case to talk with company managements, figure out how what we're seeing matches what they're seeing, how what we would think might be priorities for the long-term health of their business match with their own perceptions. You get that iterative loop. going again in terms of analysis. So backing up from all that, if you're thinking, okay, as an investor, what is it you're always seeking? You're always seeking some kind of edge. You could have a time horizon edge if you're doing something that's longer or shorter duration than your peers. You could have some kind of edge in terms of insight or wisdom or understanding. And you could have an edge in terms of your own analytics, which kind of go hand in hand with those first two. I think this is the greatest white space of relevant long-term value-generating issues that doesn't yet have a complete data set. And so if you're a researcher, I mean... I've never seen anything better in my whole life. I think the next 20, 30, 50 years are going to be determined by the value that we can create out of exploring these issues more fully. So let's talk about the data specifically. You mentioned 10 years ago there was nothing. Now we've got something. What is that something? And you mentioned earlier you could have hundreds of different things you might care about that maybe the focus should be far more narrow than that on some major issues. So I want to even question, like, is ES and G, is that the right?

mnemonic or framework for thinking about this and what data sets are most interesting and emerging today? ESG is easier to say than most of the other terms we've invented. And so it has become a big catch-all for a lot of other things. Having said that, environment, social, governance, there's very little that doesn't fit under one of those giant umbrellas somehow. So they're okay in terms of umbrella terms. What I don't think is settled yet at all, though, are the metrics that go underneath those terms. So when a lot of folks talk about ESG data, All that they're really referring to is bundled up third-party data that's available from vendors like MSCI or Sustainalytics. Thomson Reuters has some. Carbon Disclosure Project has some. Bloomberg has some. That's a... pretty small piece of the total pie. So the good news is it's structured data. It is as consistent as we currently have when it comes to comparing across companies or industries or regions, but it's still incomplete. It's still very early days. And if you look at the mismatch between the metrics and the true questions, it's a pretty big mismatch. So say you're interested in whether companies you're investing in have truly functionally diverse and inclusive teams. You can count the number of women on a board. You can count the number of women in senior executive positions. Like, I'm glad to know those things, but those aren't. even close to answering the real question that I have over here. They're sort of the first step on a very long path. So there's a lot of potential to improve upon those. And this is where we maybe bridge more into your world, but there are a lot of other data sources in the world that can inform the kinds of questions that we have. So there's been some terrific analysis the last couple of years on Glassdoor data, for example, trying to figure out, is there something here? If there is something here, how can we characterize it? And sure enough, you see the progression there that I think you're going to see on a lot of different issues. So it might be worth spending a minute on that just to get a sense of how things evolve. So the first question was just very high level. high-low Glassdoor rankings, do they tell us anything? Do they indicate any performance? And there's some evidence that, particularly for companies that are earlier in their presence on Glassdoor who have a rapidly growing data set, that there's actually information value there. Pretty short-term in nature, and a lot of investors got on that very quickly and kind of squeezed out that short-term advantage. What is just beginning to be explored, though, is much more interesting to me, which is things like, does it matter if the responses are from mid-level employees?

from brand new employees or from senior employees? Do the responses of the different questions vary in different ways? Like if you respect your CEO, is that more or less important than if you're happy with the dress code? One would assume hopefully yes, but maybe not. Does it matter where you're located if you're closer to the headquarters or further from the headquarters working in a remote region? There's some indication from some of these early studies that all of those have some really interesting longer-term effects. And so I think, okay, here's a neat data set. We kind of squeezed out the most obvious. potential benefit right from the beginning. But that's not even close to what's actually analyzable if you look at not just that data set, but that topic more broadly. And how might that inform you then if you're trying to think of having an advantage over three or five or 10 years as opposed to three or five days? So a strategic question, that's one example. So diversity within companies, let's just call it that as an umbrella. I mean, that's complicated. That one thing has got a lot going on. Data, analysis, thinking, et cetera. How do you even begin to target which of these to spend time on? And what are the arbiters? So on the one hand, you could start, this is just a good thing from almost like a theoretical standpoint versus this is a good thing empirically. I want to focus on this and spend my time here. with limited attention because I think it will have an outcome that I'm after empirically speaking. So it's like, what's the taking a step back? There's X number of things you could explore here. The current models, the number of women on boards are service level. You want to go deeper. What's the strategy for knowing what to focus on and how to evaluate it? There can be a little bit of a chicken and egg element, particularly if you're looking for that empirical evidence before you go any further. So there are a few different elements here. One is the first thing we did when we started this effort in a more formal way at Putnam is we just did a big map of all the major sectors, all the major potential issues, and we modeled it off of the SASB framework. You've probably seen the Sustainability Accounting Standards Board has a gigantic set of maps.

Ten years to develop, they included investors, corporate executives, accountants, you know, very collaborative, long development period. And the whole point of SASB is to help investors focus on the relevant material issues for any given sector. So if you're looking at extractive companies like, you know, an energy company or a mining company, you really do want to spend a lot of time on safety or emissions numbers. If you're looking at a retail company, you probably want to spend time on supply chain or wage policy. It's pretty common sense, but it took a long time just to develop this one standard map. So the first thing we did in our work at Putnam was to refine that map and actually simplify it even further, to streamline it into a few areas where we either had some insights from our fundamental research that there might be something even more interesting there, or we had a little leg up in one little piece of data that might actually lead us to some better questions. That wasn't so hard to do. And importantly, in doing that, we made sure that it really was an integrated approach. A lot of folks are running into walls with ESG practice because they have a team in the corner called the ESG team that often does really, really excellent work, but then the investment team's over in the other corner, and once in a while, they meet and try to talk to one another, and that is a... very hard way to generate any kind of value. So it's terrific benefit to us that our investment team and the ESG team are one in the same. We're embedded in each other's meetings every day. We're going back and forth. The whole goal of our ESG work is investment outcomes. Can you describe that simplified framework? So if you're taking SASB and shrinking it down, maybe to focus it more, what does that look like? Yeah, it actually fits on one page, which is terrific. And we've just got, again, each major sector, a few of the key elements split out by governance, social and environmental. As you might guess, most governance issues are fairly universal. So that's a pretty short list of topics. Could you just take off a few of those? Oh, sure. I just want to give as many contexts and examples as possible. Some of the more interesting things in governance are incentive pay and whether incentive pay is aligned with the underlying structure of the business and what makes for a good business over time. There are a lot of more straightforward metrics like board composition, as we just alluded to, and things that are a little more structural in nature. To me, the incentive question gets a little bit more forward-looking, a little more structural.

So that's one that we focus on a lot for governance. You're using this board example a lot, but it's nice to focus on one thing and kind of talk through the angle. So I'll ask the question again, which is, so you've got the obvious seeming truth that more diversity of experience and opinion and background is a good thing for a system like a company. But why do we know that that's true? Oh, yeah. I would call on the work of Scott Page, who I got to know also through the Santa Fe Institute. The thing that is unique about the evolution of his work is he started out focused on cognitive diversity. And it's pretty well accepted and pretty well proven, at least in a theoretical construct, that if you're doing a repetitive task like a factory, you really don't need cognitive diversity. In fact, the less the better if you're doing the same thing over and over and over again. If you're doing something where... environment around you is shifting a little bit is probably helpful, but you still need a lot in common because you're navigating along one or two paths, but that's it at any given point in time. If you're in an environment that's... kind of like the ocean where you're trying to chart a course and like the very ground beneath you is shifting as you go, then you really need like the maximum of skills put to bear to actually get where you're going to. So this is a well-developed theory. And one thing that Scott noted in his early work is that cognitive diversity may or may not tie to our other markers of diversity, which tend to be a little more demographically described. His newer work actually shows that there is indeed a link between demographic diversity and cognitive diversity. So differences in age. differences in income, differences in race, differences in religion, in academic training, all of that. You want to have a mix brought to bear. And so most boards at most times are dealing with that last set of issues where the company itself is changing, the circumstances it finds itself in are changing, and you're really trying to keep a steady course throughout all that change. So it's pretty good underlying theory that's baked into that. It's not coming from a place of niceness. It's coming from a place of performance, although I love it. like to think the two can coexist. You mentioned that governance is maybe the most simple of these because it's a sort of pervasive issue across all companies. Every company has to think about these set of issues. Talk about the other two verticals, which, at least from my seat, seem far more complicated. Let's start with social because I think environmental maybe is the one that gets...

the most attention, and we'll talk through it in detail. But talk about social and the categories underneath that and how you think that plays into your investing system. One reason I've given a couple examples in the social arena already is I think it's the biggest, most open white space for further exploration. If you meet with a CEO of almost any company in the world and you ask what... It's the first thing they think of when they get up in the morning. It's not what orders were overnight or if the factories are up and running. It's people related. Almost 100% of the time, it's people related. And yet you look at the amount of disclosure we have around people, around the number of questions that analysts ask on conference calls around people. There's almost nothing. It's the biggest gap by far between what determines long-term performance and the information we have to assess it. So there you have certain things that can be analyzed from the outside. And this is where some of those third-party services are good. You can tell if a company has specific policies or procedures that are encouraging of fair employment, for example, or anti-corruption policies. You can analyze whether those structures report up to the board so there's like a good reinforcement loop. Those are all really important pieces of the puzzle. But all they do is tell you what the box is around these issues. What you really want to see is how the practice is living and breathing every day. And that's where things like Glassdoor give you like one step further in that direction. But I just can't imagine that we'll look back in five or 10 years and not think like, oh, that Glassdoor data, it was so quaint. Remember when we used to look at that? Like now we've got so much more to examine. This reminds me of... maybe like the most classic example here, which is interviews with Jim Simons of Renaissance Technologies, where obviously the most famous systematic or quantitative manager probably ever, insane returns through systematic processes. Yet when he's interviewed on the success of Rentech, and I take him at his word, that the secret of their success was people, that they recruited and gave the right environment to the most talented people, which coming from a company like that, at that end of the spectrum is quite striking. So as you think about that as a potential area of edge, can you mention your...

trying to generate not just impact but returns out of this. Draw that link for me. So what is the causal process that your thesis is this will lead to better actual returns? Yeah, so this is where the art and the science kind of meet. I didn't center too much on the empirical evidence so far, so let me spend a minute on that and then I'll... bridge to how we try to connect the dots now in our fundamental process. So on the empirical side, there are a number of studies now that have a similar construct, but the one big foundational study here was done by George Serafim at Harvard Business School a few years ago. even before our current data had evolved. And so a very, very labor-intensive process. He took the SASB framework that looked at material issues by industry, mapped all of the company disclosures to those material issues, and then weighted the material issues higher as opposed to just taking everything at the same average weight for performance. And he found that when you took all of the factors on a plain vanilla average, equal weighted across every possible circumstance, you found like a little potential alpha, but it wasn't statistically. significant, it wasn't something you'd want to hang your hat on as an investment process. When you just simply weighted the issues that everyone had already agreed were more important, more heavily in the model, this huge potential alpha jumped out over 700 basis points in his initial study, which is like, when's the last time you saw that? So even if you want to quibble with the data, even if you want to poke holes in different forms of analysis, like that is a lot to work with. And so that was the first time that we really took this relevant kind of business-centric approach to thinking about sustainability disclosure, and that's what we're all working for. Sounds like a really important study that I'm not deeply familiar with, so I want to make sure I understand the nuts and bolts of it. So you've got a universe of companies, and you've got some data. So what is that data? Is it Sustainalytics? Is it something else? And then you weight it based on the SASB framework for each sector, so the kind of quilt that you laid out before. How is that weighting done? What's the data in that study?

What's the time period? Yeah, I can give you some pieces and I know I won't do it justice. So everyone go, Seraphim, first evidence of materiality is the title of the paper. So it was a couple decades of data. Admittedly, it was getting better and better along the way. So not a completely consistent data set temporarily, but a long data set in terms of its availability and a few thousand companies altogether. So pretty robust, you know, taken as a whole, especially in this arena. I'm way more robust than anything that had come before. And so, again, the plain vanilla version took all of the kind of sustainability menu, if you will, and equal weighted those factors, performance along those factors for each company, each industry. And it showed that companies that did better in terms of their sustainability performance, marginally better returns, but again, not enough to really hang your hat on over time. And then the second version took that same data set, weighted the issues that were more material, and what you found were companies that did the best job managing the relevant issues for their companies massively. outpaced the laggards. So I guess what I'm trying to get at is when you say the best job managing, what does that mean? Oh, yeah, yes. It was all a change in performance versus their own peers. So the actual metrics would vary topic by topic, but that was the rubric behind it. And so let's talk about environmental, having talked about the other two, as often when you see like products or strategies, when you ask people in our experience so far, limited experience, but what are the issues that jump to mind? If you were to... alter your portfolio for these ideas? Climate change is one that people talk about a lot. So this is a good way of asking one of my biggest questions in this arena, which is climate's a pretty complex system. We talked about Santa Fe Institute a couple of times already, the study of complex adaptive systems. Really hard to forecast these things. So how do we know? Obviously, I think a good climate is a good outcome, but how do we know how we might impact? a climate something like climate if that's something you care about what should you be trying to do in your portfolio right here is where there are two schools of thought about they really are like theories of change if you want to go back to like the true roots one

set of ways to engage is to align yourself with global protocols that have all already been established and you want to map yourself to companies that are following those global protocols doing as much as they can to kind of hold up emissions would be like a simple example so lower emissions or lower water use or improve clean water in their operations etc the nice thing about that is those global protocols are explicit and they're standardized and they're measured and many of our metrics match pretty well to them so if you're looking at a big global company it's a pretty legitimate a pretty fruitful analysis to see. what they're doing and to be able to compare it against peers. So it's analytically very satisfying, right? You feel like you're not making too many big leaps of judgment. So that is terrific. And that is a big part of what's behind. We have two portfolios at Putnam. One's called Sustainable Leaders. And that's the kind of activity we want to look for in leaders, exactly what the name implies. There's a second vector, though, and it's one that is not only necessary for truly resilient and robust climate. It's also very appealing to a lot of investors and I think might have even more return potential. over time. And that's this idea of solutions-oriented companies. So companies where the essence of what they're doing is actually solving an issue related to our climate. And so they're not managing their own emissions down. They're actually helping everyone else manage their emissions down. And I mean, I'm a mid-cap growth investor at heart. And so this just sings to me. And it's also a very American point of view, I've noticed. When I talk about this idea to investors in Europe, they're like, oh, interesting. When I talk about it to Americans, they're like, yeah, let's fix it. You know, it's a much more more enthusiastic entrepreneurial kind of zeal that's behind it. So you need both of these things. What's interesting when it comes to kind of the bureaucracy of ESG and the data we were just discussing is some of those solutions-oriented companies. might not look very good on those third party metrics. You know, they're smaller companies. They don't have a whole team managing disclosures. Their goal is to get more of their product out in the world because it's actually got this gigantic positive ripple effect. So there's a little bit of tension there. This is really interesting. So it feels to me in the ESG world, like my fear is that it's become a lot of box checking.

And to take like the UNPRI as an example, so this is something that asset managers signed saying that they're, I guess, mindful of or aware of ESG considerations in their process. And I fear this is something, for example, that we're considering signing as an asset management business. And when you look at some of the firms that have signed this, I won't name any of them, they're not ESG firms. They tend to be huge firms that it feels like a box to check because more and more allocators are asking the question. Have you checked this box? That just always scares me. It's very surface level and move on to the next, cover your, you know what, and that's it. So I guess I'm trying to tease out what is box checking versus what is really productive. One of the, in Sustainalytics, for example, when we analyzed that data set, one of the biases we found heavily was a market cap bias that like just bigger companies get better scores because. To your point, they have more time and resources to check boxes. And when you unwind that, maybe the solutions-based approach is the ones actually making a difference. So talk about box checking. I'm so glad you brought it up because this is at the heart of most of my day now. And again, I think an and approach as opposed to either or is probably helpful here, but it's really important to keep them separate. So there's a long list of protocols and procedures and governance for our own industry that has to relate to the PRI and other. fiduciary elements that, you know, occasionally appear to be in conflict, but mostly are congruent. That's very separate from the investment-oriented arguments that we just were making. And so they have the same terminology. Sometimes they use the same data, but it's towards very different ends. And again, it's not either or. I think there is a real benefit to institutions like the PRI, Putnam's designatory. But when we're answering those questions on behalf of... Putnam as a whole were answering along the lines of, tell us about your proxy process. Is it really responsible? Do you actually pay attention to it? Do you do your own voting? Do you have ongoing communications with companies? Do you promote ongoing good stewardship of the companies in which you invest? The Larry Fink BlackRock proclamations have gotten a lot of press along these lines for that same reason. The whole goal of the PRI is to promote a healthy, ongoing business and financial system, which is totally necessary. I'm 100% for it.

has very little to do with actually generating incremental alpha. And so the two can happily coexist, but they're not the same endeavor. And so you can have a firm that is completely, wholeheartedly endorsing the PRI and doing everything that they can and should do under that framework. It may or may not have anything to do with their ongoing alpha generation. You can easily be aware of ESG issues as part of your process, but not actually incorporate them. And if you didn't think they were valuable... I would argue maybe you shouldn't incorporate them. So it sounds like we probably have more data, or we know we have more data, having looked through Sustainalytics, for companies on that side of the ledger that are good practice companies versus solutions-oriented companies. So talk about the data. on the solution side? Is it younger? Is it harder? Sounds more interesting maybe because it's harder. Talk about that side of things. It's all the above. It is younger. It is harder. Pretty often the data for solutions-oriented companies really is that granular fundamental level analysis. Yeah, you got to roll up your sleeves and really understand how is this flow control valve different from the other one and do I really think it's better? Is it actually improving water quality? You have to roll up your sleeves and understand the mechanics of HSA accounts and like, is it actually a good idea for most people to have? them or not. So I like that the two kind of come together. Again, you've got some external data and protocols and themes that you know are important for the world and have outsized benefit in different dimensions. That's always been a great way to find investment candidates, but it's the really granular fundamental work that constitutes the impact for most of those companies. So let's stick with the mid-cap growth solutions oriented basket, which sounds fascinating. If you think about it in terms of just where return comes from and also where alpha comes from, let's lump dividends and buybacks as sort of reinvestments and fundamentals and sort of per share growth and ownership. So now you've got fundamental growth of the business and you've got equity re-ratings as your two sources of return and therefore of edge. Where in those two buckets do you envision this manifesting? Is it one more than the other? Is it both? It could potentially be both. I mean, obviously in the best scenario, you'd get all the above, right? You get paid twice. And I do think there's some rationale for that. So for example, I lived in London for a few years and I got my first water bill in London.

It was as much as my mortgage had been back in Boston. And I was just one person like taking an occasional shower. Like it was nuts. And then I went back to my Boston bills just to make sure I wasn't going crazy. It was like $6. And so this idea that here you have something in theory, it's a commodity. There's plenty of water in Britain. I mean, it rains every day. But the price for that was really different. And so the businesses that attached to that were increasingly valuable. You know, you save 10 gallons of water in London, you can actually see the difference much more clearly economically. So that would give you... you, in theory, some of each, right? So it's that same economic flywheel that would re-rate your securities over time and also re-accelerate the underlying business. In terms of mispricing, it's kind of the same question, but alpha comes from the market's mispriced something because it doesn't understand it or it's overreacted or whatever the behavioral reason is. Any thoughts there on why maybe the market doesn't appreciate, if this is an alpha, let's assume, plant the axiom that this is an alpha opportunity in the way you've described it. Why has the market not recognized it? Yeah, there's a couple reasons, I think. One, it is really hard and an awful lot of the work is still in that it depends category, which for an awful lot of investors these days is either something they can't do given their own process and resource base or don't want to do because they want to have something that is completely consistent and explainable. And that goes against the it depends kind of approach. The other element runs a little deeper, but I think it's... almost as powerful, maybe even more powerful, and that is there are so many folks who have come up in the industry through a very rigorous Chicago school-style training, all of which is hugely valuable, but they've taken it to be a religion instead of a set of tools, and it's really hard to free your mind and think that there's something you might not be able to measure so precisely today that's actually going to constitute the majority of your long-term return. That's a deeply uncomfortable and kind of threatening thing to posit. And so I'm really into it. That fills me with joy, that statement, but I've noticed for a lot of people that is not okay. Can you talk about the investor side of this? So we've noticed a very large wave of interest and demand for strategies which take ESG into consideration or impact in some way, shape, or form in one of the ways that we've described today. What's your sense for that LP, let's call it interest?

today versus last year versus five years ago versus 10 years ago. So how and why is it changing? There's been a pretty big shift that is more visible just this last, I'd say, five years or so. If you look at the aggregate numbers on anyone's surveys or polls, there's a nice step. up and to the right, almost every demographic group, especially pronounced for women and millennials, which is a key strategic focus for a lot of investment firms. So there's a handy alignment there. But what I'm seeing underneath that kind of high-level statistical summary is a little bit of a difference in how folks are even considering the question. Until pretty recently, the question came with a very strong supposed cost that went along with it. Like, so do you want to do this thing enough because it's riskier and it might hurt you? And even if that wasn't said, it was clear if you read the things people would say, it was clear in the underlying rolled up data when you saw the aggregate numbers. What I see now, again, particularly as we're seeing this kind of shift in the composition of who's being asked, is much more of a systems thinking kind of mindset. This idea that I want something that is... truly profitable, not like cheating a little bit. And this just much more pervasive general acceptance that a business that's going to be healthy in five or 10 years is the one that's actually taking care of these things that are really important in the short term as well. So it's going from a very zero-sum mindset to a little bit more of a systems thinking mindset. And that's a fuzzy thing to mention, but I think it's actually the most... powerful thing that's shifting under the surface. Because once you start thinking of this all as a very matter of fact, like, I want to understand the whole puzzle, and this is an important piece of the puzzle, then a lot of other things become possible. Any other thoughts on different groups of allocators or types of investors and how they're making the decision to invest? the ESG way. So I'm thinking here of like families or individuals versus corporate boards or versus public boards and kind of what matters to those different constituencies. I'm a little worried about one dimension, which is, and a lot of firms are wrestling with it right now, the question of whether this should be treated as a separate asset class or a separate allocation decision. Is it like a tiny slice of a much bigger pie?

ease of functioning a lot of folks have set it up that way right so here's your main pie and if you're really lucky when you find something really great we'll allocate this like as an exception to your main pie and that's true across individuals institutions really across the whole that makes sense if you think this is purely an opt-in values-based decision only. It doesn't square at all with the idea that this might have terrific return potential. If you actually think this has good return potential over time, you should be considering it. across every decision that you make as one of many factors. You're starting to see some of that with some advisors very geographically split, I'd say, in terms of where that mindset has taken hold. The institutional setting is pretty split, not just by type of institution, but also geographically. The Department of Labor has given some advice in the U.S. that is easy to interpret as highly cautionary, although... I think it's a very matter of fact advice. And that has kept a lot of institutions in the U.S. leaning back in these conversations. Whereas in Europe, it's almost the opposite. It's kind of a requirement. Could you use a couple, maybe it could be individual companies or just more generically speaking of. interesting best practices that you've seen at businesses, sort of at the frontier of trying to make an impact through these means? Just to give us some examples of things that companies out there might consider doing themselves. One thing we look for in the fundamental process, and again, the question is investor specific too, like what can we add at Putnam to this whole process? The thing we can add the most on is fundamental insight, you know, and that kind of granular work that complements the bigger data set oriented analysis. One thing we always look for, therefore, is their alignment between the data we see and the way people are describing how the business is actually run. So, for example, we had a company in a couple weeks ago, and they're known for having a really strong internal management system. So legendary. It's 40-plus years in the making now. Everyone internally knows all the acronyms. All their investors know the acronyms, too. Slightly cult-like, but very, very effective. And they've used it to manage first their manufacturing processes and then...

their sales and growth opportunities. And what is the newest for them just the last two years or so is they're using the exact same system to look at internal talent development and ongoing employee well-being. It's super cool. So the thing that excites me there is... One question we always have is the question you ask, like, are you checking the box because you think this is just a necessary thing, or do you actually think this is a valuable thing? The fact that they're taking all of their internal S issues, all of their human issues, and using the exact same framework that everyone is already completely devoted to for the rest of the business for these issues shows you they think this is a real business issue. They're managing it the exact same way. People are getting paid for training in this regard, just like everywhere else. We had a similar conversation on board composition with a big defense. contractor and I they have a shockingly diverse board and I asked them you know how'd you do this every other company that has a technical expertise says they can't find the right people and you know what was me there's only three female generals ever in the history of the world and they had none of those complaints and the way they described it was completely as an engineering project so this was our goal this was our process we met every six weeks here was our data here's how we processed it here's how we did the outreach like it was a very very fitting way to approach it, given the way that they run the whole rest of their business. So we look for that kind of alignment in a great way. Another element that is often overlooked is the S in businesses where you think it might not matter as much. So we spent a lot of time with a bank out in the West Coast last year. They've always talked a lot about internal culture. Everyone kind of yawns when they mention it on the conference call, like they know they have high expense rates and they assume they must spend it on something worthwhile. But like, that's it. Nobody ever asks. So we spent a few hours with them doing nothing but talking about, like, what does this actually mean in practice? Like, walk us through examples. And I was the CEO and the COO and the CFO, and they were so happy we weren't asking about net interest margins. They're jumping up, they're pulling other people into the meeting, they're telling us stories. And sure enough, you know, the six months after that, they had this terrific loan growth. And when they describe how they got that loan growth, almost all of it is coming from people who have been with them more than 10 years. And so if they didn't have this great culture, that was also keeping people.

in their seats, they wouldn't have had this loan growth. And so the analysts are all happy about the loan growth, but they're not asking about how it actually occurred. They're just thinking it's luck and it's not luck at all. Two thoughts. One that you're getting at the source of certain outcomes. maybe your source of edge that maybe doesn't show up purely in data. And the second is, you said it earlier, if you have an ESG team off to the side, it doesn't work. It's got to be integrated in like some root level of the business. I think that's a great takeaway that, by the way, the same thing happens when you try to tack a quant team onto a fundamental team. You know, they do great work and then it gets ignored. So it's got to be cultural almost that it's in the bedrock of the business and the system. Exactly, exactly. And if it's not, that's okay, but then you should admit. this is just a compliance function and it's over here, you know, or it's complimentary, but it's not actually part of the process. Just to touch on environmental one more time, any further thoughts there in terms of unique or interesting tacks that you've seen companies take? And, you know, I said climate change is one that we hear or are asked about maybe the most. What are the other... big issues that you see under the E silo? On the E front, there's a lot of work that's done on emissions, which is valid and terrific. One other theme that we look for across all sorts of issues is this idea of leverage points. So there are a lot of things that are... small proportions of a total system, but they have huge outsized impacts. So in emissions, for example, methane is somewhere around 80 times as damaging to the environment as CO2 emissions. And it's also from a very identifiable small subset of sources. So you could actually eliminate methane if you wanted to. a way that's not nearly as overwhelming as thinking about eliminating CO2. And it's also trackable. You can see it with infrared imaging. There's all kinds of attributes to getting at methane. And there's an economic incentive. Most of it's coming from leaks. Most folks would prefer there weren't leaks. Everyone's happy. Win, win, win. So in almost every sub-issue under ESG, there's something like that where you could get behind a few specific solutions or a few specific activities that had this gigantic impact and also positive economics associated with it. So we're always looking for that. So methane would be one example of that in the environmental arena. Another element in environmental that is behind overall air quality.

But I think just as important over the next 10 plus years is just basic raw materials and especially like rare earth materials. Here you've had some really ambitious things announced by companies that have mostly been met with a big yawn. So Apple, two years ago now, announced that they not only wanted to make all their products recyclable, but that they want to only use recycled materials, no new materials, within a shockingly aggressive time frame. I think it's 2030. That's unbelievable. And again, most analysts like ho-hum, you know, so are unit growth slowing in China or what? Like, OK, I know unit growth in China matters, but this is like a world changing and change everything about their whole process. Right. So if you listen to that, you might have been less surprised that they started offering more and more recycling incentives. You might have been a little less surprised that they started talking so much more about their services business. You're getting these clues that are linked to environmental challenges and benefits that ripple out in some surprising ways in different businesses. If you had to choose somebody that would give you the best debate where their view is as opposite to you as possible, meaning like ESG is a massive waste of time, who comes to mind? And this could be a best of the worst, you know, in your view. Maybe it doesn't even need to be a person, but it could be just a general position. So, you know, I said earlier, like complex systems are hard. How the hell do we know any of this actually works? Maybe that might be one straw man. But I'm curious your take on the other side of this endeavor. Usually the other side has to get at the root that we've been talking about so much here, which is this bridge from thinking about them only as value judgments to ongoing business issues. Once that bridge is crossed, it's usually semantics, but you can kind of get together on that. That's usually where there's a fork in the road. And if someone's gone way down the fork of thinking this is only ethics and values and has no link back to the world, it's a difficult conversation. But I would just argue them with my Divinity School hat on. when in the history of time have values and judgments not ended up affecting our world. It's all the same. What to you right now is the most interesting edge of all of this? So we've talked about each of the major categories, how you think about businesses, why this might lead to alpha, all these really interesting ideas. What has you kind of most interested in the field today? Well, we talked a lot about the whole range of S being kind of this wide open space. And one reason I'm spending so much time on that is

I think in the end, S actually is what ends up determining the E and the G as well, right? If you have people who are taking this more systemic, more holistic, truly long-term look at their own business endeavors and the implications that they have across everything that they touch, you can't help but see the whole thing come together. If you had to draw a quick playbook, let's say, for business managers out there listening, I think a lot of people listening do run businesses. How would you suggest, if they're thinking about this for the first time, they approach that S? What are the best practices for beginning to wrap their minds around this, the kinds of things they could do down to the tactical level? I'm really interested in this idea as well. It's a neat set of questions. I find that a lot of folks who are running businesses are a little bit stuck in the report card mentality that we mentioned before. So they get a bunch of surveys. They have to fill them out. It's almost always unpleasant. It doesn't seem that relevant. Again, to switch from that mindset and to tell me what's important to your business is thing number one. What I find is a lot of folks, even if they understand the importance of this S set of issues to their businesses, they don't have such great indicators either most of the time. And so I've been trying to ask gently but firmly a little more detail. Like you said, employee morale is high. How do you know? What are your indicators? And sometimes they're really soft indicators like, you know, parking lots full Friday at 6 or maybe that's a contraindicator. I don't know. Sometimes it's tone of inbound questions they're getting. But more and more you're seeing companies. even at a smaller size, institute some ongoing, really simple indicators so they have more of a longitudinal view of that so they can see like, okay, every time we change sales incentives, there's a big disruption in our satisfaction, but this is normal and we need to do it and onward we go. So sometimes that surveys, sometimes it's retention rates, sometimes it's data on recruiting, who's coming to them without being asked to come to them. I think recruiting is one of the easiest things to monitor because you're getting that sort of front end.

who's attracted to your company from the outside. Any thoughts on like measurements versus principles or values? So you mentioned this kind of check the box mentality. I always love that Peter Drucker idea that what you choose to measure then gets managed and improved. So it's important what you measure. But then you've got the maybe the more flexible like values based approach. So I think of Amazon's like leadership principles as one example. Like here's 14 things that you talk to someone at Amazon and they speak that language. So it's not things that they measure. It's more just like the root level. or philosophy that they put in place. Any thoughts on that as a way of impacting S? I do think there's a happy medium. I mean, if I had to choose, I'd choose the principles myself. They're inherently, you know, back to biomimicry, they're inherently more adaptable. They're inherently better designed to begin with, right? Simple, elegant principles. But there is a real power in marrying those principles with relevant metrics. and letting the metrics evolve over time as well. I find that the danger with metrics is a lot of folks skip the principles, go right to a few key metrics, and then they clamp onto those metrics, even though they're just telling a small, small piece of the story, and they might not tell you anything at all you care about five years from now. And that's where, I mean, the whole field actually is stuck in a little bit of tension there. We want to solidify our metrics as soon as possible. We want to be able to have these great longitudinal empirical studies. But I want a whole different set of metrics five years from now than what we have at the moment. And so there's a push and pull there. Any advice to me, selfishly as a quant, where everything we do is going to have a systematic component to it, even if there's always room for subjectivity in determining a metric. But any advice to me and our team as we think about trying to be a valuable player in this ecosystem with the backdrop that... We're just skeptical by nature and we are empiricists. Like we like to see evidence of stuff, which I acknowledge can be limiting for sure. We've talked about a lot of the ways why, but any advice if, you know, we're trying to be value add here to us as we gather data, where we look and how we analyze it. There's so much to be done. I'm super excited. There's in some ways even more to be done on the quant side than on the fundamental side because it's a new set of explorations and links. So you've talked a lot in different settings about

linking data in a different way than it's been linked before. And sometimes the insight or the value is in the combination of different factors that you're looking at. This field is just wide, wide open for that. Even the thoughtful work that's being done now is pretty narrow and it's... pretty much determined by this small set of metrics that we have right now. So you're already looking at a much wider set of data than most people are to be creative about that and say, hey, we've got this issue over here with like a half of a metric that we think is kind of good. What else do we have that might somehow be linked to this same issue? Ooh, that's super cool. I will say like by far the most fun is having a high level issue and then building a deeper data set. beneath it using the fancy, like this is where machine learning and classifiers and all that stuff becomes super useful, not for predicting returns, but for building more nuanced, unique data sets. Exactly. And these are the questions we've got, right? Really fascinating. Yeah. If you had to name the most memorable encounter that you've had with an individual company through the lens of ESG thinking, what would that be? One of the most memorable was a meeting where it was exactly the kind of skepticism we were talking about earlier. We asked the CFO, a couple of very open-ended, sustainability-oriented questions. And he just went, oh. And he leaned back. He's like, those ESG people, if I see one more survey, I'm going to go crazy. And this was after two hours of talking about nothing but internal development, their new product line that had these huge environmental and efficiency benefits. And so we gently kind of pointed out, like, actually, the whole meeting has been a sustainability meeting. I'm not sure you noticed. And you could just see this switch. He's like, oh, that's what you're doing? Awesome. Then we can talk. So that really stands out. Any closing thoughts for people that are interested in this topic, whether it's content or people to seek out to learn more? We mentioned a few of the organizations that are really helpful. From an investment standpoint, I really can't say enough about the SASB framework. You can always critique a big framework like that, but it is a great roadmap that hundreds and thousands of people have worked on for a long time. Whether you're a quant or a fundamental investor, there's a lot there to work with in terms of just thinking about what

some of the more important questions are. And then if you're an individual investor or an institution who's working with any form of intermediary, I would just encourage you to keep asking the questions if you're interested in this area. There is a pretty big gap, about 70% to 80% of end investors, of wealth owners. are interested in at least learning more and taking some form of action in this arena. And only about 15% of intermediaries are feeling equipped to take that action on their behalf. And so there's a gap there that we can continue to fill up. One question I realized I didn't ask before, and I know you're a fan of bottom-up processes. A lot of what I loved in the book was that exploration of the stability or resilience of systems, which are bottom-up systems. So the question is, how much of a role you think regulation plays, which is a very top-down thing in the future of sustainability at businesses? Do you think that there's a role for it? Do you think there's a better bottom-up approach to better long-term outcomes? How do you think about regulation? Yeah, you've identified my own bias pretty clearly. I always, both as a person and as an investor, want to be... betting on things that don't rely on regulation or really any kind of top-down action to work. Having said that, there's some really clear priorities for the world that I don't think are that controversial. You know, who doesn't want human flourishing? It's sort of hard to be against that. And there are a lot of ways that thoughtful policy can advocate for that. Many investors put policy first in terms of their own advocacy agenda, and that is not the case for me. But if and when it comes, I'm glad to use it. We'll bookend the conversation with a little bit of nature. So beyond beekeeping, any closing thoughts or lessons from your deep exploration of natural systems, not just for applying to investing, but for applying to life? Any big ideas that you think would be interesting to leave people with from your exploration of the natural world? It's funny. If you ask people what their favorite place is, Pretty close to 100% will name a place that's outside. And if you look at how we spend our time, it's over 90% now in the U.S. is indoors. So there's an interesting backdrop there just to think about. And so one thought would be just...

Go outside. Like whatever it is, just go outside. And if you do that with this mindset of curiosity and observation, instead of thinking of nature as like a storehouse where we get stuff, you know, to think of nature as like the biggest, greatest library we ever could possibly want. I mean, you can't help but find wisdom there. Not just data, not just information, but like true deep wisdom. I love that. You know, I agree with that one. My closing question for everybody is for the kindest thing that anyone's ever done for you. Oh, that's such a neat question. Can I give you two? Of course. All right. I have a strategic one and a tactical one. I was so lucky to be born into my own family. So my parents gave me these two roots. You know, we'd go to church every day when I was little. deeply set. And then we'd go outside all the time. Every weekend we were down at the creek, we'd go see the hawks migrate. It was just a normal part of life. And it's only later in life I'm realizing how important those two roots are for me. A lot of folks don't have either at this point, and so in my case, those have been the roots that have seen me through the toughest times. And then on the tactical side, we're both also great readers, and I do think of books as actual living friends sometimes, like a little bit over the top. A friend of mine, when I was moving and starting my job at Putnam and had a bunch of other changes in life, made me the most amazing gift. It's a big jar, and in the jar are quotes from all my favorite books in the world, so that every day. I can open up a quote and start the day with a friend. Pretty phenomenal. It was awesome. That's a lot of work too, I'm sure. Yes. A very kind thing. Well, this has been really great. I learned a lot more even than I expected to about ESG and impact investing. So big topic and the first time we've explored it in detail here. So I appreciate the thoughts and the time. Terrific. Thank you. Hey everyone, Patrick here again. To find more episodes of Invest Like the Best, go to investorfieldguide.com forward slash podcast.

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