In Paisley 80 years ago, a woman became ill after being served ginger beer from a bottle containing a decomposing snail. The ensuing claim for damages resulted in a lengthy legal process resulting in success for the claimant. This precedent created a legal risk associated with poor quality service and forms a foundation of our modern concept of ‘duty of care’ owed by enterprises to their stakeholders. It has guided how businesses operate and partly explains the explosion of disclaimers we see in everyday life. It all started with a snail.

The snail in the bottle case highlights how abruptly sloppy or questionable business practices can become a legal liability for a company. This gives rise to risks for investors such as, the enterprises exposure to compensation claims, or how changing practices impact on the future earnings and viability of the company. Understanding and managing these risks as they evolve has always been a part of investing and nowadays we classify them within ‘ESG’ risks (Environment, Social & Governance).

The inquiries being made into Facebook and Australian banks are current examples where ESG risks have come to a flashpoint where precedent, regulation and legislation could shift the playing field for these companies. The implications are stark. We believe Facebook’s capacity to collect and monetise user data is integral to its financial model, creating a high stakes gamble on the regulatory and legislative responses. In Australia, investors must grapple with multiple and meaningful repercussions if it is found that mortgage lending practices have not been compliant with responsible lending obligations.

We believe it would be a mistake to infer that the growing focus on ESG means these risks were previously ignored. Successful Investors have always needed to understand the sustainability of the businesses they own a share of. We believe fundamental bottom up research remains an effective way of monitoring these risks. The basic steps might be; trial the product, visit the operations, question management, think about who the customers are and whether they are getting a fair deal.

Taking these steps to understand the basic operational procedures of a business will frequently uncover issues which quantitative analysis alone misses. We give some examples below where we see some ESG risks (despite the unpredictability in understanding how society / government will address these issues). For example, do social networks really believe and expect a new member will have read and understood the lengthy and complex terms of their user agreement? Is it reasonable to expect that a foreign, non-resident consumer of a health / nutrition product which was sold at an Australian supermarket (labelled for use by an Australian resident), will read the packet’s product safety directions written in English? Are point of sale finance customers adequately warned about the negative implications of an impaired credit history?

ESG risks evolve over time, they are not always predictable and sometimes it can take years before a business is forced to cease unsustainable practices. However, when they are manifested the impact on investment returns is often meaningful. We believe managing ESG risks is not as simple as excluding certain industries or ticking certain boxes. Instead it requires qualitative analysis, understanding the product/ services a business provides, and taking a view on management teams governance frameworks and stakeholder alignment on a case by case basis.

Further insights

NovaPort is a boutique Australian equities investment manager specialising in small and microcap ASX-listed companies. Find out more insights from the team here