On May 17, 1984, Warren Buffett gave away the secret that has made his face the first result when you Google “the greatest investor of all time.” He opened a speech with the stories of ten investors, including himself, whose portfolios consistently outperformed the S&P 500. It’s no coincidence, Buffett insisted1, that their careers shared a common thread: tutelage under Benjamin Graham, who, as it happens, is the second person who comes up in the Google search.

Graham is regarded as the father of value investing, an approach simply defined as buying stock in companies that are worth more than they’re currently valued. In Buffett’s speech, that self-evident definition—Graham’s core teaching—was the anticlimactic reveal behind his success, which has ballooned to a net worth of $65.1 billion as of July 9.2

“I can only tell you that the secret has been out for 50 years,” Buffett said in the speech, commemorating the 50th anniversary of the publication in 1934 of Graham’s seminal book, Security Analysis. “[Y]et I have seen no trend toward value investing in the 35 years I have practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult.”

Essentially, Graham argued that you shouldn’t try to predict the future. What separated investors like him and Buffett from the rest of the pack was their refusal to speculate. He pointed in particular to the price-to-earnings ratio, one of investors’ favorite metrics, as a good barometer to help understand the value of a company. Under most circumstances, he argued after analyzing P/E ratio data between 1871-1970, anything with a ratio above 16 was simply speculation.

Nonetheless, in the decades that have passed, the mainstream reading of a P/E ratio has yet to fall in line with Graham’s reading; as of July 9, the S&P 500 as a whole has a P/E ratio of 20.053, and the Internet and software services industry has reached a jaw-dropping ratio of 556.4.4

Perhaps more than any other5 metric, the P/E ratio has emerged as a prime symbol of how investing is equal parts art and science. To some, it’s the tealeaf that determines a company’s fate more than any other. To others, it’s almost meaningless6. But whatever your school of thought, the measure has survived endless debate over its merits for the good part of a century, remaining one of the most trusted staples for how we value companies.

(ARTICLE CONTINUES AFTER INTERACTIVE)

INTERACTIVE INSIGHTS

THINKING BEYOND FINANCIAL CAPITAL

With limited information about natural, human, and social capital, integrating sustainability into valuation can be hard. Asking the right questions is half the battle.

Use our interactive tool below to
find out the right questions to ask.

  • Questions for
    the Utilities Sector

  • Questions for
    the Beverages Sector

  • Questions for
    the Tech / Hardware Sector

Utilities

NATURAL CAPITAL RISKS & OPPORTUNITIES

  • Carbon
  • Water
  • Environmental Impact
1

What percentage of your revenues/generating capacity comes from renewable sources of energy?

2

Are you developing products or services that help customers improve their energy efficiency?

1

Do you quantify the cost of water savings?

2

Does your business provide solutions for other companies or individuals wanting to improve their water consumption efficiency?

1

How is environmental legislation affecting the company's business?

2

How much do you spend on environmental matters, in terms of expenses and capital investment?

HUMAN CAPITAL RISKS & OPPORTUNITIES

  • Health & Safety
  • Employees
1

How do you ensure your contractors work to the same standards required of your employees?

2

What is the occupational incidence rate within your company?

1

What is your employee turnover rate?

2

Do you have an annual employee engagement survey? Do you publish the results?

SOCIAL CAPITAL RISKS & OPPORTUNITIES

  • Supply Chain
  • Cyber Security
1

What checks do you make before ordering from a new supplier?

2

Do you publish a list of suppliers? How many suppliers do you use? Do you disclose the location of your suppliers?

1

Have you ever experienced a cyber attack? If so, what was its financial impact?

2

How much has been invested in security technologies?

GOVERNANCE RISKS & OPPORTUNITIES

  • Corporate Governance
  • Tax
  • Ethics
1

Is there a long-term incentive plan (LTIP) for senior management. If so, what are its criteria?

2

What percentage of board members is independent?

1

What is your internal decision-making process for tax structuring?

2

Is tax planning discussed at the board level?

1

How do you define your company's culture?

2

What policies are in place to prevent bribery and corruption?

Beverages

NATURAL CAPITAL RISKS & OPPORTUNITIES

  • Water
1

Do you quantify the cost of water savings?

2

Do you operate in regions where water scarcity is an issue?

HUMAN CAPITAL RISKS & OPPORTUNITIES

  • Health & Wellness
  • Employees
1

Do you see a risk of government intervention to reduce the amount of sugar in products?

2

What proportion of your portfolio is exposed to unhealthy beverages?

1

What is your employee turnover rate?

2

Do you have an annual employee engagement survey? Do you publish the results?

SOCIAL CAPITAL RISKS & OPPORTUNITIES

  • Supply Chain
  • Cyber Security
1

Would your customers be happy to pay more for local sourcing?

2

Do you have traceability procedures in place?

1

Have you ever experienced a cyber attack? If so, what was its financial impact?

2

How much has been invested in security technologies?

GOVERNANCE RISKS & OPPORTUNITIES

  • Coporate Governance
  • Tax
  • Ethics
1

Is there a long-term incentive plan (LTIP) for senior management. If so, what are its criteria?

2

What percentage of board members is independent?

1

What is your internal decision-making process for tax structuring?

2

Is tax planning discussed at the board level?

1

How do you define your company's culture?

2

What policies are in place to prevent bribery and corruption?

Tech/Hardware

NATURAL CAPITAL RISKS & OPPORTUNITIES

  • Carbon
  • Water
  • Waste
1

What percentage of your sales is from products that provide process automation/energy efficiency?

2

How are your products exposed to the theme the Internet of Things?

1

How do you monitor the impact of your water use on surrounding communities?

2

Do you operate in regions where water is scarce?

1

Do you have take-back or recycling programs in place?

2

Do you consider the end-of-life as part of the R&D or design process of your products?

HUMAN CAPITAL RISKS & OPPORTUNITIES

  • Employees
1

What is your employee turnover rate?

2

Do you have an annual employee engagement survey? Do you publish the results?

SOCIAL CAPITAL RISKS & OPPORTUNITIES

  • Supply Chain
  • Cyber Security
1

What are the financial implications of compliance with Dodd Frank legislation requiring transparency on conflict minerals?

2

What checks do you make before ordering from a new supplier?

1

Have you ever experienced a cyber attack? If so, what was its financial impact?

2

How much has been invested in security technologies?

GOVERNANCE RISKS & OPPORTUNITIES

  • Corporate Governance
  • Ethics
  • Tax
1

Is there a long-term incentive plan (LTIP) for senior management. If so, what are its criteria?

2

What percentage of board members is independent?

1

How do you define your company's culture?

2

What policies are in place to prevent bribery and corruption?

1

What is your internal decision-making process for tax structuring?

2

Is tax planning discussed at the board level?

OTHER SECTORS

Environmental, social, and governance (ESG) factors present certain risks that companies need to manage in an appropriate way. Failing to act in a sustainable manner now only stores up financial risks that may need to be paid for at a later date. But these challenges manifest themselves differently for every industry.

AEROSPACE
AIRLINES
AUTOMOTIVE
BANKS
BUSINESS SERVICES
CAPITAL GOODS
CHEMICALS
CONSTRUCTION
FOOD PRODUCTS
CONSUMER - HPC
DIVERSIFIED FINANCIALS
INSURANCE
LEISURE
LUXARY GOODS
MEDIA
MEDTECH
MINING
OIL & GAS
PHARMA
PROPERTY
RETAIL - FOOD
RETAIL - GENERAL
SOFTWARE
TELCOS
TOBACCO
TRANSPORT

The trouble is, quite a bit has changed in that time. As the economy has evolved, particularly in recent years, we’re still valuing a more diverse marketplace of companies in a new business landscape with much of the same financial criteria that we did in Graham’s era. It’s still an open question whether the analysis translates clearly to valuation in the Digital Age. Meanwhile climate change is forcing legacy companies to deal with how existential questions such as automation and the global supply chain are reorganizing entire industries.

While the P/E ratio and other traditional metrics—company accounts, industry dynamics, and politico-economic outlooks—have served us well in the past, they’ve always served only as an imperfect, but the best available, map to navigate the ever-shifting seas of the stock market.

With the new complexity of the 21st-century global economy, we’re now finding that map to be more incomplete than we ever knew. And a growing field of research is finding that in the long run, corporate financial performance is tied to a wide array of factors—environmental, social, and governance (ESG) factors—that fly under the radar of the tools we’ve grown accustomed to using.

In recent years, financial journals have published studies suggesting the following: that companies with higher levels of employee satisfaction outperformed the market by 2 to 3 percent per year (Edmans, 20117 ); that companies with clear environmental and social goals had share prices that outperformed those without those goals by 47 percent between 1993 and 2010 (Eccles, Ionnou & Serafeim, 20128 ); and that companies with better resource efficiency saw financial performance improve in sectors including food products, specialty chemicals, pharmaceuticals, automotive, and semiconductors (McKinsey & Co., 20149 ).

“Sustainability […] is often seen as a luxury investment or a public relations device,” wrote Sheila Bonini and Steven Swartz in a McKinsey & Co. report titled “Profits with purpose: How organizing for sustainability can benefit the bottom line.” “We think that view is cynical and increasingly untenable. […] Sustainability is a long-distance journey; the evidence is growing that it is one worth taking.”

Despite the growing chorus, Bonini and Swartz found that just one in five companies have a long-term sustainability plan—even though investors are increasingly demanding it. As of last year, research from The Forum for Sustainable and Responsible Investment10 shows that sustainable investing strategies have increased 76 percent since 2012—with $6.57 trillion in assets under management in the U.S. alone. Still, there’s room to grow: A recent poll from the corporate reporting firm Radley Yeldar11 found that less than half of all investors said that human capital, natural resources, and community and social capital were very relevant to their investing decisions.

According to financial experts from Morgan Stanley, the challenge may be that “sustainability” as an idea is still tied to the usual suspects of unsustainable business practices: oil and gas, mining, and other extraction companies. While those industries have obvious downsides to not addressing sustainability, the new body of ESG criteria research has proved that those risks—and their associated opportunities—are no longer limited to them.

A 2015 equity research report by Morgan Stanley titled “Embedding Sustainability Into Valuation12 analyzed 29 sectors—from aerospace to utilities—through the lens of sustainability. Its authors concluded that there are certain ESG factors, such as corporate governance and employee satisfaction, that apply to business universally, but that, for the most part, companies and their investors need to wrestle with material sustainability issues on an industry-by-industry basis—often in unexpected ways.

For example, other industry analyses have noted that in a world where more people have access to cell phones than to clean water13, the semiconductors that fuel these gadgets require water-intensive manufacturing processes, using as much water as a small city14. Semiconductor manufacturers have found that by implementing renewable water systems, they have cut costs in ways that are good both for both business and the environment.

Meanwhile, as the U.S. deals with an obesity and diabetes crisis, beverage markets find consumers shying away from sugary drinks, forcing companies to adapt the products they already sell, while also opening up opportunities for new markets that answer rising demand for healthy and organic products.15

Fortunately for investors, momentum is building to provide them with the data they need. As of 2014, according to the Forum for Sustainable and Responsible Investment16, one in every six dollars invested in America is invested sustainably. Investment analysts expect the trend to encourage more companies to disclose more relevant data—and more investors to ask for it.

“It’s a little bit a chicken-and-egg problem in that for the companies to start disclosing more, investors need to show more interest in these ESG factors,” writes Usman Hayat of the CFA Institute. “And investors (at least partly) often show more interest in cases in which there is data to work with.”

Combined with the tried-and-true traditional metrics, the new metrics of sustainability are proving to fill in some of the gaps they fail to capture. A report from the Morgan Stanley Institute for Sustainable Investing17 recently showed that, over a seven-year study, sustainability-focused mutual funds had equal or higher returns and equal or lower volatility 64 percent of the time compared with traditional funds. As more evidence continues to emerge, and with more data to better understand companies’ sustainability efforts, investors can get a more complete image as they value their investments—and potentially better returns in the long run.

Sustainable investing is still growing and its practices are still evolving—from the emergence of green bond markets to the convergence of sustainability reports and annual reports. Like all measures of valuation, it will be subject to different interpretations and lead people to different conclusions.

But everyone can agree that with new tools come new opportunities. And as Benjamin Graham, the father of value investing, once said about opportunities: “One must have the means, the judgment, and the courage to take advantage of them.”

This material has been prepared for informational purposes only and is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Morgan Stanley Smith Barney LLC and Morgan Stanley & Co. LLC (collectively, “Morgan Stanley”), Members SIPC, recommend that recipients should determine, in consultation with their own investment, legal, tax, regulatory and accounting advisors, the economic risks and merits, as well as the legal, tax, regulatory and accounting characteristics and consequences, of the transaction. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

This material contains forward looking statements and there can be no guarantee that they will come to pass. Information contained herein is based on data from multiple sources and Morgan Stanley makes no representation as to the accuracy or completeness of data from sources outside of Morgan Stanley. References to third parties contained herein should not be considered a solicitation on behalf of or an endorsement of those entities by Morgan Stanley.

Past performance is not a guarantee of future results.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. © 2015 Morgan Stanley & Co LLC. Members SIPC. All rights reserved.

CRC [1242652]  07/2015