By Ellie Winninghoff

Customer satisfaction, employee access to health care, and carbon emissions per unit of revenue aren't the sorts of metrics you find in a company's financial statements. But they represent non-financial impacts companies create. And they are among the 30 or so environmental, social and governance indicators that HIP Investor Inc. says can lead to higher profits.   

"These are not ethical values but leading indicators of performance," says Paul Herman, CEO of HIP, which stands for Human Impact + Profit. The San Francisco-based registered investment advisor and asset manager employs a multi-disciplinary approach that marries finances with sustainability. Among other things, the company offers separately-managed accounts for client portfolios and has developed a handful of investment indexes based on its sustainability ethos.

That includes its HIP 100 portfolio that uses the company's proprietary sustainability criteria to re-weight the S&P 100 index, which is based on market capitalization.

"You own more of the leading sustainability companies and less of the laggards," Herman says. "This allows you to be more diversified [than if you invest in a traditional SRI fund.]"

In terms of how companies are weighted, the difference between the S&P 100 and the HIP 100 can be significant. The HIP 100's top three holdings are Intel, Hewlett-Packard and Cisco Systems, which are numbers 17, 42 and 23 in S&P's index, respectively. They account for 4.8% in the HIP portfolio versus 3.9% in the S&P index.

In contrast, the top three firms in S&P's index are Exxon, Apple and IBM, which rank as numbers 28, 37 and 11 in HIP's portfolio. They account for 13.5% of S&P's capitalization versus just 3.73% of HIP's portfolio.

Since inception on July 30, 2009, the HIP 100 return as of Dec. 31, 2011 was 32.5% compared to 29.7% for its benchmark S&P iShares ETF.

Now HIP has applied its sustainability scoring system to preferred stocks and real estate investment trusts. In December, it introduced HIP Preferred, a portfolio of 60 preferred stocks yielding 5.75%.  And the HIP Sustainable Real Estate, a portfolio consisting of 45 securities expected to yield 4.2%, will go live in this year's first quarter.  

HIP Dividends
While HIP's weighting of common stocks since inception has outperformed the S&P 100, the firm's performance was weakest last year. Herman attributes this at least in part to an overweighting of banks, which he notes were taking customer deposits and using them to take investment banking risks. "A lot of banks have systemic risk due to the way they're operating," he says, "and they are not treating the customer in a HIP way."

Financials, of course, account for more than half the preferred market. And while preferred stocks are generally less volatile than equities, this was not the case in either 2008 or 2011, when Herman says preferred stocks in the financial sector behaved like equity.

As a result, the HIP Preferred portfolio consists of the available universe of preferred stocks listed in the U.S. sans most financials. The firm applies the same methodology it uses for the HIP 100, adjusted for risk-rated return. The portfolio, which consists of 60 different securities, is 20% global and the rest US-based companies. Top holdings are First SpA, Bristol-Myers Squibb and DuPont, which account for 5.27%, 4.04% and 3.27% of the portfolio, respectively.

The HIP Sustainable Real Estate portfolio, on the other hand, focuses more on environmental sustainability. According to Herman, only 50 of 200 REITs provide sustainability data. To assess them, the firm also uses LEED certification and Energy Star data that shows how eco-efficient different buildings are.  And it applies a heavier weight to those REITs that are managing forests and other natural resources more sustainably and which are transparent.  Top holdings include Weyerhauser, Prologis, UDR,and Rayonier.

Thanks to factors like reducing energy costs, water consumption and waste, Herman says it's "pretty crystal clear" that sustainability has a high return on investment in commercial real estate. "I've talked to no less than three REITs or real estate management companies that said they could not share information because they consider it a competitive advantage."

Maslow's Hierarchy of Needs
Herman insists that investors can actually profit by doing good. In his book, The HIP Investor: Make Bigger Profits by Building a Better World (Wiley, 2010), he points out that companies are often so fixated on their financial and operating ratios that they become "disconnected" from the "true source" of a company's growth, which is finding solutions to customer needs.  

But if this sounds like Business 101, hang on. According to Herman, a Wharton grad who cut his teeth at McKinsey & Co. and later worked with eBay founder Pierre Omidyar's Network, many benefits of solving those needs can be quantified. Consider, for example, longer life from a medical device, more income from a savings account or lower fuel use (and carbon emissions) from a hybrid car.

"Companies that quantify these values and understand how they drive value are well-positioned for bigger profits and help to create a better world," he says.

HIP's methodology is inspired by Abraham Maslow's hierarchy of needs (physiological, safety, social and belonging, ego/self esteem and self-actualization). Herman has translated these needs into five categories--health, wealth, earth, equality and trust--and chosen indicators that represent each. Equality, for example, is represented by quantifiable metrics measuring gender balance and ethnic diversity. For trust, he focuses on a company's transparency that renders it more open and credible.

Some HIP indicators, such as employee health care, contributions to 401Ks by employers and customer service, are quite different than the environmental, social and governance (ESG) factors that socially responsible investors generally consider. But while others are similar, such as carbon emissions per unit of revenue, for example, Herman says there is a profound difference.

"Do-gooder investment approaches of the past tended to focus on policies and practices which are not methodically followed [by companies] and do not create a consistent output," he says. "The HIP approach prioritizes outcomes and results over inputs and process."

In fact, Herman does not even call his non-financial indicators "environmental, social and governance" (or ESG) factors. He calls them "Human Impact" indicators because they represent needs, what people need to be fulfilled and what society needs to thrive. For investors, he says, the key is to understand how these indicators drive profitability and shareholder value. He calls this analysis the "new fundamentals."

In most cases, HIP quantifies its indicators and then adjusts the weights of each indicator based on how it drives financial value. Employee satisfaction, for example, drives profitability substantially more than a company's philanthropy. The firm then tallies up an impact score for each company, and companies with the highest scores are weighted higher in the portfolio.

Connecting the Dots
In his book, Herman details the connections between HIP's human impact indicators and profitability. Some correlations are intuitively obvious. For example, the savings from lower energy, materials and water bills drop directly to the bottom line.

But the amount of room for improvement is not so obvious. Research he cites by INSEAD professor Robert Underwood Ayres, for instance, indicates that only 6% of all material inputs are used in the average manufacturing process. The better companies, though, are taking this seriously. He writes that Hewlett-Packard (a top rated HIP company in the Earth category) is "dematerializing" its products with a focus toward providing services. And DuPont now tracks the "shareholder value per product" as a metric of material efficiency.

Although the connections that he reports between other HIP indicators and profitability make sense, they are not on most investors' radars. Herman cites research by JD Power that proves that customer satisfaction propels revenues and profits, and even shareholder value. Other research by Wharton finance professor Alex Edmans shows that the firms in Fortune magazine's annual listing of "Best Companies to Work For" annually outperform those that are not by four percent in the stock market.

The bottom line, says Herman, is that the market is inefficient when it comes to performance-based sustainability.  

A former investment banker and veteran financial reporter, Ellie Winninghoff is a writer and consultant. Her work about responsible and impact investing is linked at: DoGoodCapitalist.com. She can be reached at: ellie.winninghoff (at) gmail.com.