Chemicals are in virtually every product we buy from clothing, cosmetics, furniture, shampoo, fragrances, and building products to the food we eat and, of course, the pharmaceuticals used to treat illnesses. In short, life as we know it would not exist without chemicals.

Yet, chemicals also can be harmful and pose risks to human health depending upon their nature and the amount of time we’re exposed to them. So as a consumer, investor or business executive, it’s critical to understand your exposure to “chemicals of concern.”

Chemicals of Concern

Across the world, various regulatory, industry and government agencies have established lists of chemicals of concern. Any chemical that can potentially cause harm can be considered hazardous. However, certain chemicals can persist in the environment (air, water, land, plants and animals), build up in animal tissues and be toxic—causing different types of harm ranging from mild skin irritations to cancer.

Chemicals of high concern (CoHCs), as defined under the California Candidate Chemical List, include:

  • Carcinogens, mutagens or reproductive toxins (CMR)
  • Persistent bioaccumulative and toxic substances (PBT)
  • Other chemicals for which there is scientific evidence of probable serious effects on human health or the environment
  • A chemical whose breakdown products result in a CoHC that meets any of the above criteria

Sounds complicated but extremely important, right? Absolutely, socially responsible investors recognize that the improper use of chemicals can cause materially adverse investment performance and even greater harm to society. Therefore, it’s important that your investment manager conduct a broad screening for chemicals of concern when selecting stocks for your portfolio. Let’s look at a real-world example.

Lumber Liquidators (LL) – Linked to Health and Safety Violations

On March 1, 2015, Anderson Cooper, CBS News correspondent, reported on 60 Minutes that the laminate flooring sold by Lumber Liquidators (LL) may fail to meet health and safety standards because it contained high levels offormaldehyde, a known cancer causing chemical. As shown below, the stock price fell sharply just before and immediately following the report—then down 72% since the start of the year.

Source: Wall Street Journal Online

What went wrong?  Allegedly, it appears that Lumber Liquidators failed to properly control its supply chain by sourcing lower-cost, formaldehyde-tainted laminate flooring manufactured overseas. The flooring was tested by 3 independent labs and failed to meet California formaldehyde emissions standards (CARB-2) with levels, on average, six or seven times higher than allowed and in some cases as high as twenty times higher than allowed.

What were the repercussions? Lumber Liquidator’s CEO, Robert Lynch, resigned on June 16, 2015, and the company announced it would discontinue the sale of the laminate flooring manufactured overseas. Now, the company faces a growing number of product liability and securities lawsuits including allegations that its directors breached their fiduciary duties by failing to properly oversee the laminate flooring manufactured overseas.

This story offers an interesting case study on the importance of Socially Responsible Investing (SRI) and the value of careful environmental, social and governance (ESG) screening. Here are a couple of key takeaways:

I. Watch the Profit Margins  – 60 Minutes reported that Whitney Tilson, a hedge fund manager, correctly identified that Lumber Liquidators had doubled its profit margins in just two years. An unusual gain in a commodity business. These gains should have led more analysts to question the sustainability of the increased profits and the underlying business drivers.

II. Don’t forget the “S” in ESG – Some key social factors that can have a material impact on the value of a stock include (1) customer satisfaction (2) product safety and liability (3) supply chain management and (4) occupational health and safety.

In this case, Lumber Liquidators frequently advertised images of children playing on new hardwood and laminate flooring. Unfortunately, due to their size, children are also the most likely to first show symptoms of exposure to harmful chemicals. So, the risks of providing an unsafe product, used by children and in the home, ultimately destroyed customer satisfaction and caused homeowners to immediately rip the flooring out. Responsible investors should evaluate if the supply chain is sustainable and provides occupational health and safety to its workers.

Sustainable Investing: The ESG Approach

A sustainable approach to investing incorporates the analysis of material, non-financial ESG factors into the investment decision-making process and helps determine the final selection of securities for your portfolio. Analyzing material ESG factors ultimately helps investors rank order stocks before making final investment decisions.

Start with the Chemicals of Concern by Industry

When screening prospective investments, it’s helpful to start by identifying the chemicals of concern used in the industry you’re evaluating. Then determine the level of revenues from products containing those substances and explore the firm’s processes and controls for managing its chemicals. Look for information from industry, regulatory and government sources such as:

Benchmark and Rank Order Your Investments

After you’ve gained a broad perspective on the industry, it’s time to collect the sustainability metrics. In the Household and Personal Products industry, for example, the Sustainable Accounting Standards Board (SASB) suggests the following four metrics regarding chemicals of concern under its Product Environmental, Health and Safety Performance topic:

  1. Revenues from products that contain REACH substances of very high concern (SVHC) (Metric CN0602-05)
  2. Revenue from products that contain substances on the California DTSC Candidate Chemicals List. (Metric CN0602-06)
  3. Discussion of process to identify and manage emerging materials and chemicals of concern. (Metric CN0602-07)
  4. Revenues from products designed with green chemistry principals (Metric CN0602-08)

Ultimately, we’re trying to identify the firm’s “chemical footprint.” To that end, the Chemical Footprint Project (CFP) Assessment Tool (released on June 19, 2015) also provides a good resource for publicly benchmarking chemical use and management. It’s backed by over $1.1 trillion in purchasing and investment power with signatories that include Aviva Investors, BNP Paribas IP, Boston Common Asset Management, Calvert Investments, Miller/Howard Investments, Trillium Asset Management, Zevin Asset Management, Dignity Health, Kaiser Permanente, Staples, Target and many others.

In the final analysis, we’re looking for best-in-class performers and screening out firms with significant risks. In the long-term, integrating ESG analysis into the investment decision-making process will help identify companies with business models that are more sustainable, socially responsible and profitable.