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ESG stocks have outperformed tremendously, but 2020 was a very unusual year. Investors want to know if this outperformance can be repeated going forward. Is there any long-term trend to speak of for ESG outperformance or is it a one-off craze? We explore how having high ESG ratings have correlated with financial metrics and returns, and look at possible mechanisms explaining why firms with ESG traits can deliver better outcomes for investors.
1. High ESG-rated companies have shown better financial performance…
A meta-study by the NYU Stern Center for Sustainable Business and Rockefeller Asset Management, examined the relationship between ESG and financial performance in more than 1,000 research papers from 2015 – 2020.
They found a positive relationship between ESG and financial performance for 58% of the studies focused on metrics such as ROE, ROA, or stock price with 13% showing neutral impact, 21% mixed results (the same study finding a positive, neutral or negative results) and only 8% showing a negative relationship.
In addition, in a recent study by Rockefeller, top quintile ESG improvers (based on Rockefeller’s proprietary ESG Improvers Score) outperformed bottom quintile ESG decliners by 3.8% annualized from 2010 to 2020.
In the next section, we take a look at specific financial metrics that have had a positive correlation with ESG ratings.
2. Including higher profitability, higher dividends, higher valuations, and lower stock-specific risk
Research shows that high ESG-rated companies were more profitable, paid higher dividends, showed higher valuation levels, lower frequency of stock-specific risks (controlled for other financial factors).
Here’s how different quintiles of ESG-rated companies have performed across the metrics.
Note: The following findings were based on Jan 2007 to May 2017 data, using MSCI ESG Ratings for the MSCI World Index universe during that period. The universe contains over 1,600 stocks and is therefore sufficiently diversified for the statistical analysis performed.
Note: Regarding the y-axis, those are normalized values. Don’t worry too much about them. They are Z-scores, which are calculated by first subtracting the cross-sectional mean from all values and then dividing the difference by the cross-sectional standard deviation.
The above shows that having a better ESG-score is correlated with better performance on these financial metrics.
But how does this work? As investors, it is important to understand the reasoning behind this phenomenon.
In the next section, we’ll explore 3 different mechanisms for how possessing good ESG traits can translate into better financial outcomes.
Learn more: What is the difference between ESG ETFs and ESG Funds?
3. Why have high-ESG rated equities performed better at these financial metrics?
Here are some of the suggested mechanisms: 1) Cash Flow Channel, 2) Valuation Channel, and 3) Stock-Specific Risk Channel. We discuss them in greater detail below.
Mechanism 1: Cash Flow Channel
Because of efficient use of resources and better human capital development, companies with strong ESG profiles are more competitive and thus able to eke out a larger profit compared to their peers. This higher profitability then translates into higher dividends. For instance, research by Goldman Sachs has shown that the top quartile of STOXX Europe 600 companies with the highest percentage of women on their boards delivered superior annualized returns (~11%) compared to the bottom quartile (~7%).
Learn more: Why ESG investing should matter for Singaporeans
Mechanism 2: Valuation Channel
Because of disciplined resource and capital management, companies with strong ESG profiles are less vulnerable to systematic market shocks (e.g. oil/commodity shocks, interest rate pressures, and forex fluctuations). Theoretically, this should translate into lower beta for the company (as described in the CAPM model) and thus lower cost of capital. Consequently, such firms should enjoy higher valuation multiples.
Mechanism 3: Stock-Specific Risk Channel
Because of better risk control standards, high ESG-rated companies are less likely to suffer from severe incidents (fraud, embezzlement, corruption, or litigation cases) that can seriously impact the value of the company. This is important for investors as such incidents can negatively affect the company’s stock price.
4. So when do ESG stocks underperform?
Earlier on, we explored how ESG stocks have been shown to outperform the broader indices over time, and also how having a high ESG rating can lead to better financial outcomes for the firm, and subsequently for investors.
That said, it’s important to qualify the periods when ESG stocks may underperform. Several of the stocks in ESG baskets tend to be tech or growth stocks, since tech companies generally don’t emit as much carbon. This is especially the case for certain verticals within ESG (e.g. new energy sectors or software companies). As such, these ESG stocks may outperform particularly so during tech rallies and underperform when value stocks are in style.
For context, value stocks have underperformed for the most part in the last decade (these periods of outperformance likely coincide with the red arrows in the chart below). But in more recent pockets of time (e.g. Feb-Mar of this year), value stocks have outperformed.
Going forward, no one can predict whether value or growth will be in style. However, with growth stocks currently expensive (relative to where they have priced vis-à-vis value stocks), a potential tilt to value stocks may be a short-term headwind for ESG stocks.
Conclusion
Extensive research suggests that ESG stocks have outperformed their peers in terms of stock market return, and that possessing good ESG traits is also correlated with higher profitability, higher dividends, higher valuations, and lower stock-specific risk. Different mechanisms have been suggested for how ESG traits translates into these better outcomes.
That said, for the individual investor, ESG investing can still be a challenge. One must choose between the different ESG investment options available in the market, given the different ESG matrices, ratings, and investment approaches that are available. The value of fund manager and fund due diligence by a trusted advisor to recommend and monitor funds is more important in ESG investing than usual passive or even thematic investing.
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