Can investing using environmental, social and governance scores help to outperform the market?

Welcome to Finance and Fury – Is ESG investing the way of the future and good for your portfolio?

Within the last few years, large publicly listed companies and investment managers investment are really paying attention to what is known as an ESG score – which stands for environmental, social and governance – it is meant to be used as a determinant on the sustainability of investments – the concept of sustainability it is growing in prominence in every sector of the economy, but particularly within institutional investments and publicly listed companies

In this episode – I want to look at what is ESG, how it is determined and scored, and can following this trend and only investing in ESG companies help your bottom line when it comes to long term returns?

To take a step back – society has been moving towards greater levels of sustainability and environmentalism – with this shift – Publicly listed Companies are becoming concerned with where they fit into this – as well as investment managers wishing to purchase these companies

1. if you are a fund manager investing in a weapons manufacturing company, is this an ethical investment based around ESG metrics? If it doesn’t score well and your mandate determines that you cannot invest in low scoring companies then this would have to be excluded from your portfolio – even if the world is going to war and Raytheon is about to make a lot of money
2. But from Raytheon’s point of view – you want to be considered by professional investment managers to be an ESG company so that that institutional money can flow your way – because if you are cut off from that market, your share prices will suffer and you would be failing your duty as a board member to maximise shareholder value – i.e. providing returns to shareholders
3. So major corporations are becoming very engaged with the parties that provide ESG scores to help not only incentives further investment in their business – but also to help determine from an outside/institutional perspective if the company is worth investing in – as public investors have shown an interest in putting their money where their values are –
   1. This has also seen the rise of many managed funds, brokerage firms, and ETF providers offering products that employ ESG criteria as the sole determinant for investment decision making – people want these products so the market is providing to meet this demand – but does following ESG scores as a criteria for an investment strategy actually work for a long term investment strategy?

What is ESG – Environmental, social, and governance criteria are a set of standards for a company’s operations

1. Environmental criteria consider how a company performs as a steward of nature – can include a company’s energy use, waste and pollution, natural resource conservation, or treatment of animals
   1. criteria can also be used in evaluating any environmental risks a company might face and how the company is managing those risks – For example, there may be issues related to a company’s ownership of contaminated land, or its disposal of hazardous waste and management of toxic emissions, or its compliance with government environmental regulations
2. Social criteria examines how it manages relationships with employees, suppliers, customers and communities
   1. Does it work with suppliers that hold the same values as it claims to hold? Does the company donate a percentage of its profits to the local community or encourage employees to perform volunteer work there? Do the company’s working conditions show high regard for its employees’ health and safety? Are other stakeholders’ interests taken into account?
3. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.
   1. A big one I have seen is ethics of the company, board composition and transparency – does the company uses accurate and transparent accounting methods and that stockholders are given an opportunity to vote on important issues? Do they have a diverse board, or is it all old white males? Are there any conflicts of interest in their choice of board members, do they use political contributions to obtain unduly favourable treatment, or do they engage in illegal practices?
4. ESG investing is sometimes referred to as sustainable investing, responsible investing, impact investing, or socially responsible investing – however – this is very similar to CSR – Corporate social responsibility

Based around these criteria – an ESG score is calculated –

1. An organisation’s ESG score is a numerical measure of how it is perceived to be performing on each of these criteria – Each of the Environmental, social, and governance criteria are given an individual score then it is combined into one
2. The key word in this score is ‘perceived’ – An ESG score is calculated based on how an organisation is seen to be performing – that is, how its behaviour relating to ESG issues is reported – not what it is actually doing behind closed doors
   1. Just as with the building of corporate reputation, there is a gap between reality and perception. While a business may have a strong policy around carbon emissions and waste reduction, or a system of transparent, performance-based promotion, if that information is not in the public domain, it won’t impact its ESG score.
   2. Alternatively – if a business has a face value of supporting every social movement whilst enacting policy behind the scenes that is antithetical to these values, then this is not picked up in these scores – ESG scores don’t necessarily reflect the internal reality of a company – as ESG scores only measure how corporate behaviours are reported and the face that they put on to the public
   3. Therefore, a reality gap exists – and poses a risk – as if you are basing investment decisions purely around an ESG score, then this not meet your investment desires if you are trying to invest in a socially responsible way
3. Let’s have a look at a few examples – when comparing the ESG risk scores
   1. Disney – they have a wonderful public perception – and own a massive chunk of media and merchandising rights – theme parks, movies with the rights to Marvel, Star Wars, media as well, like ABC in the US – they also have merchandising rights, so many toys are marketed and made – where are they made? Well, it has become apparent that it may be slave labour – through internment camps in China –
      14. So – based around the issues with the use of Chinese free labour – how would they rank? Pretty poor you would think – ESG Risk rating is Low based around the official metrics – 14.9 – Actually a lower risk than Netflix – they are given a ranking of 87% by CSRHUB – which is an ESG rating agency
   2. Another example – Tesla – Most people would consider this company as very environmentally friendly – good social governance – and is great for society at large – on a score of 0-50 – where 0 is no ESG risks, meaning it is the cleanest company on earth with the best contribution to society and lots of diversity in the board and management – where would you place Tesla – 10? 20? – well it is 31.3 – which is high risk – CSRHUB gives them 38% out of 100%
      27. But good news – BWM, or Daimler are all lower – 27.7 and 25.2 – CSRHUB gives Daimler 87%
   3. To put this in perspective – BHP has an ESG risk rating of 30.1 – with a 75% rating – so Tesla is a lot lower – even BP Oil got 64%
4. How are these risk scores calculated? Because does it make sense that these companies rank where they do?
5. It comes down to who is doing the scoring – Analysis companies use various calculation processes – but these scores are done at the behest of these companies – If you are a major company, you go to a rating provider, hand over all your information and they come up with a score – some of those scores I mentioned come from Sustainalytics – a subsidiary of Morningstar – one of the worlds top rating agencies – the others come from CSRHUB
   1. Due to the individual companies’ methodologies – it is actually harder to determine what contributes to an individual score – as these will vary depending on which analytics they employ. Research by State Street showed only a 0.53 correlation between ESG scores for the same subjects between another provider, MSCI’s ESG ratings and Subanalytics – therefore there is about a 50% relation between a score on their board, or their environmentalism – so one company that may seem to be an ESG champion on one site, may not be on another
   2. This is all due to the fact that ESG scoring is the measurement of perception rather than reality – so ESG data systems can be largely subjective and vary dependent on which company is doing the rating
   3. so how does anyone make an accurate investment decision based around these wildly varying metrics?
6. The answer is that you really can’t under their current form ESG ratings and scores are often based on voluntary company self-disclosure and partial data.
   1. The issue is that most ESG scoring systems from some companies include an analysis from publicly available print and social media content – so if a companies social media profile supports social movements domestically, whilst using slave labour abroad which is not incorporated into the metrics – this company will appear to be a higher rating on ESG than a company that doesn’t participate in the same practices, but isn’t as active in changing their twitter profile

How does an ESG investing approach help with portfolio returns –

Looking at a few examples –

1. Australian iShares ESG fund – Holdings, CBA, CSL, WES, MQG – but then FMG, Transurban, Newcrest, James Hardie – and Xero – so in the top 10, three are mining companies – performance wise this was only created this month – so no data
2. Other Funds – BetaShares has an Australian Sustainability Leaders ETF – 1 year is 17.79%, 3 years is 10.80%
   1. The benchmark index of the Nasdaq Future Australian Sustainability Leaders Index – which the BetaShares fund has underperformed by 0.5% at every stage
3. Another Australian Fund is Van Eck – 1 year is 25.02%, 3 years is 10.17% or 5 years of 7.59%
   9. In comparison – the ASX300 provided 28% over 1 year, 9.74% over 3 years and 11.2% over 5 years
4. iShares Core MSCI World ex Australia ESG Leaders ETF – Returns of 30% over 1 year, 14% over 3 years and 14.5% over 5 years
   14. International index – 28% over 1 year, 14.8% over 3 years and 15% over 5 years
5. There is no clear winner – The indexes have slightly outperformed in the long term

Can this be a good investment for the long term – as more people start ESG investing?

1. There could always be the issues of “Bad” companies performing very well and missing out on this –
2. However – due to public perception – A company with a higher ESG score may start to gain more traction in regards to investment inflows – especially from financial services companies such as JPMorgan Chase, Wells Fargo, and Goldman Sachs – and ETF providers in Australia
3. The very nature of more money flowing into highly rated ESG companies could be a long-term investment – not for the actual performance of the companies themselves in fundamental terms – but from a perspective of more money flowing into these companies and hence the prices go up
4. Even for one of the largest investment sectors within Australia – Superannuation funds – Their mandates may limit or eliminate non-socially responsible investing
   1. We have seen the divestment from Coal within superannuation funds over the past 12 months – coal companies on the ASX are not faring well – most have seen a decline in prices over the past few years – many saw a loss in EPS recently with coal prices plummeting to $50USD a tonne in July 2020 – but it is back to all time highs at $136USD a tonne – so coal companies may actually rebound quite a bit – but this component of return may not be included in the ESG investing
   2. Brings up interesting issues – as a super fund their fiduciary duty is to provide long term returns for the sole purpose of their members retirement – choosing investment strategies based entirely on investments classified under ESG and socially responsible investing score could start to lag markets depending on the score allocated to companies
5. Remember – score can be subjective – large companies with a good social presence and the ability to have great PR

In summary –

If you are going to be investing only in Large cap companies and using ESG metrics – probably nothing to be gained here – they will all have great ESG scoring based around the metrics and how companies determine these scores –

Mid and Small cap companies – these may be left unloved by these types of funds – but this is where a large chunk of capital growth comes from the market –

Companies at the top that have a large portion of the market shares have limited capital growth when compared to new companies coming in

If you are going to invest – then invest – if you are looking for ESG – don’t rely on metrics from companies providing these – decide if a company meets your ethical criteria

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