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Evolving tactic against investment dogs

Assessing good-stewardship traits can filter out the worst excesses of management.

Investors are waking up to the fact that paying attention to the environmental, social and governance (ESG) habits of listed companies pays more than just social dividends.

It turns out that companies with high ESG scores outperformed their lower ranked counterparts by three percentage points a year, according to research done by Bank of America Merrill Lynch on companies listed on the S&P 500 between 2005 and 2017.

The report, The ABCs of ESGs, goes on to say that an investor who bought stocks with above-average Thomson Reuters’ ESG scores would have avoided 90% of the bankruptcies that occurred on the S&P 500 since 2005.

Applying filters for non-fundamental attributes such as a company’s natural resource use, its privacy and data security policy, shareholder rights, board independence or remuneration policy can help investors identify:

* Stocks less likely to go bankrupt over the next five years

* Stocks less likely to have large price declines

* Stocks less likely to have earnings declines or increased earnings- per-share volatility

* Stocks that are likely to become high-quality stocks

* Stocks that are likely to see extreme inflows over the next few decades

* Stocks with three-year returns significantly better than their peers.

An alternative way of analysing and identifying potential problem stocks looks set to become essential. The report notes that S&P 500 asset transparency is at an all-time low, based on the intangible assets-to-book value ratio going back to 1998. Intangible assets such as brand equity and intellectual property have gone from less than 30% of book value in 1998 to 65% in 2017. The same trend is evident in other markets, including on the JSE.

Catastrophe avoidance

By extension, investors applying ESG filters to JSE-listed stocks might have avoided some of the bigger catastrophes on the JSE in recent years – Steinhoff and African Bank being just two of them.

If this trend continues – and there is little reason to believe that it won’t – trillions of dollars could be allocated to ESG-oriented equity investments, and to stocks that are attractive on ESG metrics over the next two decades.

BofA Merrill Lynch attempts to quantify this figure further: assuming an increase in wealth in the US of around $4 trillion per decade (in line with historical trends), as well as the transfer of wealth from baby boomers to millennials beginning in the late 2020s of $30-40 trillion of financial and non-financial assets, inflows could become parabolic.

It should come as no surprise then that this week Old Mutual launched South Africa’s first ESG Index unit trusts, the Old Mutual MSCI World ESG Index Feeder Fund, and the Old Mutual MSCI Emerging Markets ESG Index Feeder Fund. “Investors are not only looking for more affordable ways to invest, through index or passive investing but are now questioning how sustainable their investments are,” says Elize Botha, managing director of Old Mutual Unit Trusts.

Millennials leading the charge

She adds that while high-net-worth individuals and women have generally been quick to adopt this kind of thinking, it is even more pronounced among Millennials – the generation between the ages of 18 and 34. “Millennials have been labelled the ‘purpose-led’ generation as they are more interested in working for, buying from, and investing in companies that share their values than older generations,” she says. “Research from the Morgan Stanley Institute for Sustainable Investing revealed in 2017 that millennial investors are twice as likely as the overall investor population to invest in companies targeting social or environmental goals.”

Investing in companies committed to sound ESG practices shows specific measurable characteristics, such as lower cost of capital, better resource efficiency, stronger innovation, lower staff turnover, stronger social licence to operate and better access to markets – all attributes that can, and do, influence competitive advantage and long-term performance, Botha says.

Outperformance 

However, there is a perception among investors that ESG investments offer inferior performance. Jon Duncan, head of Responsible Investment at Old Mutual Investment Group, says this is a myth. “Although we cannot guarantee future performance, ESG investments have repeatedly demonstrated that capital employed sustainably can not only meet but often outperform investors’ return expectation,” he says. “ESG index funds are designed to offer returns in line with market performance while offering clients exposure to companies that are measurably better for the planet.”

So could ESG become a bubble?

Admittedly, extreme asset inflows can create bubbles, and flows into ESG types of vehicles have been robust in recent years.

 Assets tied to ESG strategies are growing exponentially

Source: BofA Merrill Lynch

For investors concerned that they are overpaying for ESG attributes, BofA Merrill Lynch advises using ESG in conjunction with fundamental attributes like valuation, growth, and quality.

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This is a classic example of “back-test overfitting”. You choose ESG factors based on how well they performed and then go “Wow look how well they performed”. This model should use naive modelling which would now doubt scupper the out of sample performance.

On a side note if it was that easy then just take all of you personal wealth, short sin stock and long ESG. Triple you money if you are right, go to zero if you are wrong, and then we will see how much you believe in these factors.

As an additional point, is it that companies who have put in place ESG are less likely to go bankrupt, or is it because of the ESG, or is it because there is an ESG bubble that the silly money is flowing into and it is time to SHORT ESG… Not sure

End of comments.

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