New research shows that companies that adhere to positive environmental, social and governance (ESG) principles have lower costs of capital, higher valuations, are less vulnerable to systemic risks and are more profitable. But beware; those higher valuations translate to lower expected returns for investors.
ESG investing covers many different investment approaches addressing three main areas, each with its own main objective:
- Values-based investing: Align the portfolio with the investor’s beliefs;
- Impact investing: Use capital to trigger change for social or environmental purposes; and
- ESG integration: Improve the risk-return characteristics of a portfolio.
The popularity of ESG investing, which now accounts for one out of every four dollars under professional management in the United States and one out of every two dollars in Europe, has been accompanied by heightened research into the subject, with more than 1,000 research reports published with mixed results – finding positive, negative and nonexistent correlations between ESG and financial performance. The inconclusive results may stem from the different underlying ESG data used, the varying methodologies applied (especially insofar as they control for common factor exposures), and the fact that the heightened demand for ESG investments has led to rising valuations of stocks with high ESG scores relative to stocks with low ESG scores. Increased cashflows have two effects. First, they lead to short-term capital gains. Ultimately, the higher valuations mean that investors should expect lower future returns over the long term.
Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltán Nagy and Laura Nishikawa contribute to our understanding of how ESG affects equity valuations, risk and performance with their study “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance,” which was published in the July 2019 issue of The Journal of Portfolio Management. They noted that one issue with prior research was that it failed to differentiate between correlation and causality: “Often, a correlation between ESG and financial variables is implicitly interpreted to mean that ESG is the cause and financial value the effect, although the transmission easily could also be reversed.” Therefore, they took a different approach: “Instead of simply looking for correlations between ESG characteristics and financial performance in historical data, we first analyze the transmission channels from ESG to financial performance and develop a fundamental understanding of how ESG characteristics affect corporations’ valuations and risk profiles. Afterwards, we verify these transmission mechanisms using empirical analysis.” Their approach provides three benefits:
1. It mitigates the risk of correlation mining between ESG data and financial performance data.
2. It reduces the risk of finding correlations that are caused by unintentional exposures to common factors.
3. It better differentiates between correlation and causality by studying transmission channels.
The authors explained that their analysis is designed to help explain how ESG affects the financial profile of companies in a fundamental way – deriving an understanding of the causal relationship of ESG by examining the transmission channels found in discounted cashflow models, specifically between cashflow, risk and valuation channels, and ESG scores – producing more convincing evidence than simple correlation studies.
They sought to answer the following five questions:
- Is there convincing evidence based on cashflow?
They explain the economic rationale of the cashflow channel:
- Companies with strong ESG profiles are more competitive than their peers. For instance, this competitive advantage can be due to the more efficient use of resources, better human capital development, or better innovation management. In addition to this, high ESG-rated companies are typically better at developing long-term business plans and long-term incentive plans for senior management.
- High ESG-rated companies use their competitive advantage to generate abnormal returns, which ultimately lead to higher profitability.
- Higher profitability results in higher dividends.
- How well do high-ESG-scoring firms manage business and operational risks (idiosyncratic tail risk)?
They explain the economic rationale of the risk channel:
- Companies with strong ESG characteristics typically have above-average risk control and compliance standards across the company and within their supply chain management.
- Because of better risk-control standards, high ESG-rated companies suffer less frequently from severe incidents such as fraud, embezzlement, corruption or litigation cases that can seriously impact the value of the company and therefore the company’s stock price.
- Less frequent risk incidents ultimately lead to less stock-specific downside or tail risk in the company’s stock price.
- Does a strong ESG profile lead to higher valuations?
They explain the economic rationale for the valuation channel:
- In a capital asset pricing model framework, the beta of a company has two important functions. First, beta measures the systematic risk exposure of companies (i.e., lower beta means less systematic risk); and second, it translates the equity risk premium into the required rate of return for the individual company. Therefore, lower systematic risk means a company’s equity has a lower beta, and investors require a lower rate of return. Ultimately, this translates into a lower cost of capital for a company. This argument can be extended to multifactor models, in which the systematic risk exposure of a company is measured by several factor loadings instead of one beta.
- In a discounted cashflow model framework, a lower cost of capital leads directly to the last step of the transmission mechanism: A company with lower cost of capital would have a higher valuation.
- The transmission channel from lower systematic risk to higher valuations can also be explained through the relative size of the investor base – companies with low ESG ratings have a relatively small investor base because of investor preferences (many risk-averse investors and socially conscious investors avoid exposure to low-ESG-ranked companies) and information asymmetry (the problem of asymmetric information between companies and their investors is less severe for high ESG-rated companies because high ESG-rated companies are typically more transparent, in particular with respect to their risk exposures and their risk management and governance standards).
- What about causality?
Do higher ESG ratings lead to higher valuations, or do higher valuations lead to higher ESG ratings? It’s the chicken-and-egg problem. The authors explained: “Higher ESG ratings can – through lower systematic risk and lower cost of capital – lead to higher valuations. Alternatively, higher valuations can indicate successful companies that have more money to invest in sustainability-related areas, leading to a higher ESG rating.” They explain the economic rationale:
- An improving ESG profile means a company is becoming less susceptible to systematic risks.
- Lower systematic risk leads to a reduction in a company’s cost of capital.
- The reduction in cost of capital leads to an increase in valuation.
- Given the results of causality tests, is there a link between changes in ESG ratings and future return performance between highest and lowest ESG scoring firms?
Their database is the MSCI ESG Rating for the MSCI World Index universe covering the period January 2007 to May 2017. The universe contains more than 1,600 stocks. All risk and factor calculations were performed using the Barra Long-Term Global Equity Model (GEM LT). Their results were neutralized for industry exposure (through the use of industry-adjusted ESG scores) and size.
Following is a summary of the authors’ findings:
Is there convincing evidence based on cashflow? They found that firms with strong ESG profiles are more competitive because they use resources more efficiently, are better at developing human capital and managing innovation, have better long-term planning, and have better incentives for senior management. This leads to the ability to generate excess returns, higher profitability, and ultimately higher dividends. The highest ESG scoring firms were more profitable and had higher dividends than the lowest ESG scoring firms.
How well do high ESG scoring firms manage business and operational risks (idiosyncratic tail risk)? Firms with high ESG scores have better risk management and better compliance standards, leading to fewer extreme events such as fraud, corruption and litigation (and their negative consequences). The result is a reduction in tail risk in high ESG scoring firms relative to the lowest ESG scoring firms. The highest scoring ESG firms also had lower idiosyncratic risk. And the research shows that firms with high idiosyncratic risk have produced lower returns.
Does a strong ESG profile lead to higher valuations? The valuation channel is governed by a firm’s exposure to systematic risk. High ESG scoring firms have less exposure to market shocks and exhibited lower recent five-year volatility of earnings when compared to low scoring firms. Thus, they have lower betas. The lower betas result in higher valuations (such as lower book-to-market and higher price-to-earnings ratios), producing lower costs of capital and thus ultimately lower expected returns.
What about causality? They conducted three tests of causality – for changes in the volatility of common factor risk, changes in beta, and changes in valuation – relative to three categories: decreases in ESG scores, increases in ESG scores, and no change. The changes in financial variables were observed over a three-year time period after the change in ESG rating occurred. Upgrades in ESG ratings were associated with declines in a firm’s systematic risk profile and declines in beta compared to neutral or downgraded companies. Upgrades in ESG ratings were associated with increases in valuation as measured by relative increases in price-to-earnings ratios. Importantly, rating upgrades had a lower incident frequency than rating downgrades. Thus, rating changes are a leading indicator for idiosyncratic risks.
Given the results of causality tests, is there a link between changes in ESG ratings and future return performance between highest and lowest ESG scoring firms? Improvement in ESG scores (ESG momentum) results in improved valuation (lower costs of capital) and reduction in specific risk (reduced incidence of tail risk) profiles, thus indicating that ESG momentum can be a source of alpha. They cited research demonstrating that “companies that show a positive ESG rating trend significantly outperformed both the benchmark and a comparable strategy that tilted the portfolio weights toward companies with high ESG ratings.” The authors concluded: “ESG momentum can be a useful financial indicator in its own right and may be used in addition to the actual ESG rating in index or portfolio construction methodologies.”
By creating transmission channels, Giese, Lee, Melas, Nagy and Nishikawa provide us with clear and intuitive explanations for how ESG affects the valuation and performance of companies, both through their systematic risk profile (lower costs of capital and higher valuations) and their idiosyncratic risk profile (higher profitability and lower exposures to tail risk).
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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