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In this interview with Tom Demaecker, we dig into ESG and Equity performance in order to draw some conclusions from the internal research conducted by our International & Sustainable Equity team.
Does ESG improve performance?
Repeated studies across different indicators and time horizons, show that ESG generally leads to improved performance. In fact, our analysis suggests that over a seven-year time horizon, there is a clear trend of outperformance compared to peers that do not actively rely on ESG.
How does ESG improve performance?
There are four factors which link ESG to outperformance:
Firstly, it avoids costly controversies. ESG-friendly companies are less likely to be involved in severe controversies. This, in turn, limits unexpected losses caused by public outcries or unexpected lawsuits. In fact, over USD 500 billion worth of damages were caused by the 24 largest ESG controversies over the past 6 years.
Secondly, ESG focuses on what matters: The world has evolved from an industrial to a knowledge-based economy and from an asset-heavy to an asset-light economy. There is an ever-greater focus on R&D and intellectual property. ESG fits right in with this trend. It focuses greatly on these intangible assets (e.g. patents, brand awareness, human capital, reputation, etc.), which have come to play an important role in a firm’s value-creation process.
Thirdly, it is all about fishing in the right pond. Our research shows that companies which score highly on ESG factors, are also more profitable overall. As such, ESG can serve as an indicator of a company’s profitability and growth, and increases the odds of picking a good company.
The fourth reason is tied to the previous point: By fishing in the right pond, you also automatically avoid fishing in the wrong pond. So called vice companies (i.e. companies that focus on industries such as tobacco, weapons, gambling and alcohol) will generally be excluded from ESG-focused funds. Recent regulation and moral considerations seem to have severely limited abnormal returns of such companies. Moreover, unlike vice and worst-in-class ESG companies, good ESG funds tend to have much lower earnings volatility. The difference between the best-in-class and the median performer is smaller. This increases the visibility of earnings and leads to improved resilience.
What about the pitfalls of ESG, do they also exist?
The contributions towards a sustainable future paired with positive outperformance might make it seem like investing in ESG is a no-brainer. However, it is important to remain careful. While ESG obviously has several benefits when used properly, there are some things to look out for. First and foremost, it is not fully clear to what extent each individual part of an ESG score contributes to outperformance. Multiple studies have managed to establish a positive link between environmental factors (E) and outperformance. The E part is both measurable and comparable to peers and through time, providing a clear image. Governance (G) and Social (S) factors, on the contrary, are notably difficult to summarize in one score, given the qualitative nature of the assessment. As such, studies have yet to discover a clear impact on performance.
Crucially, the relevance and importance of these three qualitative factors is very company-and industry-specific. This makes it even more difficult to perform a proper quantitative analysis and requires an integrated analysis by industry and company experts.
Is ESG only about avoiding risks?
ESG could only be a trend for now, but it will evolve into a structural factor with wide-ranging consequences for any companies and industries that fail to take its relevance into account. Indeed, ESG’s growing significance is illustrated by the recent surge in legislative measures and a tangible increase in societal pressure. Still, one should not only focus on the restrictive side of ESG. These ESG challenges also open up amazing business opportunities. In the past couple of years, several successful companies have emerged which specifically seek to cater to ESG problems. Pluralsight, for example, really focuses on the social aspect of ESG and matches a pressing need (i.e. more trained IT people) with an educational platform, offering the best teachers at an honest price. The company hopes to drive significant, lasting social impact by promoting and providing equal access to IT education.
What is the role of large ESG providers in this regard?
There are several large providers that try to come up with ratings to showcase a company’s relative ESG score. Although this can serve as a nice foundation on which to build an ESG portfolio, one needs to remain cautious when using these scores. ESG-providers generally put a lot of emphasis on disclosure. They favour companies with large CSR reports, with big ESG-focused teams to write nice, elaborate policies. However, we have noticed that these policy metrics only marginally contribute to performance. In order to find out what really impacts a firm’s health, we need to look at performance targets which tackle key material risks. These key material risks are unfortunately not sufficiently reflected in the standard metrics from big ESG providers such as Sustainalytics or MSCI. This is where DPAM’s expertise clearly shines through: Our experienced team of in-house buy-side analysts perform proprietary in-depth research. Through this bottom-up approach, we obtain a clear overview of a company’s fundamentals and its industry as a whole. This, in turn, gives us a unique edge when it comes to identifying and understanding its ESG profile.
Moreover, we also consider a firm’s relative improvement in ESG score to be an important metric. Indeed, a new player which suddenly makes significant progress might be more indicative of strong dedication to ESG than a well-established company, with a high –but largely unchanged- ESG rating. We have discovered that high levels of ESG improvement are also strongly correlated with outperformance, thus validating the significance of this metric.
Finally, DPAM also tries to go beyond the balance sheets, and attempts to get a full overview of the company at hand by looking at employee reviews in satisfaction surveys and online databases. In addition, DPAM experts also regularly get in touch with the firms to establish a personal connection and gain a deeper understanding of the company’s long term plans and goals.