ESG credentials and strong returns

For some time now, strong credentials in environmental, social and governance – ‘ESG’ to use the shorthand – have been the buzzwords on every investor’s lips.

It would seem that everyone now wants to make investments in companies with strong ESG scores, with asset managers wanting to offer investments that stand up to ESG scrutiny. But there can be no denying the suspicion that ESG investments may not be able to keep pace with ‘traditional’ investments. 

Many investors still believe that adhering to strong ESG principles inevitably means sacrificing returns. We disagree, and so to challenge this belief we’ve taken a detailed and objective look at the research evidence to see how, especially over the longer term, ESG factors truly affect the performance of both companies and portfolios. 

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The very good news is, taking ESG seriously is even better for companies, employees, consumers, the environment, the future and investors’ returns than current opinion may suggest. 

RESEARCHING THE RESEARCH 

Our aim with the research was to give investors solid evidence of how ESG considerations could affect their investments. We’ve focused on rigorous, peer-reviewed academic research – we’ve carried out research into the research, you could say. We hope that our findings will go some way to convincing investors and asset managers who are still skeptical.

One substantial piece of research we looked at was analysis by MSCI of over 1,600 companies from the MSCI World Index universe, between January 2007 and May 2017. This analysis divided companies into five ESG score quintiles, with Q1 indicating the lowest ESG rating and Q5 the highest. Highly-rated (Q5) firms were more profitable and paid higher dividends than lowly-rated firms (those in Q1). Highly-rated firms also demonstrated lower earnings volatility and lower systematic volatility. 

STRONG ESG AND LOWER RISK

We also found that there is correlation between a strong ESG score and the following attributes: profitability, share price growth, and a lowering of risk, at both the portfolio and the stock level. Another benefit for higher-scoring companies is that the cost of obtaining both debt and equity capital (known as the cost of capital) becomes lower.

Further proof of the benefits of a strong ESG scorecard comes from research which demonstrates that highly rated ESG companies perform better in times of volatility. This is borne out not just in the data from the COVID-19 crisis of 2020, when companies with higher ESG scores were more resilient during the volatility, but across 2004 to 2018. In short, research suggested that strong ESG credentials significantly improve a company and a portfolio’s risk-adjusted return.

We also looked at research which concluded that lower ESG-scoring stocks tended to have 10% to 15% higher total volatility and stock-specific volatility than higher ESG-scoring stocks. This means that assessing a company’s ESG ratings and exposures may inform investors about the riskiness of securities in a way that is complementary to traditional statistical risk models. 

Other research found that ESG integration reduces portfolio risk across the full spectrum of markets and investment styles. We also noted findings elsewhere which suggested that, although the performance of ESG-focused mutual funds and ETFs was similar to non-ESG focused funds, there was 20% less downside deviation, making the funds ‘less risky’ overall. So, a firm’s environmental performance is inversely related to its systematic financial risk. In addition, this positive ESG effect increases over longer time horizons.

The evidence suggests that higher-quality companies, ones concerned about their environmental impact, their ‘footprint’, their workforce, the sustainability of their products and their impact on the planet, tend to make better profits, and see share price performance that is better than those of their less ESG-oriented peers. 

EMERGING MARKETS 

Positive ESG has a particularly significant beneficial effect when it comes to emerging market investments; here, the relationship between strong ESG credentials and better corporate performance is very high. A recent and comprehensive meta-analysis of over 2,200 unique research papers on ESG integration found that a large majority revealed a positive relationship between ESG and corporate financial performance. The sample from emerging markets was particularly interesting, revealing a 65% to 71% higher share of positive outcomes over developed markets. 

Investing in emerging markets is inherently more difficult; there is far less available information around the companies, and often less sophisticated regulation. So for emerging market investors, the importance of strong ESG being displayed by a potential investment becomes quite material. ESG principles give us a framework to investigate an emerging market company. If a company is well run – it is not treating its employees badly, not polluting the area with chemicals, and it is managing its energy use and waste creation well, it will tend to have better results, both in the long and short-term. The evidence we have gathered allows us to conclude that strong ESG performance can lead to strong returns. 

To cite two leading examples: for many years now, we’ve invested in Taiwan Semiconductor Manufacturing Company (TSMC) in Taiwan and Housing Development Finance Corporation (HDFC) in India. Both have strong ESG credentials, both in terms of their business and strategy, and the way they operate. 

TSMC is focused on improving the energy efficiency of its chips, with the company’s innovations helping make end products more energy efficient, driving the development and expansion of industries like renewable technology and green transport. The company’s commitment to ESG is strong; green energy is used wherever possible at all of the company’s factories and offices, and TSMC is the first semiconductor manufacturer globally to join RE100, a global initiative bringing together the world’s most influential businesses committed to 100% renewable power. 

There is currently a 95% waste recycling rate at the company’s operations, and air pollution has been reduced by 46% since 2015. The company is building the world’s first advanced water reclamation plant for industrial wastewater from chip manufacturing, a critical capability given Taiwan is a water-stressed country. In the case of any water shortage, the company is obliged to ferry in water at extra cost, and so lowering water usage whilst driving water re-use every year is an important aim for the firm, with both environmental and business benefits. 

Housing Development Finance Corporation (HDFC) in India is focused on improving access to housing finance, with a particular focus on improving access in the Economically Weaker Section and Low Income Group segments of the country, and has financed 8.4 million homes since the company was founded in 1977. The company is equally focused on ESG in its operations. It sets strong annual targets for emissions reduction, energy usage, water consumption and waste recycling and disposal. Solar energy is used in the company offices and buildings. Small changes, such as phasing out single-use water bottles, have been adopted. Corporate governance is strong and social welfare aims are high. 

Both TSMC and HDFC have been major success stories and are perfect examples of the findings of our extensive research – that standout performance can be generated not just by doing good business, but by also placing a strong emphasis on doing business for the good of the people who work at a company, for the good of the company’s customers and to improve every aspect of the environment that is affected by the company.

ACTIVE MANAGERS AND ESG RESEARCH

Our findings have reinforced our belief that taking an active approach to equity investing can make a critical difference. Investors need to conduct their own thorough research into a company’s ESG qualities and not just rely on data from third parties. We try to use our local presence around the world to find companies with high ESG credentials that are not yet fully appreciated by the market. 

In addition, we believe asset managers have a responsibility to help companies improve their ESG standards by actively engaging with them. We are not ‘activist’ investors, but we do aim to draw on our experiences across industries and regions to constructively challenge managements to do better. 

It is now an outdated and incorrect view that ESG is ‘nice to have’, ‘an added extra’, or an ‘additional expense’ that brings nothing in return. In fact, one could argue that the very opposite is true: companies that don’t care about their people, their customers, or the effect their business is having on the air, climate, water and natural habitat, are unsustainable business models, and are businesses that increasingly investors don’t want to risk investing in.

 

David Smith is senior investment director – Asian equities at Aberdeen Standard Investments.




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