What is ESG Investing?
Participants in our latest challenge are competing to see if ESG factors improve the ability of a model to predict long term upswings in a companies valuation. See the competition here.
ESG investing is a type of responsible investing that is gaining a lot of traction as it purports to be good, not just for investors consciences, but also their balance sheets. ‘ESG’ refers to Environmental, Social and Governance filings in which companies are required to make disclosures on their performance on each of these topics. Some of the areas included in each topic are listed below.
- Climate change policy
- Greenhouse gas emission goals
- Water-related issues
- Recycling policies
- Green products
- Employee treatment
- Employee training/churn
- Ethical supply chain sourcing
- Customer service and customer relations
- Public stance on social justice issues
- Executive compensation, bonuses and perks
- Factors that decide compensation (short term vs long term incentives)
- Voting structure
- Board structure (e.g. is CEO and Chairman same role?)
Analysts will then take these reports and generate scores for each company on these facets and any sub-factors they believe will contribute to the overall score. These are then combined to create overall facet and total ESG scores. This scoring is done independently by many analysts/agencies and there is a wide range of methodologies because of this. Although we are not using their scores in our competition, Refinitiv have a detailed guide into how they create and structure these scores: See the image below for an overview and click here for a more detailed breakdown.
How does it work?
The general reasoning initially behind ESG investing was that companies who score highly on these factors (and thus care about these things) would be more focused on long term value, as opposed to short term boosts in valuation. This, in turn, would allow those companies to attract better talent, retain those staff, build a loyal customer base, mitigate reputational risk and benefit from strong and stable oversight.
Furthermore, in order to achieve these objectives, a company must commit to them long term and maintain focus in that direction. This further reinforces the belief that companies with good ESG practices will make good long term investments.
Evidence of a Link to Performance
There is a large and growing body of research and reports (anecdotal and scientific) to show that ESG investing really is superior to investing in fundamentals alone. For a long and in-depth report of these different reports (see: this article on the fool).
Worth highlighting is this 2015 paper that conducted a meta-analysis of over 2000 empirical studies conducted on the topic and revealed that 90% of results showed that ESG performance had either a positive or neutral effect on company performance, with the majority reporting positive relationships. This relationship also appears to be stable over time – suggesting that its link to performance isn’t a transient environmental coincidence.
Many other firms and investors have compiled their own reports on their experience with ESG. Again please refer to the article on the Fool for more details, but two reports worth calling out:
RBC Asset Managers
Using data from Goldman Sachs, RBC compiled a report that showed that the top-scoring quartile on ESG achieved higher returns on their capital investment than the lowest quartile. Return on capital investment (ROIC) is an important metric in calculating company valuation and is what most companies show is linked to ESG. (We will quickly look at the link between ROIC and value below)
The largest magnitude results in this space are produced in a report by JUST Capital that combines ESG data with other factors to give a JUST scoring. Here the data is broken down into quintiles, but as you can see the difference is pronounced. Again the dependent variable is ROIC.
ROIC’s and the Link to Company Value
ROIC is the factor heavily linked with ESG investing because it represents a core part of a company’s intrinsic value. ROIC itself is a measure of a companies efficiency at deploying capital to projects that create profit. A company with a high ROIC will see a greater return on the money it invests than a company with a lower ROIC.
The following two graphs will show how ROIC is linked to company performance (Segall Bryant & Hamill):
Here we can see how companies with high ROIC (green) significantly outperform their peers (grey dashed)
Here we see that companies who managed to most greatly increase ROIC (blue) managed to greatly outperform their peers (grey dashed)
This short article is mainly a summary of articles such as this one and is designed to give you some understanding of the current hypothesised links between ESG performance and company performance. From the evidence given here, there is a strong case for all investors to consider ESG factors in their investment strategy.
What do you think? Let us know in the comments below