How ESG affects stock selection
Why ESG analysis is just as relevant for emerging markets as it is for developed market equities
RESEARCH undertaken by State Street’s active quantitative equity (AQE) team has shown that environmental, social and governance (ESG) issues could provide a differentiated quality factor in its investment process to include or exclude companies.
The hypothesis underpinning the research was that companies behaving in a sustainable way should achieve better long-term performance, while firms that rank poorly on ESG criteria might be more prone to chronic operational issues or more exposed to regulatory risk and the prospect of public scandals, which could impair their stock valuations.
While some investors might think that an ESG focus is only relevant for large, developed market (DM) companies with the resources to finance ESG-related projects in more regulated countries, AQE’s research shows that emerging market (EM) and smaller DM companies with higher ESG scores have outperformed those with lower scores. In fact, this analysis finds that such companies are increasingly standing out, since participating in the global marketplace requires ESG awareness.
Take the case of two stocks in the Paper & Forestry industry that the AQE team was considering for its EM portfolio. The first company is a Brazilian manufacturer of coated and uncoated paper and a global leader in eucalyptus pulp production. The second company is a Chilean maker of forestry, pulp, paper and tissue products. In late 2017, expecting that pulp prices would remain strong, the team used ESG criteria to invest in the first company, but not the second.
AQE’s stock selection process seeks to identify companies that are well managed and therefore more likely to deliver sustainable future growth. Financial statements — and particularly balance sheets — can provide a good indication of quality, reflecting management decisions on acquisitions, debt financing, and cash flow. But other important management actions are not captured by financial statements such as the quality of their corporate governance, their environmental profile and the way they treat their employees and their community. Those are the non-traditional areas that ESG scoring seeks to encompass to give a more complete view of a company’s long-term earnings prospects.
Both South American firms had attractive characteristics based on the team’s traditional stock selection criteria. The first company ranked well across many of the earnings and cash-flow based valuation metrics. Its order book was solid, and forward earnings estimates were rising thanks to its plans for future growth and diversification. The second company also scored highly on key valuation metrics and forward earnings expectations were increasing rapidly.
Widening the lens to broader ESG issues, however, the team understood the risks associated with the industry, such as deforestation and other issues related to climate change. Using a proprietary ESG materiality methodology to see how these firms fared relative to peers in the MSCI Emerging Markets Index and the Paper & Forestry industry, AQE’s evaluations of the two companies were quite different.
For example, the first company is a signatory to the United Nations Global Compact, a voluntary initiative in which firms commit to implementing universal sustainability principles and take steps to support UN goals. It also had high scores on metrics related to greenhouse gases (GHG) and water management, corporate governance and ESG reporting standards, including a thorough sustainability report. And it scored above the industry median on supply chain monitoring, health and safety certifications, human rights policy and community involvement programs — all positive ESG signs that enhanced the favorable traditional metrics.
The same analysis for the second company raised serious issues. Several years earlier the firm had been involved in a price-fixing scandal but showed few signs of making changes to avoid future issues. While it exhibited high standards in ESG reporting, the team still had concerns about bribery and corruption issues, health and safety certifications, human rights policy and community involvement programs. Those non-traditional metrics led the team to exclude the company from its EM portfolio.
Anna Lester is a senior portfolio manager at State Street Global Advisors