This article first appeared in the Telegraph
A key challenge to increasingly popular sustainable, or responsible, investing approaches is whether there is a financial price to pay for ‘doing good’. That used to be the conventional wisdom. More recent research suggests the opportunity cost of doing the right thing might be negligible. Some go further to claim that companies with strong environmental, social and governance (ESG) credentials are better businesses and, by extension, likely to make better investments too.
One of the hurdles for anyone trying to substantiate these claims is the absence of long-run data. For broader stock market trends, we can now benefit from evidence stretching back to the 19th century. When it comes to assessing socially responsible investing, a niche pursuit until very recently, we don’t have that luxury.
This caveat is worth bearing in mind when looking at some analysis from my investment colleagues at Fidelity who have looked at the link between the ESG characteristics of 2,600 companies and their performance during the sharp market downturn between February and March this year. No-one would wish to overstate the significance of a month’s worth of data, but the findings are pretty interesting nonetheless.
The top line is that there is a very strong positive correlation between a company’s rating on ESG factors and its resilience during the recent Covid-19-related correction. The data seem to support the hypothesis that companies with good sustainability characteristics are better run businesses, with more prudent and conservative management teams. Their resilience during the recent bout of market volatility reflects these positive factors.
Here are the salient numbers. Between February 19 and March 26, the S&P 500 index fell by 26.9%. During the same period the companies rated most highly on ESG characteristics fell by 23.1%. 1Past performance is not a reliable indicator of future returns. Those rated worst fell much more than the market as a whole (down 34.3%) while the companies in between traced a straight-line correlation. The middle three rankings fell by 25.7%, 27.7% and 30.7% respectively.
If this were the result of chance, I would be surprised. Not least because the same pattern was repeated in almost all of the individual sectors analysed. Within healthcare, for example, the most-highly-rated companies from an ESG perspective fell 12% while the worst were down 32%.
Of course, correlation is not causality and it is worth pointing out that companies that score well on ESG factors also tend to be less volatile than the market as a whole. It might be that this is the key factor rather than the sustainability ranking. Stripping it out, however, paints a very similar picture even if the dispersion of returns is more compressed. A good case can be made, albeit on the basis of a short run of data, that ESG factors are a meaningful indicator of financial risk.
The link between social value and stock market performance is not a new focus for investors, although the terminology has changed. Attention has long been focused on companies at the other end of the spectrum, so-called ‘sin stocks’ - the conventional wisdom here being that the companies many responsible investors choose to exclude from their portfolios today have tended to offer the best returns over the years.
Professors Dimson, Staunton and Marsh, in their research for the Credit Suisse Investment Returns Yearbook, recently pointed to the long-run outperformance of tobacco and alcohol stocks. The former tops the leader-board since 1900 in America while the latter has been the best-performer in the UK over the past 120 years.
As with Fidelity’s ESG research, however, it pays not to confuse causation and correlation. When adjustments for a range of other factors like size, value, momentum and quality are made, the apparent ‘sin premium’ disappears. The companies operating in these controversial sectors just happen to be well-managed, profitable companies with strong financial disciplines.
The more you delve into issues of sustainability and performance, the more you realise what a minefield this topic is. One of the reasons research-driven investors like Fidelity spend so much time and effort conducting their own analysis of companies’ ESG credentials is the absence of consistent frames of reference. To take one high-profile example, Tesla is ranked as the most sustainable car manufacturer by one rating agency while another puts it at the bottom of its sector. The reason is they are looking at different things: one is rating the company on the basis of its clean products, while the other is focused on its less impressive factory emissions.
Another big unknown is the extent to which the link between ESG factors and a company’s overall quality does or does not feed through into stock performance in the long run. The key question here is how effectively and quickly investors price in environmental, social and governance issues. For example, a 2013 study of governance factors showed that highly-rated companies outperformed the market strongly between 1990 and 2000 but moved in line thereafter. The paper’s authors believed investors simply got better at spotting good governance and these companies enjoyed higher valuations, reducing the potential for future returns.
The most interesting finding of the Credit Suisse research is that the aspect of ESG investing that offers the best financial rewards is engaging with investee companies, exerting owner’s influence to create more sustainable and socially valuable businesses. Rating companies on the basis of their sustainability is not a goal in itself. It can contribute, however, to delivering investments that match both financial goals and non-financial values.
1 Fidelity International, April 2020
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