The COVID-19 pandemic has been extraordinary in countless ways. Beyond the deeply felt strains on health and humanity, it is an economic and social issue with generational consequences. We believe it could also be a defining moment for environmental, social and governance (ESG) issues.
From a social perspective, we expect companies will be remembered and rewarded on their actions during this crisis. The societal role of corporations has been illuminated like never before, and we expect business will go to those companies deemed to have done the right thing by their employees, customers and communities in this most trying of times.
From an environmental perspective, we could see this crisis bringing even greater attention to the impacts of climate change. Coronavirus has made it clear that when it comes to human vs. nature, the upper hand goes to nature. Many may begin to take environmental issues more seriously.
Both of these spur important considerations for investors.
Active investing with an ESG lens
ESG issues are not new considerations in our fundamental investment process. But they are increasingly important ones. Society, voters, regulators and investors are all placing greater focus on ESG. The portion of active equity assets directed to ESG mandates is on the rise and, not surprisingly, mentions of “ESG” in broker reports have spiked, as shown below.
ESG interest in the U.S. is in early innings and gaining momentum, we believe. We see this offering opportunity for active stock investors for three key reasons:
1. Current ESG measurement is imperfect.
Fundamental investors can capitalize on the confusion.
Data providers assign headline ESG scores to thousands of companies globally, but there are shortcomings: Not all companies are rated. Where there are ratings, they are based primarily on company disclosures. ESG ratings are not always comparable, as scorers apply their own methodologies. Disagreements are not uncommon. The table below shows utilities is the No. 1 ESG scorer according to data provider MSCI, but is ranked 10th of 11 sectors by Sustainalytics. Similar discrepancies are evident in individual company ratings. Given ample room for interpretation, fundamental investors can overlay their own analysis and uncover potential opportunities and risks.
2. ESG value is not fully reflected in stock prices.
This means opportunity to access future alpha potential on the cheap.
While it is widely accepted that ESG can be a valuable risk factor, we increasingly believe it can be an alpha factor as well. Our analysis of valuations and ESG score for U.S. stocks showed little correlation between the two ― stocks broadly are not priced in accordance with their ESG merit. We believe this will change as the industry places higher value on ESG, and presents an opportunity for active stock pickers.
We find that ESG as a price driver varies by sector. For example, environmental considerations are value creators in utilities and energy, making ESG a relatively high explanatory factor for companies in these sectors. But ESG is baked into few other sectors today, and is even less embedded in individual stock pricing. Fundamental investors can look through the top-line score and dig into the E, S and G components to identify the materiality of each and the extent to which they may or may not be reflected in stock prices.
3. ESG is not a fad.
Once ubiquitous, the opportunity will be in anticipating changes to ESG scores.
We see ESG as an enduring market theme. It is no longer only about controversies and downside risks. ESG issues will impact company fundamentals and valuation multiples. Environmental concerns, for example, can result in changes to consumption preferences, which in turn affect revenue and operating margins. Social issues can sway voting tendencies, which in turn affect regulations and even tax rates.
Once ESG is more fully reflected in market pricing, the opportunity will be in predicting changes to ESG scores. As fundamental investors who actively engage with companies on these matters, we believe this offers an opportunity to gain important insight, see beyond the headline score and extract alpha potential over the long term.
Tony DeSpirito is Chief Investment Officer for U.S. Fundamental Active Equity and a regular contributor to The Blog.