Importance of ESG in Investment Analysis

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Sustainability. A word that connotes being green, recyclability, climate change, and renewable energy. However, what is missed at these high-level connotations is the word “necessity”. Sustainability is not anymore a “nice to have” but now a need to creating progressive societal, governmental, and economic change and development.

Corporate Knights and the Norwegian Government Pension Fund have also recognized this need to act. In 2016 I was part of an MBA team of 4 that presented an investment management strategy for the Norges Bank at the World Economic Forum (WEF) in Davos, Switzerland. Our strategy, in competition with 28 teams from 14 different countries, placed first overall and helped the fund identify opportunities to reduce carbon intensity, fossil fuel exposure, and re-allocate $18.8B of the fund’s public equity assets. Our evaluation methodology was guided by a five-metric model that included Financial Health, ESG, Risk-Return, Future Performance, and Externalities (see Figure 1)

The full Business Plan is available on the Corporate Knights website.

Figure 1: Five Node ESG Investment Framework

So effectively an equity with an aggregate score of 0–8 has a higher probability of underperforming.

Tuesday, July 3rd/2018 the share price of Glencore (GLEN.L), the world’s largest commodities company, fell by 8% as the US Department of Justice (DOJ) asked for documents potentially related to corruption and money laundering. The DOJ is looking in to Glencore’s business dealings in Congo, Nigeria, and Venezuela all the way back to 2007 to explore potential bribery of foreign officials. The DOJ is not the only organization looking into these dealings. The UK’s Serous Fraud Office is also examining bribery involvement in its Congo business. (https://www.bloomberg.com/news/articles/2018-07-03/glencore-gets-subpoena-from-u-s-regarding-money-laundering)

Glencore was the lowest scoring equity based on our investment methodology. Two and half years later let’s re-examine the three equities (see Figure 2) presented as a cross-section to the panel at WEF and see how their returns have fared over the last year (see Figure 3).

Figure 2: Cross-section of equities presented to the WEF judging panel to showcase the investment methodology.

We should expect to see Svenska Cellulosa AB with the largest return over the last year time period followed by Royal Dutch Shell and lastly Glencore PLC.

Figure 3: Returns comparison over the last year

As seen from the legend, green represents Svenska, black is Royal Dutch Shell and the blue is Glencore PLC. As hypothesized Svenska performed the best (investment methodology score of 17), Royal Dutch Shell was in the middle of both (investment methodology score of 11) and Glencore performed the lowest (investment methodology score of 8) with a return of -5%.

Sustainably driven investment strategies are still burdened with the myth that they are less profitable than strategies that focus on profit maximization. This could not be further from the truth. Companies that invest in improving their performance in relation to the three pillars of sustainable business performance (environment, social, and governance) are also more likely to outperform their peers in the long run. A recent meta-study of over 190 academic studies on the correlation between sustainability and corporate performance found that, “80% of the studies show that stock price performance of companies is positively influenced by good sustainability practices” (Clark, Feiner & Viehs, 2014, p. 7). Likewise, a comparative, longitudinal, study of 180 large corporations over an 18-year period finds that companies with strong ESG performance outperform their counterparts with low ESG performance in stock price, ROE and ROA performance (Eccles, Ioaannou & Serafeim, 2014).

Adopting sustainable business practices is no longer attributed only to good publicity, but is now an intrinsic element of a successful business model. The main benefit of adopting sustainable practices is effectively experiencing lower risk. Companies with better ESG positioning have a lower probability of performing poorly (doesn’t mean they can’t!). With benefits ranging from increased profits to improved stock performance, sustainable investing can be rewarding for businesses and investors alike. The key takeaway is not to just invest blindly in “green companies” but rather recognize that ESG has an important role to play in understanding portfolio value at risk.

Verdant Analytics

Investment learning with a comment on world politics, capital markets, and the global economy

Bhupinder Singh Dulku, MBA

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Capital Markets | Leadership | Business Analysis

Verdant Analytics

Investment learning with a comment on world politics, capital markets, and the global economy