The Cornerstone Capital Group, in a new white paper, looks at some of the specific interactions between ESG and investment factors.
The paper, by Michael Geraghty, a global equity strategist for Cornerstone, begins with a review of five of the factors most thoroughly studied in academia:
- value, the capture of excess returns via the purchase of stocks with low prices relative to fundamentals;
- capitalization, the capture of excess returns by firms with lower market cap;
- momentum, stronger past performance provides a clue (though one is often rightly warned that it provides nothing more than a clue);
- volatility, the capture of excess returns through the purchase of stocks with lower than average vol, beta, or idiosyncratic risk; and
- dividend yield, capturing excess returns to stocks that have higher-than-average yields.
As to the intersection with ESG, the paper suggests:
- that value investors may knowingly overweight areas in which ESG risks are relatively high, such as materials and energy;
- that investors in small-cap firms that also have low price-to-earnings multiples have weak ESG ratings;
- that given “wide divergences in the quality of corporate governance in emerging markets, ESG-based stock selection can add significant value;”
- and that there is a greater appreciation of ESG information in Europe than there is in the United States.
The MSCI Study
The Cornerstone report alludes early on to a January discussion of ESG, written by Linda-Eling Lee and Matt Moscardi, published by MSCI, under the title “2017 ESG Things to Watch.”
Lee and Moscardi posit that 2017 “may usher in a fundamental rethink for investors.”
Many people in January of this year – it was the month of the inauguration of a new President of the United States, after all – were talking and thinking about political, policy, and regulatory changes as they might relate to environmental concerns and impact industry. Lee and Moscardi thought that the usual focus of such discussions was misdirected. The concern should be, and soon will be, not with regulatory but with physical risk.
“[W]e believe investors will turn their attention to mitigating exposure to the physical risks of climate change, especially the encroaching scarcity of water in regions that range from the Middle East to the U.S.,” they wrote.
On the subject specifically of corporate governance, Lee and Moscardi expressed the view that 2017 will upend “the conventional wisdom that Asia lags global peers in corporate governance,” because it will be the year of the “rapid adoption of codes that promote engagement between companies in Asia and investors.”
But the MSCI authors also said that ESG investing will become a “precision tool” as the present year unfolds. It will become a weapon for sharpshooters, not a shotgun. ESG is a matter of “signals” that must be integrated “across asset classes, markets, and factor exposures.” That is the aspect of their work that brought it to the attention of Geraghty at Cornerstone. It is no longer a matter of whether or of how much but of where, in what factors or geographical markets, the impact will be felt.
Back to the Cornerstone
The Cornerstone paper indicates that U.S. investors are still either unconvinced about the impact of material ESG factors or less knowledgeable on the subject than their European colleagues. American shareholders “have been known to challenge companies for over-committing to ESG issues.”
Geraghty also makes the point that governance rankings (the G part of ESG) are especially important in the emerging markets. Why was the incorporation of ESG data into index stock selection more valuable in emerging markets? In large part because governance is less developed in such countries. That, in turns, owes a good deal to the prevalence of state-owned enterprises (SOEs).
SOEs “are particularly prevalent in the energy, financial, materials, and telecom sectors in EMs,” and they get themselves low ESG ratings, especially low G ratings, largely because they aren’t run with the idea of maximizing profits. They are run for other reasons under the guidance of the state’s policy makers. Perhaps they will be willing to maximize exports or keep employment levels high at the expense of investor returns.
Attention to ESG, then, can warn investors to be wary of such situations, thereby adding significant value to a portfolio.