In late February and early March, we witnessed what the European Corporate Governance Institute calls an “an exogenous and unparalleled” crash, during which the S&P 500 shed one-third of its value, dropping from approximately 3,300 on Feb. 20 to close at 2,200 one month later. This provided a natural experiment for tests of environmental and social policies by public corporations and their impact for their investors.
In a new working paper, written by Rui A. Albuquerque and others tested whether stocks with higher ES ratings were more resilient than otherwise comparable stocks in terms of returns, lower volatility, and higher operating profit margins during the first quarter of 2020. This team excluded governance-related considerations from its study, as it provided a possible confounding factor.
Customer Loyalty and Profit Margins
The ES score they employed for their research was an averaging of an issuer’s Refinitiv Environment Pillar Score and the Social Pillar Score, as measured in 2018. They also used MSCI’s 2016 figures for a robustness test. More on that below.
How is it that the high-scoring firms show such resilience? The profit margins are broader even as sales numbers decline. So the success of ES firms appears to be related to customer loyalty. Such firms can either increase prices or maintain their high margins despite a decrease in demand, because their customers are believers. They aren’t comparison shopping on price.
ES firms typically produce that customer loyalty at the expense of high advertising expenditures. The ECGI’s research, by proving the efficacy of that expenditure, may inspire some firms to get to work branding themselves as earth-friendly, both by earning high scores in the various metrics for such matters and by letting actual and potential customers know it.
But is this the only possible explanation? Could there be reasons other than customer (or investor) loyalty that might explain why the stocks of high ES firms were surprisingly resilient?
The paper mentions a couple of possible alternatives. Perhaps the key is simply the fall in energy prices in the first quarter of 2020, which was not a result of Covid-19 and indeed got underway prior to the Covid-19-caused disruptions. Firms in this sector are characteristically low-scoring in ES metrics, for reasons that have nothing to do with customer (or investor) loyalty. So, a critic might say, the robustness of high-ranking ES firms in this particular crisis was a matter of fortuitous timing.
A second alternative view: in March, governments drew a distinction between “essential” and not-so-essential business. The essential ones were allowed to continue to run more or less as before, while the others were hampered by restrictions on the degree to which their employees and/or their customers could move around. The category of “essential” might have overlapped with the domain of high ES metrics in a way that could lead to misleading inferences.
The authors don’t accept either of these alternative explanations. As to the oil price decline, they ran the numbers after excluding energy firms from their sample and found that the comparative resilience of ES over non-ES firms was even stronger. They also say that their findings “encompass most industries” regardless of the essential/non-essential distinction.
For a robustness test, as mentioned above, the authors reran the analysis using MSCI’s ESG Research database (f/k/a KLD). Using only the non-governance attributes, they fixed on the difference between the number of strengths and the number of concerns for each issuer in 2016. They divided the number of strengths for each firm year across all six ES categories by the maximum number of strengths and did the same with concerns and maximum possible concerns. Their alternative measure was bounded by -1 and +1.
Their conclusion, that ES firms proved quite resilient in the face of the Covid-19 crisis, was robust as against this change in metrics.
The Rest of the Team
Aside from Albuquerque, who is affiliated with Boston College, the team consisted of Yrjo Koskinen and Shuia Yang, both of the University of Calgary, and Chendi Zhang, of the University of Exeter.
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