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The relationship between financial metrics and ESG (Environmental, Social and Governance) performance
Recently, Tesla stock’s relatively low ranking of its ESG score within the S&P 500 ignited the wrath of Tesla’s boss, Elon Musk (FT, 2022). ESG ratings are becoming more prominent and relevant for stock selection criteria, but what is the relationship between good ESG performance and a good performing stock?
Growth stocks (e.g., Amazon, Netflix, and Tesla), chosen for their favourable prospects of strong future growth, are characterised by high PE (Price-to-Earnings) ratios which could be an indication of stock overvaluation but is more generally interpreted as a forecast of high returns.
While this may encourage investors to pay more for these stocks, the combination of high PE ratios and elevated returns results in higher volatility and thus higher risk for growth stocks.
Value stocks (e.g., JPM), selected for investment because of their dependable cashflows, generally have low PE ratios which can signal undervalued stocks. Some investors favour value stocks for this reason – they represent potentially profitable opportunities (Corporate Finance Institute, 2020). Since 2010, value stocks have generally underperformed, although they outperformed the market briefly in early 2021 (Shroders, 2021).
Many of the stocks which constitute ESG baskets tend to be growth stocks because carbon emissions from these firms are generally negligible (particularly true for certain verticals within ESG) which lends credence to the idea that strong future growth is likely (Pastor, Stambaugh and Taylor, 2019 and Felix, 2022). However, relative to value stocks, growth stocks are currently (2022) expensive so a possible investor shift in preference from growth to value stocks may constitute a short-term headwind for ESG stocks (OECD, 2020). Figure 1 below shows various performance metrics for a sample of over 100 global stocks. Quintile 1 represents the lowest quintile of ESG scores (i.e., 0 – 20%) and the Quintile 5 the highest, (i.e., 80% – 100%).
Figure 1: Performance metrics for a sample of over 100 global stocks by ESG score quintile.
The financial metrics above indicate that better ESG-scores are correlated with better performance since they tend to improve as ESG scores increase. This could be ascribed to a culture of disciplined resource and capital management; companies with strong ESG profiles are less vulnerable to systematic market shocks (such a sharp movements in oil and commodity prices, sudden changes in interest rates, and foreign exchange rate fluctuations). At least in theory, this should translate into lower s for these firms (as predicted by the CAPM model) and thus lower costs of capital and higher valuation multiples.
Another possible reason for these positive relationships could be improved risk control standards. Highly rated ESG-rated firms are less likely to suffer from severe incidents (such as fraud, embezzlement, corruption, or litigation) that would impact the firm value considerably. This is important for investors as such incidents can negatively affect the company’s stock price.
Stock selection is based on ESG data, but the driver of superior performance may not necessarily be environmental sustainability. Contemporary asset managers, private investors and smaller institutions rely on external analysis for ESG scoring, due to the lack of skilled incumbent ESG analysts. The ESG scoring process, however, is not always very transparent and between providers of ESG scores, there are wide discrepancies (in approach and ultimately in score value obtained). If links between improved sustainability and improved performance do exist, the lack of transparency renders accurate, robust performance allocation moot. It is possible that investors could increase their portfolio performance if they knew how to select the best ranked ESG rated firms. In that case, what ESG score constituent is related to returns (only one aspect (of “ESG”) relates to sustainability)? One idea which could explain why a global SRI index might generate superior returns could be that sustainable companies ought to perform better in the long run, since sustainable businesses and products will be subject to higher future demand as environmental concerns grow. Another idea is that ESG portfolios show better performance because investors respond to temporary ESG trends, driving up stock prices for companies with good ESG practices.
Recent research has shown that there is a positive relationship between ESG performance and accounting based financial performance (Velte, 2017). The work also set out to determine which of the factors (E, S or G) showed the strongest correlation to accounting based financial performance: all factors exhibited a positive correlation to accounting based financial performance, with the governance factor (G) the strongest.
Other recent research has found that financial performance of ESG portfolio improves over longer time horizons. Investments with long-term focuses are 76% more likely to have a positive or neutral relationship between ESG and financial performance (Corporate Finance Institute, 2020).
A contemporary metastudy (of more than 1 000 research articles since 2015) examining the linkage between ESG and financial performance reveals a growing consensus that good corporate management of ESG issues results in improved operational metrics such as ROE, ROA and stock prices. For investors seeking to construct portfolios that generate , some ESG strategies generate market rate or excess returns when compared to conventional investment strategies, especially for long-term investors, and provide downside protection during economic or social crises (Alva Group, 2020).
It is clear that more work is required to explore these ideas in greater detail. The quality of the relevant analysis is highly dependent on good and detailed ESG indicators with transparency around the input coming from all aspects of ESG, not just one of them. Tesla, for example, may score well on the environmental component, but ESG-savvy investors may still be more concerned with the positive aspects that sensible social and governance components can bestow upon stocks.
Alva Group, 2020. The ESG metrics that matter most to investors. Available from https://www.alva-group.com/blog/the-esg-metrics-that-matter-most-to-investors/
Corporate Finance Institute, 2020. Available from https://corporatefinanceinstitute.com/resources/knowledge/other/esg-environmental-social-governance/
Felix, B. 2022. Sustainable investing. Available at https://www.youtube.com/watch?v=weVAN2HxXjk&ab_channel=BenFelix
FT, 2022. Interview with Elon Musk. May 13, 2002. Available from https://www.ft.com/content/697d8d32-6ef9-4b4c-835a-3e9dcbdb431a
OECD, 2020. Availabe from https://www.oecd.org/finance/esg-investing.htm
Pastor, L., Stambaugh, R. F. and Taylor, L. A. 2019. Sustainable Investing in Equilibrium. NBER Working Paper No. w26549, Available at SSRN: https://ssrn.com/abstract=3504432
Schroders, 2021. Available from https://www.schroders.com/en/insights/economics/sustainable-investment-report-q4-2021/
Velte, 2017. Does ESG performance have an impact on financial performance? Evidence from Germany. Journal of Global Responsibility, 8(2): 169 – 178.