Morningstar recently published an interesting piece of ESG research. Based on their analysts’ equity star ratings and Sustainalytics’ ESG Risk Ratings the following conclusion emerged: “investors are paying too much for good ESG companies and too little for bad ESG companies”.
There were caveats to the analysis, one being that their analysts’ estimates of fair value could be wrong, the other being that there are so many ways to score ESG that one cannot be sure theirs is the only correct one. In the author’s words: “Determining which ESG risks are most material for a company’s future is difficult; determining how material they are is even more difficult.”
Demand for ESG funds runs rampant
The conclusion is not hard to swallow. Demand for ESG funds runs rampant. From the perspective of supply and demand, if the proportion of market participants who chase companies with high ESG-ratings has been rising, this could have supported the returns of stocks with better ESG-ratings. Sooner or later, however, the popularity of ESG investing will hit its new equilibrium, reflecting the higher level of demand for stocks with high ratings. When that happens, ceteris paribus, the stocks with the highest ESG-ratings command relatively high prices and market participants should expect lower returns from them going forward.
Evli Global: Relative Valuation, and ESG with a twist
The Evli Global Fund’s conclusion remains that instead of relying on external ratings, internal ESG research done in a way that syncs with the return drivers of the Fund’s investment strategy is preferred. The strategy is to invest in quality stocks that meet our ESG criteria and have depressed relative valuation multiples. So by definition, the strategy will avoid stocks with high external ESG-ratings if they trade at high relative multiples and perhaps favor firms with low external ESG-ratings if they trade at low multiples (as long as they pass our internal ESG analysis). At least occasionally, value investing can be about going against the crowd. This goes for active investment in general too, because if sustainability becomes beta, the alternative becomes alpha.
For purposes of disclosure, Evli Global currently has a low carbon footprint (37 t CO2e/$M Sales), a MSCI responsibility score of A, no investments in companies that would fail the UN Global Compact, and it is trading at a moderate trailing free cash flow multiple of 13x.
The article concludes: “The broader lesson here is that the impact of ESG on investing returns is a question that has no definitive answer. At some points in time, good ESG companies--however defined--will be relatively cheap as a group. At other times, as appears to be the case now assuming you believe our equity analysts, good ESG companies command a premium. That’s why it’s dangerous to think there’s any one-to-one correspondence between ESG and investing returns that holds for all market environments. It all depends on relative valuations.”