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Better ESG practices boost returns

Companies with strong ESG values do not sacrifice investor returns, according to Aberdeen Standard Investments (ASI).
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Investors say they want to invest in companies with strong ESG credentials, and asset managers are keen to offer these investments, but the suspicion remains that ESG investments may not perform as well as “traditional” investments.

“However, the evidence shows there is no ‘sacrifice’ of returns for strong ESG principles,” said David Smith, senior investment director, ASI.

After analysis of how ESG factors affect the medium- and long-term performance of companies and portfolios, Smith is convinced that committing to ESG has a much more positive outcome for business, employees, customers, the natural environment, the climate and returns for investors, than has previously been thought.

“We’ve looked through the academic research and concluded that ESG principles bring significant value,” he said in a report.

Analysis by MSCI of 1,600 companies in the MSCI World Index universe, between January 2007 to May 2017, sorted companies into five ESG score quintiles, ranging from companies with the lowest ESG rating (quintile 1), and the highest (quintile 5) and Q5 the highest.

Highly ESG rated firms were more profitable and paid higher dividends than lower rated firms, and top-rate companies also demonstrated lower earnings volatility and lower systematic volatility.

Companies with a strong ESG profile are more competitive than their peers, because of more efficient use of resources, better human capital development, or better innovation management, according to the MSCI paper, “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance”.

Moreover, high ESG-rated companies use their competitive advantage to generate abnormal returns, which ultimately leads to higher profitability, and higher profitability results in higher dividends.

Risk reduction

These findings are confirmed by the NYU Stern Center, which discovered correlations between a robust ESG score and several qualities: profitability, share price growth, and a lowering of risk at both the portfolio and the stock level. Other benefits for higher scoring companies include that they can obtain both debt and equity capital at a lower cost.

Companies with ESG credentials perform better in times of volatility too. Data from 2004-2018, and from the Covid crisis of 2020, showed companies with higher ESG scores were more resilient during volatile periods, suggesting ESG credentials improve a company and a portfolio’s risk-adjusted return, according to Smith.

“It would appear that ESG integration reduces portfolio risk across every kind of market and investment style. Over longer time frames, this positive ESG effect is enhanced,” he said.

Robust ESG has a particularly positive effect in the emerging market space, where the relationship between company performance and a good ESG scorecard is positive. 

A meta-analysis of over 2,200 research papers on ESG integration found a positive relationship between ESG and corporate financial returns. For emerging markets, the 65-71% positive corporate financial outcomes revealed is much higher than that of developed markets (38-50%).

For investors who want exposure to Chinese companies with strong ESG practices in particular, Smith said that he found that they need to take a proactive approach to engagement that includes forging a trusted relationship with senior management, which is key to driving investment returns.

“We now have the evidence to show that it’s no longer correct to believe that ESG is ‘a nice add-on’, or an ’added luxury’ that brings nothing in return,” said Smith.

“In fact, we are convinced that companies that don’t look after their people, their customers, or their impact on the environment are unsustainable businesses that increasingly may not be worth investing in,” he concluded.

Part of the Mark Allen Group.