"An ESG focus has become essential for long-term compounding."
-- The Morgan Stanley International Equity Team
"If I try to be a responsible investor, will I lose money?" This is a question many investors ask about the concept of investing not only for personal financial gain, but also in the spirit of making the world a better, healthier, more equitable place (or at least doing as little harm as possible).
If you're curious about the basics of investing with a focus on environmental, social, and corporate governance (ESG), we have a primer titled "What Is ESG Investing?"
If you're already up to speed on ESG and want to know whether the investment style actually works, read on for a rundown of compelling reasons to add ESG analysis to your investing toolbox. There's even a Rule Breaker Investing podcast episode titled "So, Does ESG Work?" to tune into, where The Motley Fool co-founder David Gardner voices his support for ESG.
It's time to put to rest the conventional wisdom that investing for anything other than shareholder value results in poor investor outcomes. There's plenty of evidence that companies prioritizing ESG issues actually generate superior long-term financial performance across a range of metrics -- including sales growth, return on equity (ROE), return on invested capital (ROIC), and even alpha (market outperformance).
Image source: Getty Images.
When companies pursue a stakeholder-centric approach to value creation by incorporating ESG into their long-term investment strategy, they're able to attract the best talent, build loyal customer bases, prosper through strong corporate governance oversight, mitigate risk, and drive profitable growth by investing in sustainable innovations that positively impact the world.
A company cannot become an ESG powerhouse overnight. It takes time to develop a deeply rooted ESG culture and leadership team capable of systems-based thinking, and dedicated to investing (through research and development, and capital expenditures) in long-term initiatives to drive shared-value creation. High-ESG organizations seek to avoid short-term, bottom-line thinking. Instead, they envision the cause and effect of corporate actions, and seize stakeholder-centric, value-creating opportunities while avoiding stakeholder-related risks. Shareholders still prosper, though not at the expense of employees, customers, suppliers, the community, or the planet -- and usually over a longer time horizon.
Therefore, modeling a business around ESG can be an underappreciated source of sustainable competitive advantage, which is why these companies can boast such strong business fundamentals and generate market outperformance.
If you're already convinced that ESG analysis is a great way to find awesome stock ideas, you might want to check out The Motley Fool's ESG investing framework. Otherwise, read on for a wealth of information on ESG investing sourced from all sectors of the financial industry. You'll also learn about ESG's connection to a key metric, return on invested capital (ROIC).
What is the proof that ESG investing works?
Exploring the links below, you can delve deeper into how ESG can produce better results for you as an investor. To be fair, not all of the research published on this topic supports the notion that ESG factors always lead to better stock returns. There are plenty of variables that can result in varying degrees of success, including elements as simple as time frame, and the fact that not all stock pickers are good stock pickers. (Of course, such elements can affect every investment philosophy and method, not just ESG investing.)
However, a significant amount of research suggests a positive correlation between companies that do good and companies that do well financially -- and by extension, do well for shareholders.
Harvard Business School professor George Serafeim wrote for Barron's: "Even if you do not believe that ESG factors will improve performance, I haven't seen any recent evidence that integrating material information about ESG will hurt performance."
This exploration gravitates toward sources that are fairly current and diversified. These include some of the largest investment firms in the world as well as some smaller boutique firms, and "sell side" equity research firms and investment banks as well as "buy side" asset management firms. Established news media sources are featured as well.
Business and investing success using ESG
Here's an overview of the most esteemed investing sources sharing insights on how ESG drives superior investing returns.
JUST Capital, co-founded by legendary hedge-fund manager Paul Tudor Jones, reported:
Top-quintile ranked JUST companies have 18% to 22% lower volatility, 6% lower beta, 5% shallower drawdowns, nearly half the quarterly earnings-per-share volatility, and 4.5% higher ROIC than bottom-quintile companies. These findings are consistent, though more pronounced in magnitude, than other research from the Environmental, Social, and Governance (ESG) investment community.
Image source: JUST Capital.
There's a growing body of evidence to suggest that stocks of companies that meet high standards for environmental, social and governance factors (ESG) are actually likely to outperform the market. In other words: Investors can do well by backing companies that do good. Data from asset management start-up Arabesque, for example, found that S&P 500 companies that ranked in the top quintile for ESG factors outperformed those in the bottom quintile by more than 25 percentage points between the beginning of 2014 and the end of June 2018, while their stock prices were less volatile. Other research, from organizations including consulting giant McKinsey & Co. and advocacy group JUST Capital, has reached similar conclusions.
There is growing consensus that integrating material ESG factors correlates to long-term financial returns and can help generate alpha.
We apply an ESG filter to a highly selective universe of 100 companies that have already been screened for value creation as measured by ROIC, economic spread, margins and asset turnover ratio. We found that, over the last five years, companies with higher ESG Ratings exhibited higher average return on invested capital, compared to companies with lower ESG ratings. They were also valued at a premium over their other top performing peers with lower ESG Ratings.
We believe sustainability creates business value. A growing body of research demonstrates that resource-efficient companies produce higher financial returns than benchmark indexes. They also exhibit higher levels of innovation and corresponding margins, returns on assets and returns on equity. A 2015 Harvard Business School study of more than 2,300 firms found that companies that commit to and invest in strategic sustainability efforts have higher risk-adjusted stock performance, sales growth and margins -- and that these sustainability activities drive business value.
Our BofA Merrill Lynch Global Research team authored a research report in 2016 that showed incorporating ESG factors into an investment approach can be critical to achieving one's long-term financial goals -- and that ignoring ESG may be costly to investment performance. Specifically, they found that those companies ranking highest in ESG criteria tended to have consistently lower future stock price volatility and higher average subsequent returns on total equity as compared to their lower-ranked counterparts.
It turns out that you can "do good" and do well: during the full period we analyzed (2005 to 2017), S&P 500 stocks with high Environmental scores based on the three datasets we analyzed would have outperformed their low ranked counterparts by as much as 3ppt [percentage points] per year. ... And ESG is a better signal of earnings risk than any other metric we have found.
Companies that score highly in terms of their approach to ESG factors tend to deliver higher cash returns on their investments than their sector peers, which constitutes a powerful and persistent source of alpha over the long term. The importance of sustained high cash returns, strong cash generation, and the ability to profitably invest it in growth is evident in the growth rates of high and low return companies over the last decade. As Exhibit 5 in the article illustrates, those companies with the highest cash returns, such as those firms in the top ESG quartile, delivered growth approximately 40% faster than the averages of their industries over that period.
Image source: RBC Global Asset Management. Data source: Goldman Sachs.
A working paper by professors from Harvard Business School and the London Business School:
We track corporate performance for 18 years and find that High Sustainability firms outperform Low Sustainability firms both in stock market as well as accounting performance. Using a four-factor model to account for potential differences in the risk profile of the two groups, we find that annual abnormal performance is higher for the High Sustainability group compared to the Low Sustainability group by 4.8% (significant at less than 5% level) on a value-weighted base and by 2.3% (significant at less than 10% level) on an equal weighted-base. We find that High Sustainability firms also perform better when we consider accounting rates of return, such as return-on-equity (ROE) and return-on-assets (ROA) and that this outperformance is more pronounced for firms that sell products to individuals (i.e., business-to-customer [B2C] companies), compete on the basis of brand and reputation, and make substantial use of natural resources. Finally, using analyst forecasts of annual earnings we find that the market underestimated the future profitability of the High Sustainability firms compared to the Low Sustainability ones.
Mounting evidence shows that sustainable companies deliver significant positive financial performance, and investors are beginning to value them more highly. Arabesque and University of Oxford reviewed the academic literature on sustainability and corporate performance and found that 90% of 200 studies analyzed conclude that good ESG standards lower the cost of capital; 88% show that good ESG practices result in better operational performance; and 80% show that stock price performance is positively correlated with good sustainability practices. Here are some other datapoints to consider: Between 2006 and 2010, the top 100 sustainable global companies experienced significantly higher mean sales growth, return on assets, profit before taxation, and cash flows from operations in some sectors compared to control companies.
In recent years a wide literature of academics and practitioners has been developed which supports the proposition that high ESG characteristics are associated with lower costs of capital and higher quality profitability including high ROIC. Several meta studies illustrate the "do well by doing good" premise that corporate responsibility as proxied for by ESG is consistent with stronger firm performance. As we observe across these multiple studies, there seems to be clear evidence that companies with high non-financial indicators of quality seem to perform significantly better on market and accounting-based metrics.
ESG investing is not just about doing good. A growing body of research points to a link with asset performance. Companies that manage sustainability risks and opportunities well tend to have stronger cash flows, lower borrowing costs and higher valuations.
"Sustainable, responsible and impact investing" funds account for some $9 trillion in assets under management in the U.S. and have grown 33% a year over the past two years, according to a December report from Bank of America Merrill Lynch. The report's authors found that companies that scored in the top third on environmental, social and governance characteristics relative to their peers outperformed stocks in the bottom third by 18 percentage points.
Companies with better environmental, social and governance standards typically record stronger financial performance and beat their benchmarks, according to research from Axioma. The risk and portfolio analytics provider said the majority of portfolios weighted in favour of companies with better ESG scores outperformed their benchmarks by between 81 and 243 basis points in the four years to March 2018. Portfolios tracking large and medium-sized companies in developed markets, excluding the US, demonstrated the largest outperformance of 243 basis points. A portfolio weighted for all top-scoring ESG companies in the US, regardless of size, outperformed by 175bp, while companies in emerging markets did so by 129bp.
One of the biggest trends I've seen in 2018 regarding ESG investing is the growing belief in the ability for these concepts to be long-term producers of alpha in addition to being socially responsible.
According to research by Deutsche Bank, which evaluated 56 academic studies, companies with high ratings for environmental, social, and governance (ESG) factors have a lower cost of debt and equity; 89 percent of the studies they reviewed show that companies with high ESG ratings outperform the market in the medium (three to five years) and long (five to ten years) term.
We ... find a strong relationship between financial productivity [measured using cash flow return on investment] and environmental and governance ratings.
If a company has a competitive edge from an ESG issue, this should become visible in its value drivers. That is, it should in the end have higher sales growth, higher margins, a more efﬁcient use of capital, or lower risk. These value drivers in turn drive the firm's return on invested capital and valuation.
Our research shows a high correlation between material ESG factors and return on invested capital (ROIC), confirming the significant financial impact of ESG and importance of inclusion in the investment process ... Our research has clearly identified material ESG factors that are highly correlated with increased ROIC and increased alpha, presenting the opportunity to enhance investment performance.
We find a consistent correlation between ESG ratings and operational metrics. For example, companies with top ESG ratings have higher ROE and ROCE [return on capital employed], and lower net debt/EBITDA [earnings before interest, taxes, depreciation, and amortization] than the market.
The global top-quartile of ESG rated companies consistently tends to achieve higher ROICs compared to bottom ESG rated companies. Additionally, better ESG rated companies tend to offer better ROIC resilience.
Of all the metrics mentioned in the references above, we want to zero in on ROIC, because it's the primary driver of intrinsic business value and stock-price performance. So, if you're wondering why ESG's connection to ROIC is important, grab another cup of coffee and settle down for round two.
Why the ROIC connection is important
We reported finding that very few financial quality metrics appear to generate significant alpha. The main exception was ROIC, the use of which has created alpha consistently over a long period of time. Furthermore, the persistence analysis shows that for investors capable of identifying a priori high ROIC companies that will maintain their high ROIC attributes for multiple years, the alpha will continue as "the gift that keeps giving."
Valuation, a book by McKinsey:
Always start with the key drivers of value: return on invested capital (ROIC) and revenue growth.
The key financial characteristic of compounders is that they enjoy sustainable, high return on invested capital (ROIC).
We believe ROIC is a strong driver of stock prices and equity valuation. Top-line growth and profit growth also help drive stock price, but ROIC is, by far, the most important driver because the market cares most about assigning value to the companies that produce the most cash per dollar of capital invested in them.
Image source: New Constructs.
New Constructs, elsewhere:
ROIC is the primary driver of stock prices.
When we looked across the various potential drivers of total return (ROE, EPS [earnings per share] accretion, ROIC, etc.), ROIC was the metric with the strongest correlation to total return.
Over longer periods, high ROIC names have historically outperformed low ROIC names by a wide margin.
Our research also revealed that investing in companies with top-quartile ROIC has been most likely to deliver strong long-term shareholder returns. Over the analysis period [1988-2016], 58% of companies that started with top-quartile ROIC were able to maintain that over a rolling five-year period. These Quality companies delivered outperformance of 5.4% p.a. [per annum] on average versus the market.
There is indeed a positive relationship between firms' return on capital and their share prices over the long term.
ROIC matters in driving stock returns.
We can trace new value creation to its most fundamental components: reinvestment and return on invested capital (ROIC).
Our research has shown that over time, stock price performance has a higher correlation to improving ROIC as opposed to traditional valuation measurements such as price to earnings (P/E).
New York University valuation professor Aswath Damodaran:
We can safely conclude that the key number in a valuation is not the cost of capital that we assign a firm but the return earned on capital that we attribute to it.
We've found, empirically, that long-term revenue growth -- particularly organic revenue growth -- is the most important driver of shareholder returns for companies with high returns on capital (though not for companies with low returns on capital).
Historically, higher-quality stocks have tended to outperform over the long term. To illustrate, we looked for a common measure as a proxy for quality. There are many available, including return on equity or assets, margins, leverage, and earnings variability, but in this analysis we use a company's return on invested capital (ROIC) because it provides an assessment of how efficiently management allocates capital to profitable investments. The universe is the Russell 3000 Index. High-quality stocks are those in the Russell 3000 Index within the top quintile of ROIC; low-quality stocks are those within the bottom quintile.
As you can see from ... the quarterly performance difference between the top and bottom quintiles as measured by ROIC, higher-quality companies have historically outperformed lower-quality companies.
Analysis shows that Return on Invested Capital (ROIC) is often a reliable proxy for value creation.
[From March 1994 through August 2014, investors were] handsomely compensated with a total return 2.93x greater than the market (top ROIC quartile of the Russell 3000 Index vs. the index’s equal-weighted return) since 1994, which has translated into an annualized alpha of 6.63 [outperforming the index by 6.63% annually].
Janus (now Janus Henderson):
Historical analysis by Credit Suisse Research shows that companies in the top quintile of ROIC outperformed companies in the bottom quintile over a 20+ year period (January 1990 - April 2012).
From 1999 to 2008 ... the firms with the top quartile ROICs also generated the highest stock returns, whereas firms with the bottom quartile ROICs generated the lowest stock returns during this 10-year period.
On board? Next steps to add ESG analysis to your investing strategy
The interrelationship between ESG, ROIC, and other important business performance metrics can help you build a portfolio that not only provides competitive financial returns, but that you can also feel good about. Be sure to explore the links in this article to read more in depth, and bookmark this page to revisit.
If you're ready to try this style of investing for yourself, check out The Motley Fool's ESG hub, where you can find a variety of content to help guide you; it includes the handy ESG investing framework, and high-ESG stock ideas, too.
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Alyce Lomax has no position in any of the stocks mentioned. John Rotonti has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends FactSet Research Systems. The Motley Fool has a disclosure policy.