Like many banks and asset managers, Bank of America BAC has grown increasingly vocal about the importance of environmental, social and governance factors to investment and asset allocation decisions. Last year, BofA Global Research sought to demonstrate the value of ESG through quantitative analysis. According to its report published in November, ESG investing strategies can deliver superior returns. Yet, as I discussed in Part 1 of this series, the claimed performance advantages are far from certain.
Superior returns were not the only advantage of ESG strategies claimed by BofA, however. The report also found that companies ranking high on ESG factors face reduced risk compared to their peers.
Avoiding future earnings risk
ESG strategies may be able to help investors avoid the nasty pitfalls of business scandals and other crises. Indeed, Bank of America found that companies’ ESG rankings could serve as a powerful predictor of future trouble:
“ESG analysis can help you steer clear of the meltdowns. Just this year, three out of the five biggest chairperson/CEO resignations in the US were related to E, S or G scandals. And in the last five years, corporate ESG blunders have destroyed more than half a trillion dollars of market cap in the US market alone. In Asia, 73% of companies with credit downgrades over the last five years had below-median ESG scores.”
The bank’s conclusion is unequivocal: Not only are ESG metrics important signals of future earnings risk, they “are the best measure for signaling future earnings risk – superior even to financial risk factors, like the level of a company’s leverage,” as companies that score poorly on ESG factors are more prone to experiencing operational, financial and public crises.
On its face, it makes intuitive sense that companies that rank poorly on environmental and social factors are more prone to scandals and crises involving those factors. However, everything ultimately appears to come back to governance.
Everything comes back to governance
The importance of management integrity and good corporate governance has long been understood by investors, and is considered vital by most value-oriented investors. In his 2003 letter to Berkshire Hathaway BRK.ABRK.B shareholders, Warren Buffett (Trades, Portfolio) highlighted the importance of a strong, independent board to companies’ success:
“True independence—meaning the willingness to challenge a forceful CEO when something is wrong or foolish—is an enormously valuable trait in a director. It is also rare. The place to look for it is among high - grade people whose interests are in line with those of rank-and-file shareholders—and are in line in a very big way.”
The scandals and blowups described in Bank ofAmerica’s report highlight the importance of management integrity, open disclosure and good governance. While there are environmental and social components to this, it appears that poor governance is really at the heart of the issue. When a company fails to report ecological damage, for example, it is a case of management failure and improper disclosure.
While valuable information to have, it is still unclear how this can translate into a dedicated market-beating investing strategy.
More tool than strategy
ESG metrics are designed to help investors, analysts and observers understand a company’s overarching attitude and approach toward a range of business factors. That is undeniably valuable, in my assessment.
But building a dedicated strategy around the concept is less of a sure bet, as investor Mark Gutman observed on July 3: “ESG and Impact Investing would not exist as distinct investment styles if they were actually better.” In other words, while ESG analysis offers some new tools for investors interested in understanding management quality and governance risk, it does not rise to the level of a novel strategy around which one should build their investment portfolio. Rather, it suggests a valuable additional screener one can use to weed out bad companies.
According to the CFA Institute, “more thorough consideration of ESG factors by financial professionals can improve the fundamental analysis they undertake and ultimately the investment choices they make.” I find myself in full agreement with this view. There is far more study ahead, especially as ESG grows in popularity.
My verdict
ESG metrics clearly offer investors another lens through which to conduct fundamental analysis. However, I cannot recommend that investors make ESG the centerpiece of their strategies.
Disclosure: No positions.
Read more here:
- Can ESG Investing Beat the Market? Part 1
- Boeing’s 737 MAX Problems Are Far From Over
- Warren Buffett’s $137 Billion Question
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