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John Engle
John Engle
Articles (529) 

Can ESG Investing Beat the Market? Part 2

Bank of America says companies that score highly on ESG metrics are less risky than their peers

July 06, 2020 | About:

Like many banks and asset managers, Bank of America (NYSE: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 banks 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 companys 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 (NYSE:BRK.A)(NYSE:BRK.B) shareholders, Warren Buffett (Trades, Portfolio) highlighted the importance of a strong, independent board to companies success:

True independencemeaning the willingness to challenge a forceful CEO when something is wrong or foolishis 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 shareholdersand are in line in a very big way.

The scandals and blowups described in Bank ofAmericas 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 companys 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.

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About the author:

John Engle
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an MBA from the University of Oxford.

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