With the explosion of big data around the world and the need for advancements growing exponentially when it comes to processing this data, so too is there an increasing need to explore available ESG data in the most efficient way possible.
Over the past 12 years, we have been on a journey, as an investment business, of deep exploration into the world of ESG (Environmental, Social, and Governance) data. Looking for efficient ways to analyse data points to assess ESG credentials. And we've developed a profound understanding of the methodologies that exist within the global ESG landscape.
Imagine sifting through data encompassing over 1 600 stocks, spanning a decade's worth of information. Our goal was to uncover whether these companies had substantial exposure to factors that consistently translated into strong financial performance over time.
There is a pivotal role that ESG factors play in the world of investing. What's more, we've discovered meaningful relationships that underscore the strong connections between ESG considerations, quality metrics, and the management of unique risks. These findings underscore how responsible business practices not only lead to financial stability but also play a vital role in mitigating risks. It's a reminder that ESG considerations are not just a checkbox; they are an integral part of modern investment strategies.
ESG as a competitive advantage
Research has shown that by selecting companies with strong ESG attributes, we are gaining exposure to resilient companies that are potentially more competitive than their peers.
This competitive advantage can be due to the more efficient use of resources, better human capital development, or better innovation management. In addition to this, high ESG-rated companies have a disciplined approach to managing assets and liabilities and can fortify their balance sheet with greater capital reserves that can help ride out a downturn and withstand market crises like the Global Financial Crisis of 2008/9 and, more recently, the unprecedented Covid-19 pandemic. These resilient companies have above-average risk control and compliance standards across the company. With better risk control standards, they suffer less frequently from events such as fraud, embezzlement, corruption or litigation cases that can seriously impact the value of the company and therefore the company’s stock price.
It is widely known that a better competitive advantage will lead to stronger profitability, which has a greater potential to translate into long-term profits for investors.
Superior risk management
It is also worth noting that high ESG-rated companies employ superior risk management practices, which translate into lower residual volatility and lower occurrences of severe incidents that may impact a company’s valuation and share price (see chart below Low residual volatility). This means that high ESG-rated companies tend to be better at managing company-specific business and operational risks and therefore have a lower probability of suffering incidents that can impact their share price. Consequently, their stock prices display lower idiosyncratic tail risks.
Looking at the impact of investing in companies that are leaders within the ESG realm, we also find that investors who consider this third dimension of ESG screening are not negatively impacted in terms of investment returns. This is aligned with our thesis that, over the long term, the risk-adjusted return of companies with strong financial moats and lower idiosyncratic risk will outperform their peers.
In testing this, we developed an optimal approach to assessing long-term investment risk associated with a company. It combined short- and long-term ESG metrics.
Our proprietary ESG Risk Screening Model is a blend of:
- The long-term ESG risk profile of a company, which is derived from analysing a company’s risks and opportunities that arise from ESG factors that may not be captured by conventional financial analysis of a company, and
- The faster, more short-term sentiment and accounting risks.
In the attribution table below, you will see that in quintile 1, Residual Volatility returned 11.94% compared with -4.14% in quintile 5. A similar trend is seen with Profitability and Dividend Yield attributes, where quintile 1 returned 0.64% and -0.59%, respectively, compared with quintile 5’s -1.54% and -2.90%.
In summary, this indicates that the best-rated companies, those falling within the top 20% (quintile 1) as per our proprietary ESG Risk Screening Model, are more profitable, pay higher dividends, have better management of business-specific or idiosyncratic risk and are ultimately more resilient.
The growth of big data continues to advance the analysis of companies’ ESG profiles and we’re constantly finding new tools with which to assess companies on this basis. Big data technology advancement will allow us to continue to ensure we have the best possible investment signals, which will drive and further increase our value proposition to clients and result in a future-fit investment offering. This allows us to continuously scan the horizon for new data sources, develop tools, employ technologies in machine learning and adapt processes that strengthen our ESG and investment frameworks. We are therefore able to identify patterns across thousands of companies with millions of data points, which enabled us to find the link between a company’s ESG credentials and its idiosyncratic risk/residual volatility, profitability and dividend yield. These relationships would be challenging to unearth without big data technology advancements and artificial intelligence (AI).