Over the last several years, the financial markets have seen increasing discussions around ESG investing. However, there remain a lot of questions regarding how to leverage ESG ratings to make better investment decisions. There has been a lot of conversation about whether focusing on ESG factors leads to better performance, effectively rewarding sustainable decisions that could set up a company for future success.
For this article, I wanted to take a deeper look into ESG by analyzing performance across its three core pillars: Environmental, Social, and Governance. My goal was to find out if there is a correlation between high ESG ratings and outperformance and whether certain sectors with unremarkable overall ESG performance correlations stand out when examined across the individual pillars.
We started with the companies in the S&P 500, grouped by sector. We then pulled in the companies’ MSCI ESG scores as of 2015, and used those to further divide each sector into thirds (terciles), reflecting their position in the scoring distribution. For each tercile, we calculated the five-year total returns from January 1, 2015 to January 1, 2020. Using this information, we looked for sectors that showed interesting insights or correlations that might guide an investment strategy. In searching for these outlying sectors, we looked for large gaps in performance between the top and bottom buckets. We also looked for sectors that had at least one bucket which performed significantly better than the sector average.
MSCI defines the environmental score using the following four themes:
Pollution and waste
When evaluating sector returns across our ESG terciles, the first sector that jumped out at us was the energy sector. Energy companies with the highest E-scores were not only underperforming but losing a significant amount of their value over the period analyzed. On the other hand, the information technology sector showed significant outperformance — for both the environmental component as well as the overall ESG rating. The healthcare sector showed a massive underperformance in the lowest bucket, while the top bucket stayed in line with the industry average.
These results suggest that while high E-scores don’t necessarily correlate with outperformance, avoiding a low E-score may provide strategic benefits and defend the stock from potential downside. Pharmaceutical company Mylan was one of the healthcare companies that underperformed, with an environmental factor exposure score of 2 (on a scale of 0 to 10) and a total return of -64.3% over the past five years.
At the end of 2018, Mylan initiated a voluntary recall of its Valsartan-containing blood pressure medications. The drugs were recalled as a precaution after Mylan found traces of a carcinogen commonly associated with air pollution and industrial processes. This highlights the potential damage a company can face with a lack of environmental controls — especially in a sector such as healthcare where recalling a potentially harmful product can be costly in terms of both money and reputation.
MSCI defines the social score using the following four themes:
When analyzing social scores and tercile returns, we noticed that the healthcare sector again showed one of the more interesting insights. While the lowest scoring third seems to be approximately in line with the sector average, we see that the highest scoring third appears to correlate with above-average returns. However, communication services stood out as the sector whose highest scoring tercile seemed to contribute the most to outperformance.
Conversely, in the real estate sector, a high S-score had a negative correlation with returns. The highest scoring tercile performed below the sector average, while the lowest scoring third appears to drive substantial outperformance. When taking a deep dive into the real estate sector, one of the key drivers of this inverse correlation could be tied to the nature of the business model itself. In reading company filings and transcripts for REITs like UDR and Invitation Homes, real estate companies reference gentrification as a bullish signal. This can place real estate companies in direct opposition with members of the community who can no longer afford housing in newly gentrified areas. Thus, the most successful firms might have a lower S-score due to backlash from their local communities.
MSCI defines the governance score using the following two themes:
When examining performance based on governance scores, we observed some interesting sector correlations that could warrant additional investigation. Within the energy sector, strong governance scores seem to correlate with outperformance. In contrast, the communications and healthcare sectors appear to be penalized for higher G-scores; the companies boasting the highest G-scores see significant underperformance when compared to their peers.
The final sector that drew our attention was information technology. This sector appears to enjoy the greatest outperformance concentrated in the highest scoring constituents. Taking a closer look at some of the winners in this sector, players that place a heavy emphasis on governance thrive. For example, IPG Photonics (IPGP) scored a perfect 10 on the governance score and enjoyed a 93.4% return over the past five years. IPGP has continued to invest in corporate governance year after year, introducing measures to protect shareholder value. 70% of the current board members are independent, the company employs an audit committee comprised of financial experts, and the company has taken steps to ensure proxy access is available to all shareholders. Steps like this can potentially go a long way in fostering and cultivating shareholder confidence, which can be a major factor in long term performance.
Breaking the ESG scores into the three components, environmental, social, and governance, allows us to gain a deeper understanding of how these factors can affect performance in various sectors. Our examination of the returns data across each of the three ESG pillars indicates that stocks that outperform their peers don't necessarily rank the highest across all three components. If we were to only look at the overall ESG score, we could potentially overlook predictive variables which would benefit our security selection process.