Article November 17, 2020

ESG Momentum: a way to add value to your portfolio?

Ajeet Manjrekar, Co-Head of River and Mercantile Solutions, explains how our investment team look for “ESG momentum’ to add value to the portfolio.

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It is fair to say that Environmental, Social and Governance (“ESG”) has been the investment hot topic of 2020, and doubtless will remain so for some time to come. Despite the events surrounding the COVID-19 pandemic rightly taking up a lot of our thoughts, ESG is still very relevant and for those who are still asking “how can I reduce the ESG risks in my portfolio without sacrificing investment returns?” we explain how our investment team look for "ESG momentum" to add value to the portfolio.

What is ESG Momentum?

ESG momentum is a term used to describe how companies are changing their ESG characteristics through time. Those with positive momentum are improving their ESG practices. For example, improving governance by appointing non-executive directors to the board, improving supply chain transparency to ensure suppliers meet human rights standards or setting carbon reduction targets.

Any such improvement in ESG characteristics is expected to be reflected in a company's stock price because of the improvement in its underlying financials. This leads to long-term benefits for investors.

How can it add value to my portfolio?

The most common ESG strategies are to either invest in “best of breed” ESG stocks or use exclusionary strategies (excluding things like fossil fuel companies, tobacco, alcohol, and gambling). However, this does not always lead to improved returns. For example, over the last 13 years, the performance of the MSCI World ESG Leaders Index has tracked very closely to the MSCI World Index. Indeed, investing in ESG Leaders over this period would have earned you a mere 0.01% p.a.[1] over the broad market. This leaves one speculating whether strong ESG credentials are already priced into markets. As ESG solutions are generally more expensive than traditional market trackers, investors might question how investing with an ESG focus can add any value net of all costs.

There is evidence that the market has been slow to pick up the benefits of positive ESG Momentum. Over the period since 2015, the relative performance of the top 20% of ESG rated companies versus the bottom 20% has been positive. But performing the same analysis for ESG Momentum rather than ESG rating gives even better results. These results were corroborated by third party analysis done using data from both the dominant ESG data providers, MSCI ESG Research and Sustainalytics.

ESG Momentum_Chart 1

Source: River and Mercantile Solutions, Bloomberg, certain information © 2020 MSCI ESG Research LLC. Reproduced by permission; no further distribution. Based on analysis of average equity returns for US large cap companies. Date of analysis: 1 January 2008 to 30 September 2019. Past performance is not a reliable indicator of future results and should not be relied upon.

Timing

Positive ESG Momentum may happen when there is a significant change in the board composition of a company. This can be when long-standing board members step down or begin thinking about building their legacies. At this point, the company may seek to improve its approach to corporate social responsibility. For example, by implementing better and enhanced talent management programs, or by reviewing current business practices and looking to improve health and safety for their employees.

In practice there can be a significant time lag between these changes happening and the impact on a company’s financials and share price. This is because companies that start the journey to improving their ESG standards can often face scepticism from investors. Many investors prefer to invest in an ESG positive index, which is theoretically an efficient way of removing unwanted potential risks. As a result, there can be an opportunity to enhance returns by investing when a company focuses on improving its ESG approach before the rest of the market catches up.

“At River and Mercantile Solutions, we believe an integrated approach to ESG not only reduces risk, but can add value. That’s why we screen for positive ESG Momentum in our fiduciary management portfolios. Ultimately for our clients, ESG investing doesn’t have to mean sacrificing return. ”

Case Study - US Consumer Staples Company

As an example, we consider a US Consumer Staples Company, which is an American multinational corporation. Their ESG rating, based on MSCI ESG data*, was CCC in August 2016, putting it on the lowest rating possible.

In 2016 and 2017, two of the company’s founders retired from the board of directors. This led to a change in the corporate governance approach. Over the following months and years, the firm’s ESG rating improved because of three key drivers:

  • Improvements in quality and safety, leading to a reduction in the number and repetition of product recalls;
  • Continued efforts in the organic food space; and
  • Strong labour management practices - unlike its main competitor Walmart, the company does not have a ban on unionised employees, and it pays roughly twice the federal minimum wage, which is higher than its competitors.

The company showed significant positive ESG Momentum over this period and improved its ESG rating by two notches to a BB in 2019. Over the same period, the company outperformed the Consumer Staples sector by 84%.

ESG Momentum_Chart 2

Source: River and Mercantile Solutions, Bloomberg, certain information © 2020 MSCI ESG Research LLC. Reproduced by permission; no further distribution, 30 September 2019. Date of analysis: 29 January 2016 to 30 September 2019. Past performance is not a reliable indicator of future results and should not be relied upon.

However, although the company had been improving its ESG standard since September 2016, it wasn’t until -2018 that this started to feed into the financials and share price. This provided a period for savvy investors to take advantage of this opportunity and capture the 103% increase in the share price.

Concluding thoughts

A lot of active ESG funds are invested in a limited set of companies with strong ESG characteristics. If we expand the investable universe to include stocks which are not yet as far along the ESG journey, but have positive ESG Momentum, there are more opportunities to outperform. This can provide a different approach to a “best of breed” or exclusionary strategy, and when accompanied by active ownership can help to raise companies' ESG credentials.

At River and Mercantile Solutions, we believe an integrated approach to ESG not only reduces risk, but can add value. That’s why we screen for positive ESG Momentum in our fiduciary management portfolios. Ultimately for our clients, ESG investing doesn’t have to mean sacrificing return. With positive ESG Momentum, you can add value to your asset portfolio - all whilst supporting the companies working hard to improve their credentials.

 

*MSCI ESG Ratings aim to measure a company's resilience to long-term ESG risks. Companies are scored on an industry-relative AAA-CCC scale across the most relevant key issues based on a company's business model.

[1] Source: River and Mercantile, data analysed over period 28/09/2007-30/09/2020. Past performance is not a reliable indicator of future returns.

This article constitutes a financial promotion and has been issued and approved by River and Mercantile Solutions, a division of River and Mercantile Investments Limited which is authorised and regulated in the United Kingdom by the Financial Conduct Authority and is a subsidiary of River and Mercantile Group Plc (registered in England and Wales No. 04035248).

Please note that this communication is directed at, and intended for, the consideration of Professional clients only.

The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a guide to future performance. Changes in exchange rates may have an adverse effect on the value, price or income of investments.

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