Feature Don’t forget the fundamentals
Lewis warns against seeing these ratings as an accurate reflection of a company’s ESG profile. “It is not simply taking the numbers and the ratings you get from third-party data providers at face value,” he says. Research published by academia and the financial services indus- try shows that companies with greater ESG credentials generate higher risk-adjusted returns over the long term, but perhaps it is not the best strategy to blindly pile into companies with high ESG scores. “The danger with investing in companies with the highest ESG ratings is that you can overpay for an expensive stock that has a green premium or a halo,” McAllister says. “This approach is more effective when the market has yet to appreciate a best in-class company, thus making it a good time for us to invest.” A popular strategy appears to be looking for companies with an improving ESG score that could positively impact its future finan- cial performance. “Recognising that there are many different investment approaches, it won’t always pay to focus on companies with a high ESG rating,” Childe says. “If you have a value-driven, fundamental equity approach, maybe you should look at compa- nies that could benefit from positive ESG momentum.” So investors should not forget the basics when using ESG ratings to pick stocks. “There are many assessment strategies you can take with ESG,” McAllister says. “For us valuation is key, but to make sense of that within the context of ESG issues, the fundamentals, the macro-economic picture and the thematic long-term drivers of the economy all need to be considered too.” Newton does not use ESG ratings as a trading signal; they are part of its wider research process. “We don’t use them to give us the definitive answer, we treat them as providing material information that we deconstruct to understand how we could apply it within our own investment process,” McAllister says. This proactive approach is shared by Robeco. “Ratings are impor- tant, but they are a starting point,” Zandbergen says. “We apply our own view through a fundamental analysis based on the infor- mation behind the rating and remove size and sector biases.” One issue to consider is that ratings tend to focus on larger, multi- national companies. “There is an inherent bias in the ratings because larger companies are typically better resourced to respond to the questionnaires and the disclosure requests,” McAllister says. A lot of the issues being measured here, such as equality and cli- mate change, are global issues, which may be another reason why such analysis typically focuses on larger businesses.
Differing opinions
The starting point to selecting a ratings provider is to decide what you want to measure. Are you interested in the impact ESG has on valuations or the impact a company has on the planet? It appears that taking an individual approach could be the best
20 May 2020 portfolio institutional roundtable: ESG
option, as using a rating that combines several factors may not work. “This can make it generic and meaningless, because differ- ent variations produce different outcomes,” McAllister says. With so many different metrics being considered and by so many pro- viders, is it a surprise that you get different viewpoints? But low correlation of opinion is also evident when assessing com- panies on mainstream issues. McAllister points to there being 100 years’ worth of accounting standards, auditing and infrastructure on the traditional financial metrics, yet you still end up with broadly half of analysts saying “sell” and half saying “buy”. “There are long-term and complex sets of issues to analyse in ESG, so it should come as no surprise that there can be a wide variety of views on the same company,” he adds.
It appears that the differences in this area run a lot deeper. “Low correlation not only comes from rating companies looking at dif- ferent issues, there is no consensus on which metrics to use to measure performance on the different topics,” Zandbergen says. So there are many issues to consider when employing such scores in your research. “If you run data from one provider on a company’s ESG profile, you will get a different picture from running another provider’s data,” Manuel says. “You can’t just pick one off the shelf believing that rating systems A, B and C are pretty much the same, because they are very different.” Additional expertise might be useful. “This is where an active manager may have an advantage in that they can unpack the ESG rating or score and focus on what is material to their investment decision-making process,” Childe says.
Setting the score Putting an ESG score on companies is not a new initiative. The SAM ratings that Robeco use were originally developed by its subsidiary RobecoSAM more than 20 years ago. Their creation
It is difficult to accurately reflect the sustainability profile of a company in a simple score. It is not an exact science.” Masja Zandbergen, Robeco
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