Analyzing Stocks against Environmental, Social and Governance Risks

From The Jakarta Post, Published 24 November 2016

How can we quickly transition to a low carbon economy? Will there be sufficient healthy food to feed 9 billion people? Are supply chains respecting human rights and reducing inequalities?

These are some of the many long-term questions that companies need to address in order to adapt to a changing world and ensure their long-term prosperity.

And for investors the opportunity is to direct capital towards those companies that are actively managing environmental, social and governance risks and opportunities to drive sustainable (in the broadest sense) growth and returns.

Sustainable Investing has grown significantly over the past decade due to initiatives such as the UN Principles for Responsible Investment, which now boasts over 1,500 signatories who together manage and own US$62 trillion.

The investment approaches explicitly labeled “sustainable” can take many different forms. Thematic funds may focus on renewable energy while Impact Investing requires evidence of a measurable social or environmental benefit in addition to a financial return. Screening aims to exclude companies with a relatively poor sustainability performance and ESG integration considers factors, such as water scarcity or employee engagement, alongside traditional financial drivers.

However, even investors that don’t have an explicit sustainability strategy should consider these extra ESG datapoints. At Morgan Stanley we view ESG or sustainability as an additional lens through which to better understand companies and enhance investment decisions.

We see plenty of evidence to demonstrate that sustainability can be financially rewarding. Morgan Stanley’s Institute for Sustainable Investing studied the potential performance and risk differences between sustainable and traditional investments.

It concluded that Manager selection is crucial, with a high dispersion of returns and volatility for both types of funds. Furthermore, sustainable equity mutual funds had equal or higher median returns and equal or lower volatility than traditional funds for 64 percent of the periods examined.

On average 38 percent of companies do not have any female board representation.

While we see sustainable investing as a structural growth trend, its adoption has not been equal across the globe. Its roots lie firmly in Europe although the United States is quickly catching up. Together these two regions account for 99 percent of the world’s sustainable assets under management, according to the Global Sustainable Investment Alliance (2014). Asia, in contrast, represents less than 1 percent of this pool of funds. But there are signs that things are changing.

Firstly, we see an appetite to strengthen governance in the region. Japan particularly stands out following the introduction of The Stewardship Code (2014) and Corporate Governance Code (2015). Governance reform in Asia certainly focuses on topics such as board independence and executive remuneration, but it also has the potential to directly impact financial metrics such as dividend payout ratios and ROE.

Secondly, sustainability reporting is becoming more commonplace with stock exchanges, such as Singapore and Hong Kong, requiring companies to publish data such as carbon emissions, water consumption, employee turnover and injury rates. Better disclosure is paramount for investors to be able to successfully incorporate ESG into their investment decisions.

In a recent Morgan Stanley report on Gender Diversity, only 46 percent of companies in the MSCI World index reported the percentage of women employees. Given our conclusion that better gender diversity results in higher risk adjusted stock returns, a lack of data of such subjects could reduce an investor’s ability to enhance fund performance.

Engagement with corporates is another way through which investors can drive the sustainability agenda. This could be a request for additional quantitative data to help deepen ESG analysis, or the creation of an open dialogue to drive change on environmental or social matters that could be material to the company’s valuation.

Morgan Stanley is driving sustainability through its research process, and recently published a report that considers ESG for 45 companies across the ASEAN region. Governance has to be the starting point, in our view, and we observe that on average 53 percent of board members are independent, while 38 percent of companies do not have any female board representation. Disclosure on CEO compensation is limited outside Singapore, although 91 percent of the companies analyzed disclosed total management compensation.

Environmental and social factors need to be analyzed within the context of a particular industry. In the plantations industry, for example, deforestation and supply-chain management are the most material issues. Palm oil is used in the production of a wide range of consumer goods from processed foods and shampoos to cosmetics and biodiesel.

Companies that comply with or exceed the requirements of the Roundtable for Sustainable Palm Oil, a certification body, should reduce business risk, improve investor confidence in the business model and potentially see better stock performance.

Sustainable Investing in Asia may only be in its infancy, but we believe it will continue to gather momentum until not considering ESG in investment decisions becomes the exception.    

 

For additional reading regarding sustainable investing, please refer to the following links:

Transforming Our World Through Impact Assessments

What is Impact Investing?

How Do We Integrate Climate Change into Our Current Business Strategy?