Investing in the ESG leaders of tomorrow

As sustainable investing becomes more mainstream, investors increasingly put premium valuations on companies with strong ESG profiles. As such, there is an investment opportunity in identifying companies which should improve their ESG profile in the future and it’s this improvement potential that we believe is underappreciated by the market. These sustainable improvers are companies that are taking real steps in addressing ESG risks and opportunities to improve their ESG profile.

To demonstrate the alpha potential, we analyzed how ESG scores impact company valuation. Our analysis revealed that companies with ‘excellent’ ESG profiles typically trade at a 22% price to book valuation premium when compared to companies with poorer ESG profiles (shown below). This valuation premium gap has only widened, doubling in the last two years. We believe this premium is here to stay and identifying future ESG leaders presents an exciting investment opportunity.

Source: UBS Asset Management, MSCI ESG data, data as of March 2021.
Note: Poor= score 0-3; Average= score 3-6; Good= score 6-9; Excellent= score 9+. Universe: MSCI ACWI

As early as 2015, an MSCI study showed that Sustainable Improvers (ESG Momentum) outperformed ‘best in class’ ESG Companies (ESG Tilt) from 2007 through 2015. This independent study reinforces the potential of this investment opportunity.

Source: MSCI, ‘Can ESG add Alpha?’, June 2015 and AllianceBernstein, ‘ESG in Action 2021: Improvers and Enablers’, as of 10 June 2021
Note: This MSCI study looked at Active Return and Risk of ESG Tilt and ESG Momentum strategies (annualized, Feb-07 to Mar-15). ESG Tilt and ESG Momentum both outperformed the MSCI World Benchmark.

While today’s ESG momentum may be easy to measure and invest in, we believe the more attractive opportunity is to invest in future ESG momentum.

To identify stocks we anticipate will improve their ESG profile in the future, we adopt an actively-managed, ‘quantamental’ approach. Specifically, we source a diverse set of ideas from our bottom-up fundamental research approach together with a quantitative screening framework. The quantitative screen combines proprietary climate models, alternative data and natural language processing to form a holistic forward-looking view of improvement potential.

The portfolio manager validates ideas and selects the most attractive ones to be included in the portfolio. In addition, active engagement with company management on their ESG strategy also can play a critical role to turn improvement potential into reality.

Our analysis revealed that the relationship between ESG ratings and returns or company valuation varies substantially by sector and by ESG pillar(example shown below).
This highlights the need for a more targeted approach.

Source: UBS Asset Management, MSCI ESG data, data as of March 2021.
Note: Poor= score 0-3; Average= score 3-6; Good= score 6-9; Excellent= score 9+. Universe: MSCI ACWI

To identify the best high potential candidates, you need an approach that takes into account the variances that exist between sector and market.

In our view, a ‘quantamental’ approach that is driven by bottom-up fundamental research process and supported by quantitative data takes these unique relationships into account to identify high potential sustainable improvers.