Integrating environmental, social and governance data (ESG) into a tried-and-tested intrinsic value methodology is part of our fundamental approach to investing because our analysis shows that it can result in better risk management and alpha generation.
The ability to estimate intrinsic value and invest actively in undervalued companies is essential for long-term investment success. But today, investors are increasingly focused on companies with better ESG practices, in addition to strong financial characteristics. When identifying stocks that are both attractively valued from a relative valuation perspective, we are proactively analyzing material sustainability factors in addition to traditional analysis.
An industry evolving
Today, the integration of ESG data into the equity investment and analysis process is gaining momentum thanks to the trend toward greater disclosure of ESG performance data. This is driven largely by growing investor demand for ESG disclosure, supported by the first moves toward internationally agreed disclosure standards, such as the publication of the Financial Stability Board's Task Force on Climate Risk Disclosure guidelines1. The SASB Materiality Map2 that we use as a foundation for our proprietary database is gaining acceptance as first movers such as JetBlue issue reports using the SASB guidelines.
Owning the data is crucial
Using the SASB framework, we developed our own sustainability database and methodology for scoring companies and integrated it into our investment processes ten years ago. Customized KPIs reflect the most material factors in each industry with a preference for quantifiable factors. For example, companies with lower carbon intensity levels (i.e. carbon emissions relative to revenue) would be given a higher score than their high-intensity peers. These KPIs are converted into a score based on industry weightings and then combined to produce a final score for each company.
However, there are limitations to sustainability data, which still lacks standardization. There are also biases because larger companies have the resources to report more data than small companies. To mitigate these challenges, we ranked all companies relative to their industry peers based on their ESG raw score sorting them into deciles. By so doing, we ensure scores are industry neutral and can control any industry biases. This gives us a transparent and comparable ESG score which reflects our proprietary assessment of a company’s sustainability profile.
We strongly believe in owning both the data and the scoring methodology. Not only can we continuously improve our database by including new sources of data, but owning the entire information chain helps drive a differentiated investment thesis.
In our report "Measure what matters – expanding the scope of intrinsic value to include ESG", we back test companies with strong governance profiles as determined by our ESG database and strong profiles of our proprietary valuation framework against the MSCI ACWI World Index benchmark (during the period from January 1, 2010 to December 31, 2015). The objective was to test the efficacy of combining our proprietary valuation signal with our ESG scores to determine if ESG can be additive to the fundamental investment process.
The results show that companies that scored high in our ESG methodology consistently outperformed the MSCI ACWI benchmark3. While we are still evaluating various back testing methodologies, this test would suggest ESG can help mitigate downside risk and that incorporating ESG does not compromise alpha.
While sustainability data is not yet standardized and continues to evolve, we have found that its judicious use in an active investment process helps bring more "mathematical accuracy" to valuation models. We would also argue that by incorporating sustainability data, portfolio managers and analysts are able to create more value for clients and make choices at the margin. As data availability and investment management techniques become more sophisticated, it's increasingly feasible for investors to integrate ESG factors into their portfolio.