Quantifying the value of sustainability

There are three types of investors:
1. Fundamental investors that analyze the potential of a business model backed by a refined understanding of industry trends (currently the largest group)
2. Those that count on quantitative analyses to capture alpha potential and focus primarily on risk premium or factor investing (a smaller group but one that is vastly gaining ground against the fundamental investor)
3. Those who emphasize sustainability aspects in the investment process when evaluating business models (we believe this group will dominate the other two groups in the long term).

Corporate managers often struggle to interpret what the sustainable investor really wants because they believe there is no universal definition of what sustainability actually stands for – or is there?

The common denominator: Translating sustainability preferences into valuation frameworks

Wouldn’t it be helpful to be able to translate investors’ sustainability preferences into financial performance indicators that neatly tie into corporate valuation frameworks? Indeed. But the challenge, of course, is to figure out what investors really mean when they claim to invest sustainably, because if we ask a hundred portfolio managers how they define sustainability, we get a hundred different answers.

Instead, corporate managers should wrap their heads around the following questions:
1. What are the portfolio managers’ preferred methods for factoring sustainability aspects into investment strategies, among both active and passive funds?
2. Which datasets do they source from third-party vendors to structure and quantify these sustainability preferences?
3. What are the sustainability-related regulatory requirements that force investors to align their product offerings a certain way?

Once this is understood, corporate managers can anticipate how capital flows will change in the future and create a specific corporate investment profile deemed to be a sustainability leader in a given industry group. Why does the industry group matter? Because the ex-ante tracking error matters when comparing the risk-return profile of a fund to a given benchmark index. (If a model is used to predict tracking error, it is called ex-ante tracking error. Ex-post tracking error is more useful for reporting performance, whereas ex-ante tracking error is generally used by portfolio managers to control risk.) A commonly applied method for keeping the ex-ante tracking error in check is to start off with an industry-neutral stance before picking individual securities that offer the highest alpha potential for a given investment horizon.

This is why industry-specific ESG ratings are generally preferred over ESG ratings that result when weighted E, S and G ratings are compared across industry groups. For example, even when a company obtains the highest ESG rating in its industry group, this does not imply a high rank across the entire investable universe.

Relevant sustainable investing strategies benefit a specific type of investment profile

According to the Global Sustainable Investment Alliance, 36 percent of worldwide assets under management are already subject to sustainability commitments. We believe this share could surpass 80 percent by 2030 and 90 percent by 2035 and is yet to be reflected in asset prices.

In a recent 2020 review, ESG integration (70 percent of assets under management, up 14 percentage points on 2018) surpassed negative screenings (45 percent, down 21 percentage points on 2018) as the most frequently considered approach for embedding sustainability aspects into the investment process – ahead of corporate engagement and shareholder action (30 percent, unchanged from 2018).

ESG integration is the systematic and explicit inclusion by investment managers of environmental, social and governance factors into financial analysis. Negative screening refers to exclusions from a fund or portfolio of certain sectors, companies, countries or other issuers based on activities considered not investable. Corporate engagement refers to employing shareholder power to influence corporate behavior, including through direct corporate engagement, filing or co-filing shareholder proposals and proxy voting in accordance with comprehensive ESG guidelines.

Hence, the focus lies on sustainability aspects that are financially material: factors that have had a statistically significant effect on corporate performance or are likely to be impactful in the future. 

And our analyses reveal that high-level sustainability KPIs, such as headline ESG ratings, have been more impactful on security prices than those from sub-categories, such as E, S or G ratings. Why? It is more likely that the majority of investors consider an ESG rating as opposed to the sub-component of a sub-component. This suggests to keep it simple instead of getting lost in the details.

Overall, we observe that there are mainly four sustainability datasets that most investors focus on when claiming to invest responsibly:
1. ESG ratings (shying away from the laggards and preferring the leaders)
2. Negative lists that comply with regulatory requirements (potentially including Mifid II) or established normative concepts (such as the UN Global Compact and Sustainable Development Goals)
3. Ecological and societal impact exposure (as a share of group revenues and soon also as a share of group capex and opex)
4. Climate data. 

A neat way to bridge the gap between associated sustainability preferences and corporate valuation frameworks is to analyze the risk premium profiles that such preferences imply. For example, if a portfolio manager prefers stocks from entities with high as opposed to low ESG ratings by MSCI, the portfolio will be tilted in favor of quality, growth and low-volatility risk premiums, while value and high-beta risk premiums will be underweighted relative to a broad market benchmark. This also tilts portfolio strategies toward a more defensive stance and away from cyclical business models. 

Our analyses reveal that no matter what approach to sustainable investing one prefers, be it ESG ratings, exclusions, impact exposure or a focus on climate issues, the differentiation between sustainability leaders and laggards yields a similar risk-premium profile.

How does this translate to financial performance indicators?

Low exposure to value means the sustainable investor doesn’t mind expensive valuation multiples. Amid their expanding investment horizon, sustainable investors accept that a larger share of corporate earnings will be generated in the more distant future. This is because higher investments in the form of growth capex or R&D expenditures are needed upfront to foster organic top-line growth.

The sustainable investor prefers companies that grow organically because external growth – such as via M&A – poses a higher risk that goodwill write-downs will negatively affect the income statement in the short term, and this makes the earnings profile more volatile. Volatility isn’t an attribute the sustainable investor prefers – in terms of neither the earnings profile nor the share price development.

This means sustainable investors prefer corporate profiles with a specific focus in terms of the allocation of proceeds from operations. Preferred are those with a higher equity duration, which is the inverse of the dividend yield – the lower the yield, the better. This is because a lower yield indicates that fewer proceeds are distributed to (short-term-oriented) shareholders. The freed-up capital can be used to either back up growth prospects or reduce (excess) leverage to improve quality exposure.

In a nutshell, the sustainable investor interprets the combination of low valuation multiples and a high dividend yield as a value trap, which likely points to a challenged business model. This view contrasts with that of value investors, which screen for attractive investment opportunities based primarily on cheap valuations. The longer a corporate profile is stuck in this section of the risk-premium spectrum, the more difficult it is to escape, given that the share of sustainably invested capital is set to rise and establish itself as a standard over time.

Conclusion

Corporate managers are highly incentivized to become the sustainability leader in their respective industry groups. As the share of sustainably invested capital rises, such profiles are likely to attract more capital, thus boosting corporate valuation multiples and share price outperformance versus conventional market benchmarks.

This, in turn, lowers funding costs when raising capital – a self-reinforcing competitive advantage because comparably lower funding costs make a higher number of projects profitable. This helps companies gain market share, outgrow peers, gain pricing power and achieve higher profitability – all attributes the sustainable investor prefers when screening for attractive investment opportunities.

Jan Rabe is co-head of the sustainable investment office at Metzler Asset Management

This information is not intended for private investors. Metzler Asset Management GmbH does not guarantee the accuracy or completeness of the information presented here. Please see our complete disclaimer at www.metzler.com/disclaimer-mam-en