In June 2017, BofA Merrill Lynch Global Research released follow-on research to a December 2016 study that evaluated the reliability of ESG data (based on Thomson Reuters’ scoring system) as a signal of future volatility and directional trends in equity market valuations.
The BofA Merrill Lynch US Research coverage universe was applied and the period of analysis was from 2002 to 2015. Below are some takeaways from the combined studies as well as the PRI’s commentary on the findings.
ESG factors demonstrate meaningful efficacy as measured by equity valuations
- Stocks that ranked within the top third by ESG scores outperformed stocks in the bottom third by 18 percentage points in the 2005 to 2015 period.
- Relative to other fundamental factors, ESG was a better signal of future earnings volatility, based on findings that the higher the ESG quintile ranking, the lesser the median change in EPS volatility over the next five years.
- The relative enterprise value/EBITDA ratio for companies within the highest decile by overall current ESG score relative to that of the bottom decile expanded from 2005 to 2016.
- Governance has impacted valuations, as companies with factors considered to be negative to shareholders, such as zero voting rights, experienced a meaningful compression in their P/E and P/B ratios relative to the market, and those with positive factors such as no dividend cuts and no dilutive equity capital raises experienced a large expansion in their P/E ratios, relative to the market, in the last seven years.
These results appear to statistically validate the value proposition of investing in the stock of companies with superior ESG profiles, as measured by equity valuations. Similarly, the results demonstrate that ESG integration is an effective risk mitigation technique, as companies that rank higher on ESG attributes historically have exhibited lower risks based on price and earnings volatility (and even bankruptcy risk) compared to their lower-ranked peers.
ESG factors demonstrate varying degrees of efficacy across market capitalization rankings, sustainability pillars and industry groups in equities investing
- Assessing ESG efficacy while adjusting for size based on market capitalization provides an important perspective into the magnitude of size biases, as larger (smaller) companies tend to have higher (lower) ESG ranks. BofA Merrill Lynch Global Research ranked its US coverage universe by ESG scores across quintiles within four size segments, and then assessed performance spreads (returns between highest ESG ranked quintile [Q1] and the lowest ESG ranked quintile [Q5]). The findings showed that performance spreads based on overall ESG score were positive across all four size segments, with the smallest performance spread in the top quartile by size (largest companies) and largest spread in the second quartile by size, followed by the third and then fourth quartiles by size.
- Additionally, performance spreads were generally equal to or higher for E and S scores individually than for G scores across all size quartiles.
- Performance spreads across sectors showed inconsistent results across individual E, S and G as well as overall ESG scores, and even showed large negative, counterintuitive results in the consumer staples, healthcare and technology sectors.
Evaluating ESG efficacy adjusting for size appears to reveal that ESG factors, while in general are additive to financial performance, do not contribute to returns consistently across companies with different size profiles. As such, it is important to look at ESG performance in terms of trending as well as absolute point-in-time scores. Alpha opportunities may either be present in a company with a meaningful yearover-year improvement in ESG score or high absolute ESG score, depending on its size profile. The results also showed that performance spreads (based on the highest versus lowest ranked stocks by overall ESG score) were positive across the E and S pillars, but performance based on G scores was not as consistent. Finally, the study uncovered counterintuitive results in performance spreads within certain sectors. The results highlight the need to recognize that certain ESG factors are more relevant and impactful in certain industries than others. SASB (Sustainability Accounting Standards Board) has developed standards that allow for comparability across industries and a framework of materiality-focused, industry-specific key performance indicators.
Paper on financial performance of ESG integration in US investing
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BofA Merrill Lynch Global Research's ESG in equities investing study