Case study by New Amsterdam Partners
Establishing a relationship
Researching the relationship between ESG ratings and stock returns, volatility and risk-adjusted returns since the 2008 financial crisis, we found that higher return companies in aggregate had better ESG ratings, but that there was a stronger (negative) correlation between ESG ratings and stock volatility, and this relationship was even stronger when market volatility was higher. The results held after controlling for sectors. The correlation between ESG rating and risk-adjusted return turned significantly positive in recent years, and this positive correlation strengthened further by removing the lowest-rated stocks.
The negative relationship between ESG and volatility was explored in greater depth, given the well-documented low volatility anomaly (outperformance of low volatility stocks). Chi-square frequency tests – used to evaluate whether to reject or fail to reject a statistical hypothesis – showed that stocks rated high on ESG tended to be in the low volatility group, and vice versa, and that the ESG rating had an impact independent of the low volatility effect.
Deleting the lower tail of ESG-ranked companies did not harm portfolio returns (including risk-adjusted), tending to improve the probability distribution of returns with a higher average and higher maximum.
Integrating into investment process
We integrate ESG research within the investment team and research reports, which include an ESG section to be completed by each investment analyst.
Our investment process starts by using a proprietary valuation model to compute expected returns for equities. A research universe is created of the highest expected return stocks, which are then analysed using traditional fundamental analysis techniques (market share and competitive analysis; financial analysis and valuation analysis). Within the final stage, ESG research informs the portfolio construction process to adjust the weights of poor ESG-rated stocks to zero for all portfolios.
Investment decision impact
Kroger is a fundamentally attractive-looking supermarket chain, with a PE ratio around the levels of its peer group but a much higher return on equity (ROE), along with a solid balance sheet and a history of consistently beating estimates. Looking past those numbers, however, a number of ESG-related controversies raise concerns, including health and safety issues, supply chain labour standards, and an incident involving faulty reimbursement claims that resulted in a fine. Some of its stores also sell firearms, which is an issue for many investors. When passing through our portfolio construction process, these issues caused the weight of the stock to be reduced to, zero leaving it out of our ESG portfolio.