What are we looking for?
Growth-oriented Canadian stocks with lower levels of ESG risk relative to global peers.
The 2021 federal budget released this week outlined the government’s plan to invest in clean-tech projects and confirmed the issuance of the first federal green bond, among many other initiatives. Alongside these announcements, Morningstar’s own data show that the market for sustainable mutual funds and exchange-traded funds in Canada has grown by a whopping 160 per cent in the one-year period ended March 31. It is clear that the idea of investing sustainably is not going away. Along this same vein, today I use Morningstar CPMS to look for growth-oriented companies in the S&P/TSX Composite Index that show lower degrees of environmental, social and governance risk relative to peers. To do this, I ranked the 229 stocks in the index on the following metrics:
- Five-year average return on capital (a profitability metric, higher figures preferred);
- Latest reported return on equity;
- Five-year average growth rate in earnings per share (on average, how much the bottom line has grown each year over the past five).
I also placed a screen using Morningstar Sustainalytics’ ESG Risk score. The score is meant to measure the ESG risk associated with a company and is derived by analyzing financially material ESG risks for a given subindustry and comparing a company’s ability to manage those risks against global peers. For example, an energy producer will have higher environmental risks as the world transitions to a low-carbon economy and hence greater emphasis would be put on the company’s ability to manage these risks. Technology companies that hold large amounts of client information have a greater need to manage social risks. The Sustainalytics’ ESG Risk score appears as a number from zero to 100. A company with a score greater than 40 would be deemed to have a high degree of ESG Risk relative to peers. In today’s strategy I only included companies with a score less than 20.
More about Morningstar
Morningstar Research Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. Morningstar offers an extensive line of products and services for individual investors, financial advisers, asset managers, retirement plan providers and sponsors, and institutional investors. Morningstar Direct is the firm’s multi-asset analysis platform built for asset management and financial services professionals. Morningstar Canada on Twitter: @MorningstarCDN.
What we found
I used Morningstar CPMS to back-test this strategy from November, 2011, to March, 2021, using a maximum of 15 stocks with no more than four per economic sector. Once a month, stocks were sold if they fell below the top 35 per cent of the index based on the aforementioned metrics and replaced with the highest ranking stock not already held in the portfolio. It should be noted that the ESG Risk score was first made available in November, 2018; prior to that, the screen was not used. On this basis, the strategy produced an annualized total return of 10.3 per cent, while the S&P/TSX Composite gained 7.9 per cent. Between November, 2018, and March, 2021, the strategy produced an annualized total return of 15 per cent while the index advanced 12.9 per cent on the same basis.
The stocks that meet the requirements to be purchased today are listed in the accompanying table. This article does not constitute financial advice. It is always recommended to speak with a financial adviser or professional before investing.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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