What are we looking for?
U.S.-listed stocks that are growing earnings while maintaining low levels of ESG risk against global peers.
Announcements from multiple Canadian pension plans in support of more transparent and standardized environmental, social and governance disclosures from public issuers have recently made headlines, and with good reason. Pensions often have a long term investment view in ensuring their members’ plans are adequately funded. In the case of the Canadian Pension Plan, this outlook can span multiple generations. ESG risk is also long term in nature. Unlike traditional fundamental measures such as earnings or revenue, the risks inherent in a company’s corporate policy (or lack thereof) around ESG issues may not immediately reveal themselves, but are imperative in considering the long term realization of value.
Morningstar Sustainalytics’ ESG Risk score for a company is derived by analyzing financially material ESG risks for its subindustry, and then comparing the company’s ability to manage those risks against its 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 can range from zero to 100; a company with a score greater than 40 is deemed to have a high degree of ESG risk relative to peers. Today, I use this measure alongside traditional growth metrics to seek companies within the S&P 500 index that exhibit the best of these characteristics. I start by ranking stocks based on:
- The Sustainalytics’ ESG Risk score (the score is inherently relative to peers, lower is better);
- Three-year EPS growth rate (on average, how much earnings have grown each year in the past three);
- Three-year average return on equity (a profitability metric, higher figures preferred);
- Three-month estimate revisions (a sentiment indicator measuring the current consensus estimate for earnings compared with the same figure as it appeared at month-end three months ago).
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, 2019 (when the Sustainalytics ESG Risk score commenced in our database), to October, 2020, 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 25 per cent of the S&P 500 index based on the aforementioned metrics and replaced with the highest ranking stock not already held in the portfolio. Over this period, the strategy produced an unannualized total return of 13.6 per cent, while the index advanced 5.9 per cent on the same basis.
The stocks that meet the requirements to be purchased today are listed in the accompanying table. Admittedly, 11 months of performance data are not nearly enough to conclude that low ESG risk is an indicator of future outperformance, but perhaps a good starting point for further research.
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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