Causeway Capital - ESG and Alpha: The Role of Materiality

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- By Holly LaFon



September 2017



Recent years have seen expanding interest in Environmental, Social, and Governance (ESG) issues. Public sentiment on less controversial issues such as oil spills (E), child labor (S), and corporate fraud (G) has mushroomed into a broader consciousness about an array of ESG issues more generally. Investors also have been paying attention, scanning for potential risk, rewards, and value alignment. Many investors ask whether there is a potential tradeoff between return performance and ESG investing. New evidence sheds some light on this question.



In an academic article1 published in 2016, Mozaffar Khan (who has subsequently joined Causeway) explored the alpha (return in excess of a benchmark) potential of U.S. firms' ESG momentum.2 Khan and his coauthors hypothesized that it is important to sift through the large array of ESG issues in order to identify those, termed "Material," that potentially matter most for alpha in a given industry. In doing so, the authors presented new evidence of significant alpha from investing in firms with high performance on material ESG issues. Key elements of the paper are described below.



1. ESG AND ALPHA


The study was motivated by two observations: (a) there are economic reasons to suggest alpha from ESG performance; and (b) discriminating between material and immaterial ESG issues could purify the alpha signal in firms' ESG performance.


1a. Economic rationale for alpha potential


It is important to outline the economic mechanism that could link firms' ESG outperformance to future stock return outperformance. Two conditions are needed for such a link. First, ESG performance should on average be economic value-added in the future, and second, the market must currently underestimate the future value potential.


Economic value potential. The economic value potential of Environmental performance could come from both risk mitigation and opportunity capture. Risks stem from current negative externalities that the firm might be forced to internalize to some extent in the future. For example, carbon emitters and other polluters might be forced in the future to bear disproportionate costs from adverse community action, customer sentiment, regulation, shareholder activism, and reputational damage. Proactive risk mitigation could circumscribe these costs (cash flow effect) and lean against return volatility (risk effect).


Environmental opportunity capture relates to capitalizing on business and innovation opportunities generated by current environmental concerns. Such efforts could result in higher future profits. For example, electric vehicles benefit from, and are a response to, eco-consciousness. Here environmental concerns have led to a new product. As another example, servers in commercial data centers generate a lot of heat and require considerable resources for cooling. Locating such

facilities in areas where naturally cooler temperatures and wind can be harnessed for cooling could reduce both energy costs and the eco-footprint.


Social performance could create future value. As an example, investment in employee development and growth could lead to better execution of internal business processes, which could in turn lead to enhanced product and service quality, customer satisfaction, and ultimately profits.3 For example, there is some evidence that investing in the "Best companies to work for in America" can result in alpha.4


Governance mechanisms may also facilitate the preservation of value and a return on shareholder capital.5 Governance in the abstract is therefore related to economic value axiomatically, although its ultimate effect on value empirically depends on which governance mechanisms, among the many, are installed, and on their effectiveness. For example, effective boards and active ownership by investors could encourage firms to pay out excess cash, thereby removing potential temptation for empire-building or over-investment by corporate executives. In many emerging markets companies, more independent directors on boards could more effectively represent non-family shareholders. Effective compensation contracts could more closely align executives with shareholder risk appetites and, for example, prevent executives from playing it too safe by underinvesting in risky high-return projects. Effective external auditors can provide an independent opinion about the strength of firms' internal controls and reduce the likelihood of fraud.


Overall, one perspective is that E, S, and G are non-financial measures of performance that, in conjunction with financial measures, provide a more complete dashboard for managers in steering the business towards long-run shareholder value maximization. These non-financial measures may be leading indicators of future financial performance.


The story of course does not end here. There are a number of potential concerns about the relation between ESG and shareholder value. ESG efforts are not expected to be costless and, given diminishing returns to investment, more is not always better. Some ESG efforts might therefore represent over-investment. This is especially problematic if the payback period and return on investment are difficult to assess. For environmental and social efforts, these concerns are easier to see because the outlay costs are more readily observable. For governance as well, more does not always have to be better. For example, a bigger board could hamper timely decision-making and impose other coordination costs. In Japan, companies often have huge, bureaucratic, and static boards of directors, whereas smaller and more nimble boards might be more effective. As another example, excessively restrictive executive compensation policies could hurt a firm's ability to hire the most talented executives who ordinarily have more employment options. Further, global investors often encourage non-U.S. companies to better align managers with shareholders through stock options and other vesting equity awards. If taken too far, however, management compensation tied to short-term share price performance can lead to myopic investment decisions

by managers and rob the company of needed long-term capital expenditures and growth. These arguments motivate some investors' concerns about the positive alpha potential of firms' ESG performance.


In essence the arguments above suggest alternative ways that ESG efforts might impact the fundamental elements of shareholder value: profitability (CF), future growth (g), and risk (r). On one hand, ESG efforts might lower short-run CF but enhance g and mitigate r, thereby enhancing long-run shareholder value. Equivalently, ignoring ESG might raise CF but reduce g and raise r, reducing long-run shareholder value. On the other hand, ESG efforts may penalize CF without sufficiently offsetting effects on g and r. Fig. 1 below illustrates some potential tradeoffs between the elements of value. Firm A chooses to spend more on ESG efforts at the cost of lower profits today, but has higher sustainable future growth and lower long-run risk. Firm B chooses to spend less on ESG efforts and enjoys higher profits today, but has lower sustainable future growth and higher long-run risk. Managerial skill and judgment are invoked in calibrating the appropriate choice of CF, g, and r at any given firm.


Fig. 1: Example of potential tradeoffs between the elements of long-run shareholder value



The upshot is that competing arguments about the potential relation between ESG and alpha provide precisely the tension that makes this an empirical question. We have to look to the data to seek answers. What is the relation between ESG and alpha on average? If the various ESG issues are not equally material for a given industry, would parsing the issues on their materiality give us a better alpha signal?

Mispricing. A second condition for ESG performance to have alpha potential is that the market currently underestimates its future value potential. Such mispricing could result from incomplete disclosures by firms of their ESG efforts (due to, for example, proprietary costs or litigation exposure), difficulty in verifying what is disclosed in the absence of independent attestation, and heterogeneity in investor opinion about the value of ESG.6



1b. Materiality of ESG issues


Stakeholders can assess firms on a large array of ESG issues. Which of these issues matter most to shareholders interested in maximizing long-run shareholder value? These issues are referred to below as "material" issues.


The materiality of ESG issues varies by industry. For example, in the healthcare sector, fuel management is likely a material issue for healthcare distributors (that operate large fleets of trucks and other vehicles) but not for healthcare providers, while access and affordability is likely a material issue for providers but not for distributors.


In the financial sector, access and affordability is likely a material issue for consumer finance companies but not for asset management and custody companies.


In the technology and communications sector, data security and customer privacy is likely a material issue for software and IT service companies but not for electronics manufacturers. Appendix A presents additional illustrative examples of likely material and immaterial issues across selected industries.


The total number of potential ESG issues is large. For example KLD, a leading data source used by Khan et al. (KLD was purchased by MSCI in 2009), rated companies on more than 60 issues. Only some of these issues were likely material for firms in a given industry. As such, the authors hypothesized that discriminating between material and immaterial ESG issues could improve the signal to noise ratio (or purify the alpha signal) in testing for a relation between ESG performance and future stock return performance.


The authors needed to classify ESG issues into material and immaterial, by industry. Such a classification had to be systematic and evidence-based. The authors were in a position to provide evidence on their hypothesis using newly available materiality guidance from a non-profit, the Sustainability Accounting Standards Board (SASB). Generally, SASB adopts a shareholder perspective in identifying material issues as those with evidence of widespread investor interest and expected financial (revenue and cost) impact.7 However, the effectiveness of SASB's identification of material issues had not previously been tested.


1c. Data and Sample


The Khan et al. paper describes the data used by the authors, and this is summarized here. The authors obtained data on material issues by industry from SASB, and firm-level ESG performance scores from KLD. The data in the study was for U.S. firms between 1992 and 2013. As of 2014 when the study was initiated, SASB had issued materiality guidance for six out of ten sectors, covering 45 industries. The final sample included 14,388 firm-years (see their Table 1 for more detail). Fig. 2 below shows the sample composition. The outer wheel shows the percent of available ESG data from KLD for which materiality guidance was available from SASB. The inner wheel shows the sector composition of the outer wheel.













































Fig. 2: The figure depicts the sample composition. The outer wheel shows the percent of KLD data for which materiality guidance was available from SASB. The inner wheel shows the sector composition of the outer wheel.



KLD evaluated firms on over 60 ESG issues, and evaluated strengths separately from concerns on each of these issues. It assigned a binary score of 1 or 0 for every firm on its strengths in each ESG issue, and a binary score of 1 or 0 on its concerns. As in prior literature, the authors calculated firm-level ESG scores by subtracting the sum of concerns from the sum of strengths. A negative score for a given firm indicates more concerns than strengths.

Continue reading here.

This article first appeared on GuruFocus.


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