Signaling Quality with ESG
As we see it, a high ESG score can signal that a firm is in good health, reflecting another facet of quality that may help us build high-performing portfolios while avoiding potentially risky positions. We’ve developed a proprietary ESG rating to measure a firm’s focus on long-term profitability. Unlike most quality metrics, our ESG rating is not based on financial analysis, so it has a low correlation with other earnings quality metrics. For us, this adds a new dimension of quality on a multi-year timescale, enabling us to incorporate another possible source of alpha into our models.
We believe firms that rank poorly on ESG may be more prone to chronic organizational issues — perhaps even leading to controversy or scandal — which could affect valuations both directly and indirectly, as management teams would be forced to deal with these problems instead of focusing on long-term growth prospects. Before investors ever learn of such issues, low ESG scores can act like red flags, indicating a need for more scrutiny into whether we should hold stocks with questionable management quality. Not surprisingly, based on preliminary analyses of our ESG factor on European data back to 2005, we have found that firms with the lowest decile ESG scores may be more likely to underperform in the future.
For the next generation of our research process, what really makes ESG an alpha signal is how we consider materiality. We tailor the metrics we use based on which factors are most and least relevant to each industry, appropriately weighting E, S and G accordingly. So, for example, for real estate firms, environmental issues are important because buildings are the biggest consumers of energy in the world. By contrast, with pharmaceutical firms, environmental issues might not be as important as metrics around drug affordability or availability or issues related to clinical trials.
The Active Quantitative Equity team has incorporated this innovative ESG signal into our models at the end of last year, augmenting the investment process for all our portfolios. As standardized sustainability reporting moves into the mainstream, textual analysis can be taken directly from these reports and more years of data become available beyond what we have now, incorporating low- correlation ESG signals into our models could provide another path to generating alpha to help our investors meet their goals.
To learn more about next-generation ESG research, visit us on ssga.com/esg.