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Stocks with high ESG scores signal higher future return on equity – BofAML equity research

ESG factors are “too critical to ignore” say US Equity & Quant Strategy team

A new research report from BofA Merrill Lynch’s US Equity & Quant Strategy team has found that stocks with high environmental, social and governance (ESG) scores have signalled a higher return on equity (ROE) across sectors.

They also feature lower earnings per share volatility in most sectors “and alpha in some”.

“What if we told you how to avoid stocks that go bankrupt?” its analysts ask in a BofA Merrill Lynch Global Research report. “We think you would listen. Environmental, Social & Governance (ESG) factors are too critical to ignore, in our view.”

“ESG is the best signal we’ve found for future risk,” the analysts write. “Prior to our work on ESG, we found scant evidence of fundamental measures reliably predicting earnings quality.

“But ESG may isolate non-fundamental factors that have real earnings impact: ESG has been a better signal of future earnings volatility more than any other measure we have looked at both at a market level and at a sector level.”

In the energy and materials sector, “ESG has been effective at identifying alpha opportunities, ROE and earnings risk within these two sectors, especially the environmental factors.” In real estate and utilities, ESG “has been a strong and consistent signal” of future alpha, earnings risk and ROE, “particularly social factors”.Within real estate, it found that stocks with above-average ESG ranks “outperformed peers by 10ppt over the subsequent five years”.

And in the financials sector, BofAML reckons improving / deteriorating ESG scores have been more effective in signaling future earnings volatility than for any other sector.

ESG may isolate non-fundamental factors that have real earnings impact”

“In particular, ahead of the Global Financial Crisis, US financials – especially those that did not survive – saw disproportionate drops in compensation policy, shareholder rights and diversity ranks.”

The bank says its May survey of BofAML’s institutional clients saw 20% citing using ESG, “well above the estimated 5% of float that corporations believe is held by ESG-oriented investors”.

“The market is listening: shareholder-friendly companies have seen significant multiple expansion – and we see strong signs that this re-rating continues.”

These views are echoed by PIMCO. Alex Struc, head of ESG Portfolio Management at the fixed income giant, has outlined 10 reasons why ESG is growing. In a blog, he highlights good governance as being “systemically important” and that climate change is a reality and that energy sources are shifting.