What The ESG…F

The Importance of Financial Materiality in ESG Investing

What’s the ESG-F

Broadly, ESG as a concept has evolved greatly over the past two decades and now reaches nearly every aspect of the corporate decision-making process and equally the investment decision-making process, and rightfully so. That growth has presented so many amazing opportunities for investors and corporations to measure and improve practices across all aspects of the E, S, and G. It has also created a host of challenges for investment professionals who are trying to answer the question, ‘Does ESG matter?’ Globally we continue to see and measure the improving practices of corporations with ESG:

  • Environmental with more companies committing to carbon goals and more biodiversity awareness
  • Social initiatives with more inclusive CSR policies, board, management, and employee gender and ethnicity representation
  • Governance through board composition, shareholder rights, engagements, and voting

We have also watched and listened as ESG reporting continues to evolve with different regulatory situations globally. These changes have driven the availability of data (clean, comparable, and consistent data) but still one of the biggest and ever-growing struggles is to capture, measure, and analyze that data. Multiple studies have been published that point to discourse and even confusion in ESG ratings and rankings which cloud the analysis process with uncertainty and data risk. We at ISS ESG not only agree with discourse in ratings and rankings, we believe it is extremely valuable and that better mythology, better data, and better analysis produce better results. So back to that question, does ESG matter? The global ISS ESG team has continued to answer that question with a resounding yes – ESG Matters and here’s why.

ESG Matters … Here’s Why

ESG (Environmental, Social, and Governance) has a fourth pillar – Financial materiality. The last pillar in the ESGF acronym is the one that can help to connect ESG to the front office in a most critical way, by providing measurable ways to link ESG to an investment process. We evaluate the F pillar through the Economic Value Added (EVA) lens. EVA converts accounting profit to economic profit by reversing accounting distortions found within the as-reported financial statements and measures the dollar value profit after ALL costs, including the cost of giving shareholders a fair return on invested capital. EVA is a cleaned up, consistent, and comparable measure of profitability which allows investors to parse through thousands of companies globally with comparable accounting adjustments to drive informed investment decision making on a systematic basis. Think of EVA as financial quality, more EVA is always better, so firms that generate more EVA are most times assessed as higher quality. So why is EVA Quality important?

Why the F

The use of ESG metrics in investment has been shown to provide sustainable value to investors. In our most recent ISS ESG publication, ESG Matters: Part II, we highlight that combining our ISS ESG ratings with EVA is even better. In a simple back test outlined in the paper, firms that exhibit both high-ESG and high-EVA Margin produce returns that are up over 100% over the last five years (i.e., doubling), when compared to firms that are low-ESG and low-EVA Margin which are up less than 40% over that same time period. This represents an annualized spread of ~12%.

To pass the test of whether an investment strategy works, the results must not be driven by outliers. That means it should work in most sectors, countries, time periods, and in more stocks than not, and if it does not outperform, then it must make sense (e.g., risk-on versus risk-off markets favor different factors). Combining ESG with EVA passes all these tests. Using EVA as the foundation of our assessment of Financial Quality brings additional comparability for ESGF analysis. Empirically we have measured how investors care about EVA, and the results show us that higher EVA Margin leads to higher valuation multiples. While this is not a groundbreaking relationship (nod to Benjamin Graham and many investors before and after him) it only further supports the use of EVA as the measuring stick for Financial Quality. When compared to traditional P/B ratios, our EVA-based data consistently outperforms global benchmarks.

How the F

ESG-minded investors are faced with two somewhat binary decisions: 1. Integrate with ESG mandate and philosophy and 2. Continue to generate alpha. The challenge is that their fiduciary responsibility lies between them both – but it does not have to. ESGF can be applied in myriad of different ways, and our work and research does support that view: There are many ways to be an effective ESG investor. With ESGF our entire team globally has worked to support our clients in building ESGF strategies that allow for persistent risk-adjusted outperformance versus global benchmarks. Our research supports the foundational view that integrating ESG into an investment decision process is not only sustainable for returns but sustainable for the world.

Anthony Campagna

Director of Research, ISS EVA