“DO sweat the small stuff”: how ESG missteps impact future performance

We’ve written extensively on our concept of “corporate karma” – the idea that what goes around, comes around with regard to how companies treat their stakeholders.

Since the start of the pandemic, we’ve written about our belief that a new social contract is emerging, particularly in relation to how employers treat their employees, and we’ve shown how it’s possible for companies to balance the needs of all stakeholders.

We’ve also looked at how well companies are supporting their stakeholders. Above all, we’ve tried to emphasise why corporate karma is crucial for your investment returns.

Companies that look after their stakeholders are less likely to experience controversies such as customer boycotts, strikes and walkouts, litigation, regulation, environmental or occupational accidents. This implies a lower risk profile for your portfolio.

What does the research say?

Controversies are a hard thing to study empirically because headline-grabbing episodes like VW’s “Dieselgate” or BooHoo’s 2020 modern slavery scandal are, thankfully, pretty rare.

But a new paper from the University of Virginia1 expands the data set by examining more minor ESG incidents such as environmental damage, discrimination, occupational health and safety issues, fractious relations with local communities, and anti-competitive practices. There were as many as 80,000 such incidents among listed US companies over the decade 2007-17.

The paper's author finds a clear relationship between the number of past incidents and future financial and stock performance.

A portfolio of stocks with high environmental, social and governance (ESG) incident rates had lower profits and underperformed the wider market by about 3.5% per year, even when taking into account sector exposure and other risk factors.

The model also held for out-of-sample data in European markets, where a similar portfolio would have underperformed by 2.5% per year.

Why do controversies result in underperformance?

Even relatively minor incidents can be indicative of weak internal controls or issues with corporate culture. So the same companies are likely to experience more of these types of events in the future.

No one ever forecasts a controversy, so analysts tend to overestimate the sustainable earnings power of “incident-prone” companies. This leads to negative earnings revisions and resulting underperformance in the future.

Furthermore, analysts tend to look through minor incidents so are more likely to be blindsided by big ones.

The author calls out the example of BP which, before the Deepwater Horizon spill in 2010 wiped 50% off the company’s value between April and end-June, had a long history of environmental and safety incidents. Until Deepwater Horizon, these had not had a material impact on the share price.

Even if the incidents remain small, over time they can undermine a company’s reputation and the trust of its customers, workers and investors.

Markets aren’t efficient at pricing ESG factors

Despite the surge of interest in sustainable investing, financial markets are still poor at pricing environmental, social or governance information (ESG), particularly when there is no clear implication for short-term earnings. The author attributes this to “limited attention theory”, whereby investors find it easier to absorb salient, readily processable information.

Furthermore, the author finds a much stronger relationship between the incident data and performance than third party ESG ratings, which aggregate hundreds of data points into a single score or grade.

This shows the value of doing our own homework. We need to tease out what historic data and incidents can tell us about a company’s culture or controls, rather than just putting numbers into an algorithm.

Stocks with a higher share of short-term focused investors saw the biggest negative reaction to incidents, presumably because these investors were less focused on the implications of a firm’s ESG track record on its long-term earnings power. Long-term investors seemed to be better at anticipating future controversies and selling high-risk stocks.

How can investors use this information?

This tells us that when assessing minor or major controversies we should be focusing on the root cause rather than the proximate cause.

For example, the specifics of a product recall matter less than whether it indicates a culture of chasing growth at the expense of quality control.

Following a controversy, we should challenge companies to demonstrate what has changed to prevent further incidents, and hold them to account.

And we believe when constructing a portfolio, companies classed as “improvers” should, all else being equal, be held at lower weights to reflect their higher risk profile and greater uncertainty of long-term earnings power.

1 ESG Incidents and Shareholder Value, Simon Glossner, University of Virginia – Darden School of Business, February 17, 2021

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