Equity Quant 7 June 2018 Research Insights ESG – Rested and ready Despite continued solid operational performance, the best ESG companies have not been properly rewarded by the market. AAA-rated companies have never had better ROCE or lower share price volatility versus the market than now. On share price, the top ESG companies have outperformed the worst by as much as 5% per annum since 2012. However, ESG-based investment strategies did not yield any alpha in 2016-17, as multiples contracted despite the strong operational performance. With the underperformance having erased the ESG valuation premium alongside our muted market outlook, the ESG factor is rested and ready for a comeback, and we find ESG-based investing even more compelling. Nordea Markets - Analysts Hugo Fredriksson Senior Analyst hugo.fredriksson@nordea.com Elias Porse Head of Research Insights, Senior Director elias.porse@nordea.com Adrian Bergem Analyst adrian.bergem@nordea.com Performance in ESG strategies stumbled in 2016-17 The best ESG companies have, on average, outperformed the worst by close to 5% per annum since 2012. However, 2016 and 2017 did not provide ESG investors with any alpha. Positive movements in macro indicators increased the risk appetite in the market, benefiting value and momentum strategies at the expense of defensive strategies like low volatility, high earnings quality and ESG. Strong performance in companies with positive ESG rating changes does, however, indicate that ESG remains an important part of investment strategies. ESG ratings point to operational excellence The top ESG companies delivered better returns (ROCE) than ever in 2017 compared with the market; the opposite holds true for the worst ESG companies. The spread in average share price volatility per ranking is also at a record high. Furthermore, we continue to see better return stability and lower debt levels in strong ESG companies. We argue that these trends will continue in the wake of increasing ESG-related regulation, higher energy taxes, increased willingness to pay a premium for sustainable products and greater interest in ESG among younger generations, and that this will eventually be visible in share price performance as well. ESG performance protects above-market returns Combining ESG with other known factor strategies such as value and quality has, since 2012, yielded more stable returns and hence better risk-adjusted returns than the individual strategies alone. We argue that the forward-looking aspects of ESG ratings could be particularly valuable for most factor strategies. Our research suggests that strong ESG performance has protected abovemarket returns in quality companies, which should be attractive to any quality investor. The multiple contraction and lack of alpha over the past two years indicate that the market has overlooked this attractive trait. Hence, we deem the current setup as a good buying opportunity, especially as the better half of companies based on ESG trade on a par with the worse half on forward P/E. Stronger performance ahead is warranted We see good odds for lasting operational outperformance for fundamental reasons and hence we argue for the long-term prospects of ESG investing. Our muted market outlook presented in our Nordea View report should also be supportive for ESG-based investment strategies in the short to medium term. RELATIVE PERFORMANCE PER RATING 125 120 115 110 105 100 95 90 85 80 75 2012 AAA 2013 2014 AA A 2015 2016 2017 2018 BBB BB B & CCC Source: MSCI ESG Research, FactSet and Nordea ROCE RELATIVE MARKET PER RATING 40% 30% 20% 10% 0% -10% -20% AAA B/CCC Source: MSCI ESG Research, FactSet and Nordea ESG VALUATION PREMIUM 1.15 1.1 1.05 1 0.95 0.9 0.85 Fwd P/E - Best vs Worst - Europe Source: MSCI ESG Research, FactSet and Nordea This report is a summary. The full report can be found here. IMPORTANT INFORMATION AND DISCLOSURES AT THE END OF THIS REPORT
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