By Steve Barrett, product specialist at European and Global Advisers (EGA)
While the number of ESG funds has exploded in recent years, one thing has remained constant – most strategies focus on the ‘E’ more than the ‘S’ or the ‘G’.
Given the heritage of ESG funds, that makes intuitive sense. But would ESG investors be better served by focusing more on the ‘G’?
Our research shows that well-governed companies deliver positively not only on the ‘G’ but also on the ‘E’ and the ‘S’. That is because companies are more able to achieve the goals and targets they set for themselves, whether they are financial, social or environmental.
Without effective governance, their ‘E’ and ‘S’ objectives, as well as financial and operational goals, are unlikely to be successfully met.
Identifying good governance
The key here is to be able to systematically identify good corporate governance and company culture. One of the most effective ways to do this is to analyse the language used by senior executives, which can reveal how well they manage risk, handle crises, demonstrate prudence, and embed their values and beliefs.
However, simply poring over the transcripts of quarterly earnings calls, which by nature are upbeat and limited in scope, can only give a partial picture.
In the US, this problem can be overcome by analysing firms’ 10-K filings, comprehensive annual reports listed companies are required by law to submit to the Securities and Exchange Commission. While long and complicated, these provide an exhaustive and honest account of a firm’s current position and challenges, and thus a real sense of the core DNA of its board and management.
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Using AI and machine learning, our stewardship model allows us to assess hundreds of these annual reports in a consistent way, enabling us to rank the S&P 500 by the quality of their governance, and measure how well they are performing on key ESG metrics.
One of the key findings is that well-governed companies are much better than average at delivering on their Sustainable Development Goals, as well as their financial targets.
Compared with the broad index, the top 100 best-governed S&P 500 stocks emit 73% less GHG, generate 96% less waste, and use 85% less fresh water. The ‘G’ is therefore a reliable guide to how likely a company is to achieve their sustainability objectives.
Performance
Assessing how well a company is managed also helps predict the successes and challenges companies could face, and their potential for outperformance.
Companies which score highly in the model tend to share certain characteristics, such as concern for employee welfare, prudence, and a focus on R&D, which generate more shareholder value.
Conversely, companies ranking the lowest in terms of governance tend to underperform. Our stewardship model has consistently shown that well-governed companies tend to outperform the S&P 500 Total Return Index by an average of 5% gross per year.
Of course, good governance is not static and companies within sectors or groups can differ substantially.
Take the Magnificent Seven, which now account for 31% of the S&P 500. These exhibit significant differences in their governance characteristics. Based on their most recent 10-K filings, our latest rebalance shows that five of them score much higher on governance scores than the S&P 500 average: Microsoft, Apple, Alphabet, Amazon, and Nvidia.
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Microsoft leads the way, having a consistent track record of excellence in several key areas including strategy development and execution, stakeholder management, and employee engagement.
Conversely, Meta has consistently faced challenges in stakeholder relations and in integrating robust ethical standards into its corporate ethos. Meta scores well below S&P 500 averages in the part of the model that assesses whether companies are keeping pace with societal and market developments, with a forward-looking approach.
Tesla has also found itself outside the model’s Top 100 due to its limited emphasis on strategic and cultural elements in its corporate statements. Specifically, Tesla scores below average on an ‘agility’ measure which indicates risk management concerns and caution in its management approach. This score reflects various risks faced by the company, including challenges in maintaining its market share.
Tesla has now not been included in our model since it went live in 2016. In contrast, Microsoft has been included every year, while Nvidia and Alphabet have only missed out once.
No need to bet the house
Of course, some of the Mag 7 have been at the heart of the explosion of growth at the top of the S&P 500, with Microsoft, Apple, Amazon and Nvidia hitting multiple trillion-dollar market caps in quick succession.
The problem for active fund managers is that outperforming a ‘hot’ market like this means betting the house on one or more of these top-weighted stocks. The risks of this approach, as we have seen recently, are significant, and it requires an almost divine prescience to time exit points and lock in gains.
We believe that identifying and investing in the best managed companies will, over time, prove a more reliable approach. They may not soar indefinitely, but well-governed companies are likely to outperform their less well-governed counterparts over the long term, while significantly improving portfolio sustainability scores. Perhaps ESG needs a new acronym.
