The post “How ESG Affects Valuation, Risk, and Performance” first appeared on the Alpha Architect Blog.
Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance
- Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltán Nagy, and Laura Nishikawa
- Journal of Portfolio Management
- A version of this paper can be found here
- Want to read our summaries of academic finance papers? Check out our Academic Research Insight category
What are the research questions?
We have done a fair amount on the investment merits of ESG investing, but the question of how ESG affects the fundamental performance of a firm (in a causal fashion) is addressed in this study. For example, this paper askes questions such as, “Are high ESG scoring firms more adept at managing their risks, thus leading to higher valuations? Or is it the reverse: are firms with higher valuations better able to manage and improve ESG activities, thus leading to higher ESG scores?”
Instead of using a correlation-based analysis, the authors of this study attempt to derive an understanding of the causal relationship of ESG by examining the transmission channels found in discounted cash flow models, specifically between cash flow, risk and valuation channels, and ESG scores. Certainly, this is an interesting approach grounded in firm fundamentals with the goal of producing evidence explaining the economics that underlies the performance of high and low ESG scoring firms.
Why does it matter?
The existence of “ESG momentum” has been documented elsewhere (Khan, Serafeim and Yoon, 2015) and is robust to numerous competing variables including size, market-to-book ratio, leverage, profitability, R&D intensity, advertising intensity, institutional ownership, and sector membership. However, this article ties the phenomenon to fundamental valuation (DCF) models, making a powerful argument for using ESG momentum not only as an addition to the use of ESG ratings in portfolio strategies but also as a standalone signal. 1
Editor Note: An open question is whether or not ESG scores/factors will produce excess returns in the future. Assuming one believes in the results in this paper, one might expect lower expected returns in the future, as ESG seems to increase free cash flows and decrease the cost of capital. Of course, this is under the assumption that the market is reasonably efficient and there are no limits to arbitrage associated with investing in ESG stocks.
Visit Alpha Architect to read the full article:
Disclosure: Alpha Architect
The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
This site provides NO information on our value ETFs or our momentum ETFs. Please refer to this site.
Disclosure: Interactive Brokers
Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.
This material is from Alpha Architect and is being posted with permission from Alpha Architect. The views expressed in this material are solely those of the author and/or Alpha Architect and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.