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
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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.
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