Matching Market Opportunities With ESG Investing

By:

CFA, Chief Investment Strategist

Too many investors view environmental, social, and governance (ESG) investing as an either/or decision. Either investors embrace a broad ESG strategy designed to mitigate risk and deliver long-term value or they invest more tactically in market opportunities they perceive will be more profitable.

But why not choose both — a disciplined ESG approach and a compelling market opportunity? The increasing number of ESG ETFs means investors can do just that.

It’s time to break down existing ESG silos and use thoughtful, well-constructed ESG solutions to target market opportunities, like those available today in international developed markets, small-cap stocks, and municipal bonds:

  • International developed market stocks have attractive relative valuations and resilient fundamentals, and a softening dollar might finally spark outperformance
  • Small-cap stocks have outperformed large caps over the past three months and historically lead the market in the early stages of a rebound1
  • Municipal bonds offer attractive tax equivalent yields as duration risk shifts to credit risk in an evolving fixed income landscape

International Developed Market Stocks: Peaked Dollar May Be a Catalyst

Compared to US stocks, international developed market stocks have had a relative value advantage for some time now. For example, the Bloomberg SASB Developed Markets ex US Large & Mid Cap ESG Ex-Controversies Select Index has a 12-month forward price-to-earnings (P/E) multiple of 11.8 versus the S&P 500 Index figure of 18.2.2 What may be less widely known by investors is that international developed market stocks have delivered higher revenue growth than US stocks during the second quarter earnings season.3 But, despite being considerably less expensive and generating comparable earnings outcomes, they have continued to struggle to outperform their US counterparts.

However, a new catalyst may be emerging to propel international developed market stocks higher. The US dollar has climbed more than 11% year-to-date,4 creating a headwind for international developed market stocks. Consistent with previous Federal Reserve (Fed) monetary policy tightening cycles, the dollar advanced in anticipation of higher interest rates and during the early stages of the tightening cycle. But as the cycle matures, the dollar often begins to weaken. That could be the catalyst international developed market stocks need to improve their performance.

Potential Relief for International Stocks as Tightening Cycle Matures

Potential Relief for International Stocks as Tightening Cycle Matures

Small-Cap Stocks: Starting to Shine, Ready to Lead Recovery

For much of the first half of the year, investors attempted to recession-proof their portfolios. Tightening monetary policy, fading fiscal stimulus, surging inflation, the continued aftershocks from the pandemic, China’s zero-COVID strategy, and the Russia-Ukraine War conspired to produce at least a cyclical economic slowdown, if not a full blown recession. As a result, investors flocked to Treasurys, gold, and defensive sectors like utilities, consumer staples, and healthcare.

But, one of the enduring investment lessons from the pandemic is that the economy is not the market. For example, risk assets rallied strongly at the peak of the pandemic misery. Soon — and before the economic and earnings data bottom — investors will likely begin to price in a recovery. Historically, when that happens, small-cap stocks tend to lead the market in the early stages of an economic rebound.5

In fact, the S&P SmallCap 600 Index has surged 11.6% over the past month. And entering August, small- cap stocks are on a three-month winning streak against large caps.6 If that momentum continues, an array of small-cap ETFs will likely benefit, including those that incorporate ESG factors.

The S&P SmallCap 600 ESG Index is designed to measure the performance of securities meeting certain sustainability criteria, while maintaining similar overall industry group weights as the S&P SmallCap 600 Index. Compared to the S&P 500 Index, the S&P SmallCap 600 ESG Index has higher expected EPS growth (17.2% vs. 12.6%) and a lower 12-month forward P/E multiple (12.3 vs. 18.6),7 making it an attractive opportunity for investors.

Small-cap Fundamentals Remain Sound with Added ESG Analysis

Small-cap Fundamentals Remain Sound with Added ESG Analysis

Moreover, thanks to S&P’s profitability screen when constructing the parent Index, the S&P SmallCap 600 ESG Index typically has fewer constituents with negative earnings, higher return-on-equity (ROE), better profit margins, lower financial leverage, and more attractive P/E multiples compared to similar small-cap indexes.

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Footnotes

1 FactSet, 01/01/2000 – 7/31/2022. Small cap = Russell 2000, large cap = Russell 1000
2 Bloomberg Finance, L.P., August 12, 2022.
Bloomberg Finance, L.P., August 12, 2022.
4 FactSet, 01/01/2000 – 7/31/2022. Small cap = Russell 2000, large cap = Russell 1000.
5 Bloomberg Finance, L.P., July 31, 2022.
6 State Street Global Advisors, August 12, 2022.
7 Bloomberg Finance, L.P., August 12, 2022.
8 Bureau of Economic Analysis, Consumer Price Index Summary, August 10, 2022.
9 Bureau of Economic Analysis, June 30, 2022.
10 Bloomberg Finance, L.P., August 12, 2022.
11 S&P Ratings Research, February 2022.
12 Tom Lydon, “RDMX: Efficient Developed Market ESG Solution,” VettaFi, August 9, 2022.
13 Jon Hale, “Are Sustainable Investors More Likely to Stay the Course?,” Morningstar, August 1, 2022.
14 Jon Hale, “Are Sustainable Investors More Likely to Stay the Course?,” Morningstar, August 1, 2022.

Glossary

Environmental, Social and Governmental Investing (ESG)
A set of criteria that socially and ethically conscious investors can use to screen investments. Environmental criteria look at how a company performs as a steward of the natural environment; social criteria examine how a company manages relationships relevant to its operations; and governance criteria deal with a company’s leadership, executive pay, audits and internal controls, and shareholder rights. An increasing number of investments, including ETFs, are now being marketed as ESG-compliant.

Large-Cap Fund, or Large-Cap Companies
An abbreviation for “large-capitalization fund,” an equities portfolio composed of companies each with a market value of more than $10 billion.

Return on Equity (ROE)
The amount of net income returned as a percentage of common shareholders’ equity. ROE shows how well a company uses investment funds to generate earnings growth.

Small Cap Stocks
Stocks with a relatively small market capitalizations— generally companies with market values of between $300 million and $2 billion. Small-cap stocks are more volatile than mid- or large-cap stocks, but tend to deliver higher returns over longer time periods.

Originally posted August 23, 2022 – Matching Market Opportunities with ESG Investing

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