ESG Focus: ESG And The Hunt For Alpha

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ESG Focus: Rise Of ESG ROC In Hunt For Alpha

There’s a new ROC on the block, and it’s called ESG rate-of-change investing, and Morgan Stanley has singled it out as the next big screen as global equities prepare, for an impending ESG-induced capital crunch.

-Harvard warns of impending ESG capital crunch
-Morgan Stanley promotes ESG ROC over traditional screens
-Macquarie names improvers and laggards
-Social and Environmental compounding pays for big caps
-Morgan Stanley says ESG ROCs will bump off existing leaders
-A wave to wash out the greenwashers
-Quality is King

By Sarah Mills

As inflation and high interest rates bite, investors are increasingly seeking safe havens with solid returns and rising prospects.

After ESG investing took a breather in 2022, pundits are tipping a recovery in 2023 as sustainable finance regains its footing and higher interest rates support a return of the greenium.

In a previous report, FNArena pointed out that another defining trend of FY23 would be “impact investing” fired by generous support from the US Inflation Reduction Act and the European Green Deal. 

Add generous subsidies to greeniums and the regulatory incentive to drive impact and suddenly the global investment focus shifts.

In our last article on impact, we mentioned that researchers estimate the only way the world will reach its climate change goals is with massive innovation, and therefore "business as usual" approaches are not likely to be encouraged.

We also touched on the idea that impact relates to size – mainly the size of the company adopting new technologies or processes, but also the size of the impact delivered by a technology or process.

Combine the two and you get a multiplier effect – the holy grail of impact investing.

But the impact arena is fraught, with many companies adopting innovation solely for the purpose of attracting generous subsidies while appearing to boost their ESG credentials. 

This article discusses research from analysts offering investors tools to isolate alpha.

[Alpha is a measure of a company's upside potential on an individual basis, as opposed to beta which measures risk relative to the market. Active fund managers attempt to generate alpha and thus outperform a benchmark.]

Harvard Warns Of Impending ESG Capital Crunch

Harvard Law School’s recent report The Top 15 Anticipated ESG-Related Considerations That Will Influence Strategy in 2023 expects the new global impact and enforcement focus will drive the switch from virtue signalling to results and that this will breed an increased focus on measuring impact.

The institution says this will affect global capital deployment strategies in 2023, impacting equities, commodities, real estate and fixed income markets.

Harvard believes pursuing net zero for net zero’s sake (which often involves a lot of virtue signalling and carbon offset purchases) will increase the cost of capital “and the scarcity value of capital to the point which impedes the long-term ability to foster innovative capabilities”.

Therefore, it says, tangible action is crucial near-term if long-term compounding of returns is to be achieved and alpha generated.

“The incentive structure should align more with management teams who can simultaneously display attractive financial returns and improve emissions, safety, waste and water profiles,” says Harvard in its report 

“The data indicates this is already taking place.”

Harvard expects this will result in a growing material gap to emerge between achievers and laggards this year.

Enter ESG ROC – The New ROC On The Block 

Morgan Stanley, in several reports in the December and March quarters, has been heavily promoting the adoption of ESG Rate Of Change Investing (let's call it ESG ROC) as a valuable tool for investors chasing alpha. 

ESG ROC is related to impact investing, which Morgan Stanley expects will be deployed in 2023.

The ROC acronym most commonly refers to Return on Capital, and Rate of Change investing has been its lesser-known counterpart. Typically, the latter affects the former.

The measure implies whenever ROC goes above the zero line from below, it reflects positive momentum, while when the ROC goes below the zero line from above, it generates a negative momentum in price.

It is a momentum-based technical indicator that measures the percentage change in price between the current price and the price a certain number of periods ago.

Its application to ESG highlights the understanding that ESG is a process as much as an outcome.

Morgan Stanley’s research, in collaboration with Quantitative Investment Strategies and Alpha Wise, asserts that companies "(transitioners" in particular) with improving ESG metrics can deliver alpha.

The broker says the ESG ROC methodology represents a departure from typical ESG analyses, which tend to revolve heavily around strategies such as exclusion or integration, carbon efficiency, social and governance metrics, or percentage of revenues tied to fossil fuels. 

From a quant view, the group found “little evidence of a significant positive or negative effect on performance from screening on such broad criteria”. 

“In our dialogue with investors around the world, we have sensed a growing interest in owning “improvers” rather than in owning only the stocks that screen as ‘best-in-class’ on a range of ESG metrics,” says the analyst, and says the focus is shifting to improvement metrics.

All up, the research basically concluded that stocks leading the way on improving ESG metrics were benefiting from a compounding effect, in which momentum played a critical role.

They are “demonstrating a rate of change that can generate tangible financial benefits such as revenue/margin growth and risk reduction, and offer attractive risk-reward skews – a clear path to generating alpha,” says the analyst.

Isolating The ROC ESG Impact Opportunity

Morgan Stanley observes that deflationary technologies are driving improvements in both ESG and financial metrics, offering strong net gains for both innovation and costs.

The analyst isolates renewables, green ammonia, precision agriculture, improved molecular plastics recycling, more efficient electric motors, energy storage cost reductions, green steel, more durable tyres, recycling tech, broad electrification, carbon capture, and waste/energy to plastics as the focus areas for innovation this decade.

But the main focus for the next few years remains solidly upon decarbonisation.

Qualifying For ESG ROC

To qualify as ESG ROC alpha generators, Morgan Stanley says companies must meet three criteria:

– evident and quantifiable capital expenditure on sustainability criteria;
– be rated Overweight by MS analysts with a bull/bear skew of greater than 1;
– align with MS’s strategists market and sector preferences.

On the ASX, Morgan Stanley singles out Macquarie Group ((MQG)), as one of its top 5 Asia Pacific ESG ROC stocks.

“Macquarie Group has become an alternative asset manager and real asset developer with global operations with, potentially, the world’s best green capabilities among financials,” says the analyst.

Among Morgan Stanley’s 50 global ESG ROC Overweight-rated stocks, Perpetual ((PPT)) joins Macquarie as the leading light in the financials sector; and Cleanaway Waste Management ((CWY)) is called out among the Industrials.

The analyst also singles out Alcoa, listed on the NYSE but also joint venture partner with ASX-listed Alumina ((AWC)), among materials.

Here’s The Rub

Controversially from an ESG perspective, the broker rejects a dichotomy between investing in ESG ‘enablers’ vs ‘improvers’, suggesting transition companies offer the best ROC opportunities.

Morgan Stanley observes that the initiatives pursued by most of its top five ESG ROCs in the US (for which it expects potential 20% to 100% returns above the broker's target prices), are at the heart of the energy transition, because they provide the basic infrastructure and or raw materials/products needed to promote sustainability in other sectors.

This is controversial because it supposedly opens the door for ESG pariahs such as fossil fuel companies to gain big capital’s ESG favour, if they can improve ESG ROC.

For example, the analyst points out that companies closing coal-fired plants while simultaneously building renewables, energy storage and transmission, can drive superior EPS growth, but many screen negatively on traditional ESG methodologies surrounding carbon intensity.

Many would consider this strategy fraught given the potential for greenwashing and the potential deployment of ineffective technologies purely for the purpose of capturing generous government subsidies.

So the analyst includes a big proviso that ESG ROC analysis needs to be combined with strong sector-specific knowledge to be effective.

It is worth observing that Morgan Stanley has been a long-term supporter of the carbon-capture prospect.

Meanwhile, Morgan Stanley’s quant team showed companies leading the way on a carbon rate-of-change strategy enjoyed superior returns.

Also, the analyst points out that, globally, ESG ROC investing aligns with government policies and taxonomies (read subsidies, particularly in US).

The broker expects this will play out globally.

For example, the analyst observes the UK’s new proposed Sustainable Disclosure Regulation introduces a third category focus on “sustainable improvers” defined as assets that are improving the environmental and/or social sustainability over time including in response to the stewardship influence of the firm.

Macquarie Research Points To Compounding Effect Of ESG

Despite ESG investment taking a breather in 2022, observed over time, ESG investing has delivered strong alpha, note analysts.

To quote Padma Iyer in the Australian Financial Review, “Since the beginning of the pandemic, sustainability-correlated exchange-traded funds and sectors with a direct or indirect link with ESG have had a good run. ESG, in fact, has been the winning horse in the alpha stakes".

Along a similar theme to Morgan Stanley, Macquarie’s ESG December Equity Strategy Report finds a link between ESG scores and compounding share price performance.

The report covers 86% of the ASX300 by market capitalisation, and 79% of the All Ords.

Macquarie observes the basket of companies with the highest ESG scores have broadly outperformed those with the lowest scores by 4.6% a year, on a risk-adjusted basis, since 2011, while those with the lowest ESG scores underperformed relative to both the highest and middle baskets.

The analyst considers this to be proof that its ESG screens can be used to improve stock selection. 

Macquarie observes that in 2022, the top basket returned higher returns of 11% and lower volatility of 16%, while the lowest has lower returns of 7% and higher volatility of 16%. The middle basket had strong returns of 10% but higher volatility at 17%.

The analyst also found that positive ESG revisions were a predictor of outperformance versus negative revisions (approaching an ESG ROC concept).

For example, in the resources sector, Macquarie highlights the difference in in performance between miners such as IGO ((IGO)) and Resolute Mining ((RSG)); or technology companies such as Wisetech Global ((WTC)) and Megaport ((MP1)).

Macquarie assesses that governance was the main differentiator between ASX performances, and tended to propel companies between quintiles, but that environmental and social scores also featured heavily.

Macquarie Ranks ASX Progress

The top, consistent outperformers among Macquarie's entire sample include CSL ((CSL)), REA Group ((REA)), Mirvac ((MGR)) and Cochlear ((COH)).

Companies in the top quintile included a few surprises Transurban ((TCL)), Cohclear, Wisetech, Mirvac, REA Group, Charter Hall Group ((CHC)), Commonwealth Bank ((CBA)), Ramsay Health Care ((RHC)), Brambles ((BXB)), Dexus ((DXS)), GPT Group ((GPT)), Resmed ((RMD)), Stockland ((SGP)), Orora ((ORA)), Carsales ((CAR)), Coles ((COL)), National Australia Bank ((NAB)) and James Hardie Industries ((JHX)).

Laggards, which also included a few surprises, included Seek ((SEK)), Star Entertainment Group ((SGR)), Fortescue Metals ((FMG)), Downer EDI ((DOW)), Iluka Resources ((ILU)), Endeavour Group ((EDV)), Northern Star Resources ((NST)), Lendlease ((LLC)), Pilbara Minerals ((PLS)), Whitehaven Coal ((WHC)), Insurance Australia Group ((IAG)), Harvey Norman ((HVN)), Lynas Rare Earths ((LYC)) and Alumina.

Macquarie says factors negatively impacting a company included: accounting irregularities; cyber security incidents and data breaches; high management turnover; and delayed FY22 results, 

Outside of the ASX100 in 2022, Macquarie rated companies Australian Finance Group ((AFG)), Arena REIT ((ARF)), Growthpoint Properties ((GOZ)), Helia ((HLI)) and Netwealth ((NWL)). 

The broker observes that Arena REIT and Growthpoint also outperformed in 2021, suggesting some solid compounding.

Ex-ASX100 laggards included Capricorn Metals ((CMM)), Dacian Gold ((DCN)), De Grey Mining ((DEG)), Jupiter Mines ((JMS)), Nickel Industries ((NIC)) and Silver Lake Resources ((SLR)).

Nickel Industries, Jupiter Mines and Capricorn Metals also lagged in 2021.

Environmental And Social Scores Pay Off For Big Caps 

While the focus on 2022 appears to have largely been on decarbonisation, Macquarie’s research showed strong social scores translated into a big alpha differential for large caps, but not so much for smaller companies.

The analyst believes this reflects on their larger supply chains, regulatory security and community footprint.

Large caps with positive social scores outperformed large caps in negative scores “generating a cumulative return of 19%, in comparison to -24%, since 2011,” observes the broker.

Since 2011, companies with leading environmental scores have generated a cumulative return of 97% versus 73% for laggards, with large caps again outpacing small caps.

For 2023, Macquarie believes the differentiating factors for ASX companies will be Scope 3 emissions, physical risk and due diligence.

The analyst observes the European Union’s Carbon Border Adjustment Mechanism (CBAM) will be rolled out in 2023 and says the leaders will be those who take the opportunity to incorporate Scope 3 emissions as they rejig their supply chains after covid.

Morgan Stanley Argues ESG ROC winners will bump out ESG Leaders

Morgan Stanley expects an impending divergence between current ESG leaders, and companies in transition which fall strongly into its ESG ROC category.

For US investors, the analyst’s top-five picks include Deer & Co, Eastman Chemical Co, New Fortress Energy Inc, Nu Holdings, and Raizen.

In its brave new ESG ROC world, the broker advises screening for:

-an increase in revenue related to ESG themes;

-potential cost savings from improving ESG metrics;

-margin improvement from new ESG products or services;

-more favourable cost of capital, typically due to reduced risk based on improving ESG metrics;

-analysis of a company’s ESG goals based on its most recent sustainability disclosure.

“Both best in class and rate of change stock criteria, if applied thoughtfully, can have the potential to generate alpha. In particular, investors should look for growth opportunities over the long term which are not always considered in existing valuations,” says the analyst.

Morgan Stanley advises screening for opportunities that extend over a ten-year period.

In journalism, the saying goes that you are only as good as your last story. Under an ESG ROC regime, this would appear to apply to companies. The good, solid ESG tortoises with solid ESG credentials, the broker suggests, will be outpaced by the hares (and the canny foxes). There'll be no resting on ones laurels.

Greenwashing Regulation to Accentuate Winners and Losers

Regulators globally are expected to crack down on greenwashers, and most analysts expect this will heighten the need to apply ESG ROC and general ESG compounding analysis.

The International Organisation of Securities Commissions issued a call for action to fight against greenwashing on November 7, as did regulators across APAC; and Australia is set to introduce its Australian Sustainable Finance Taxonomy, with accompanying legislation on ESG definitions.

Morgan Stanley points out that US legislation is supportive of an ESG ROC strategy but that this situation is less clear in Europe and Australia given their taxonomies may not support ESG ROCs (keeping in mind that many Morgan Stanley ESG ROCs are transitioners from anti-ESG business models and include fossil fuel companies).

Analysts expect more companies to give up on offset strategies, or do less, in order to prioritise research and development for long-term sustainability. Even Woodside Energy ((WDS)) recently shuffled the composition of its offset purchases.

Morgan Stanley Expects Strong Scrutiny On Goals

US investors will need to be keep a strong eye peeled to genuine innovation and not just innovation aimed at capturing generous short-term incentives from the US Inflation Reduction Act.

As tangible action becomes more critical, Morgan Stanley suggests adopting greater scrutiny of a company’s ESG goals, these include:

-which ESG metric improvement can drive improved financial performance;
-capital deployment into ESG goals over the 3-5 years relative to peers with tougher questions around concrete actions and metrics; 
-keeping an eye peeled to social and governance controversies; and
-greenwashing.

Quality Is King

Meanwhile, many analysts argue that all the ESG screens in the world can’t compete with quality but that ESG combined with quality are the most important determiners of alpha.

A Springer article titled Alpha enhancement in global equity markets with ESG overlay on factor-based investment strategies argues that “alpha can be harvested by restricting investment exposure to ESG themes, combined with various style characteristics that display low systematic and idiosyncratic risks".

Springer says ESG overlay on “quality” factors provides the highest return among ESG target indices, however, the underlying “quality” factor provides even higher excess return.

Companies making significant improvements in sustainability metrics as well as traditional financial metrics have the potential to outperform on both fronts, say the analysts.

Meanwhile, a Honeywell survey observes that more than 90% of companies are planning to boost their ESG budgets over 2023 across four main categories:

-energy evolution and efficiency;
-emissions reduction; 
-pollution prevention and circularity/recycling.

The Contrarian View

ScientificBeta begs to differ, saying that after accounting for exposure to standard factors, none of the 12 strategies it used to tilt to ESG leaders added significant outperformance. It adds:

 “75% of outperformance is due to quality factors that are mechanically constructed from balance sheet information”.

Nor can it find evidence to support the argument that ESG strategies protect on the downside, saying that quality remains the decider.

It also points to strong swings in alpha in ESG focus and non-focus years.

“We find that alpha estimated during low attention periods is up to four times lower than alpha during high attention periods. Therefore, studies that focus on the recent period tend to overestimate ESG returns.”

So perhaps this closing comment from Chris Berkouwer of Robeco in the Australian Financial Review is apt:

“The next ESG alpha opportunities are those improvement stories that are not yet well understood by others.”

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future: 
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/

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