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Ideas Farm: Separating ESG style from substance

When ESG flam trumps ESG fundamentals, and when it doesn't
Ideas Farm: Separating ESG style from substance
  • Is there value in corporate virtue signalling?
  • Is sustainability part of a company's fundamentals?
  • How can ESG be made more easy to understand?
  • Impact-weighted accounts could be coming – hooray!

Terry Smith’s latest annual letter to Fundsmith Equity investors highlights a case of energetic corporate virtue signalling. “Unilever seems to be labouring under the weight of a management which is obsessed with publicly displaying sustainability credentials at the expense of focusing on the fundamentals of the business.”

The statement raises two interesting questions for investors (doubtless ones already considered by Smith who also runs a version of Fundsmith Equity with a sustainability focus). Firstly, is any shareholder value created by this kind of activity? And, secondly, to what extent should sustainability itself be considered part of a business’s fundamentals?

A piece of research from 2018 by leading Harvard environmental, social and governance (ESG) academic George Serafeim sheds some light on both these issues.

Serafeim’s study looked at companies’ ESG scores, as calculated by MSCI, alongside public sentiment towards their sustainability credentials. He used big-data sentiment indicators compiled by Truvalue Labs, which in 2018 alone analysed a quarter of a million articles focused on ESG issues covering 8,000 companies from NGOs, think tanks, industry experts and the media. 

While the research only covered the period between 2009 and 2018, the results were nevertheless insightful. 

When there was a mismatch of poor sentiment towards companies with a high or improving ESG score, shares tended to go on to perform well. By contrast, misplaced positive sentiment toward companies with poor ESG performance tended to be associated with shares doing badly. A long/short strategy based on these findings would have produced returns of 4 to 5 per cent a year over the period studied.

This seems to imply that there is some value in ESG flam, but the upside is short-lived. That’s based on the fact that shares with misplaced positive sentiment were seemingly overvalued but came back to earth, and vice versa. And the fact that ESG fundamentals ultimately bore out suggests that substantive ESG action can be a long-term positive influence on shareholder value. 

Another implication of the research is that if misplaced sentiment causes mispricing, then it suggests investors struggle to identify what really matters when it comes to sustainability. 

Serafeim, along with colleagues at Harvard, is involved in another project that aims to make the substance of ESG reporting much clearer. This involves creating impact-weighted accounts (IWA) for companies. 

IWAs have the potential to bring immense clarity and investability to the issue of ESG. The idea is to put a monetary value on a company's externalities. Externalities are the hidden net costs or benefits a company's activities have on the wider world. These are costs the rest of us have to bear or benefits we get for free. For every pound of sales a company produces, IWAs aim is to tell how many pennies of external net benefit or cost (it is usually cost) is created.

The problem for those compiling IWAs is a lack of standardised and audited data. But the creation of the International Sustainability Standards Board late last year means it may not be too long before we see IWAs becoming part of the mainstream. In principle, companies won’t have to shout about their virtue, they’ll be required to report it.

But what about Unilever? The company boasts impressive ESG scores which suggests it’s a case of both style and substance. Serafeim’s study found companies like this – those with positive ESG sentiment and scores – saw little discernible trend in future share price performance. 

What is likely to matter more for investors boils down to whether it is a sound business. That’s Smith’s focus, and despite his misgivings, he says “...we continue to hold the shares because we think that its strong brands and distribution will triumph in the end.” 

External links:

Read Terry Smith's annual letter here

Read George Serafeim's 2018 research here

Find out more about impact-weighted accounts here