A recent study concludes that companies with effective ESG reporting and messaging deliver alpha for institutional investors.

At Clermont Partners, we believe that improving a company’s environmental, social, and governance (ESG) initiatives can help that firm be more attractive to investors in a very crowded marketplace.  As we have stated in a prior article, investors have raised their ESG assets from $8.1 trillion in 2016 to $11.6 trillion in 2018.  Investors seem to appreciate (and reward) companies that are actively seeking to lower their carbon footprint, while treating employees more responsibly, and delivering wider diversity in the workplace and boardroom.

For years, Socially Responsible Funds had a difficult time attracting new investments because of lagging returns against benchmarked indices.  Conversely, some pundits argued that eliminating certain investments, such as “sin” stocks, wasn’t a sound strategy for building a solid portfolio.  However, a recent study has concluded that adding more socially responsible funds to a portfolio could be a better way to achieve an alpha return on investment. 

In 2018, three well-respected researchers, Aaron Yoon (assistant professor at the Kellogg School of Management), Mozaffar Khan (professor of Accounting at the University of Minnesota until 2018), and George Serafeim (professor of Business Administration at the Harvard Business School) set out to determine whether or not companies with ESG reporting standards actually did perform better in the investment marketplace.

In prior attempts at assessing an association between the implementation of ESG programs and market rewards, the data needed to prove that companies implementing ESG reporting standards performed better than traditionally run businesses was insufficient.  In the quest to find more conclusive data, the trio decided to use a different approach.  They applied the accounting-based concepts of materiality to better quantify ESG investments. 

Materiality Explained

In layman’s terms, “materiality” measures how new ESG reporting programs are integrated into the actual core functionality of a business.  By tracking a small subset of these ESG reporting initiatives (which can vary by industry), the researchers could more accurately determine how these new programs fundamentally changed the way business was done and its overall risk to business operations.  For example, a real estate company that significantly lowers the waste footprint at all its locations will get a higher materiality score than a technology firm with a rigorous waste footprint regiment at its corporate headquarters alone.  In short, you don’t get materiality points for actions that don’t have a material impact on your business.

Measuring Materiality

The trio used the Sustainability Accounting Standards Board’s metrics for materiality to rank firms based on the principles mentioned earlier.  They compared companies with higher materiality levels with companies with lower materiality numbers over a 20-year horizon.  The result?   Returns for companies with high materiality ratings performed 300 basis points higher than companies with lower ESG reporting standards.  For portfolio managers chasing 50 basis points at a time, this improved ESG metric can be a very meaningful benefit.

“Our paper shows that investing in ESG is not value-disrupting,” Yoon says, “as long as the ESG investments the companies make improve materiality.”  Spending capital on ESG initiatives does seem to pay off from a “branding” perspective, but also literally pays “balance sheet” dividends as well.  Yoon again puts it best: “Our work suggests that there is now a way to better understand firms’ ESG-related efforts…with the lens of materiality.”

At Clermont Partners, we help companies create more effective engagements with investors, and assist them in maximizing their market potential by creating compelling stakeholder narratives that maximize investor communication and drive equity valuation upward.