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Willem Schramade, Sustainability and Valuation Specialist in Robeco’s Global Equity team, recently published an article on ESG integration in the Journal of Sustainable Finance & Investment. In this article, he explains the Robeco Global Equity team’s advanced approach to ESG integration.
True Environmental, Social and Governance issues (ESG) integration means ESG factors are systematically fed into the valuation models and investment decisions of analysts and portfolio managers. However, most ESG approaches fail to do this. As a result, sustainable investing is much less an application success than a marketing success.
Our value-driver adjustment approach is different: it ties into traditional valuation approaches by linking ESG issues to value drivers via their impact on business models and competitive positions.
The analyst first identifies the most material issues for a sector or company. Subsequently, he (or she) assesses how the company performs on these issues versus peers, based on indicators, policies, strategy, etc. He then determines if the company derives (or will derive) a competitive (dis) advantage from these material issues, and how that affects its value drivers.
These links are hard to prove statistically or capture in an algorithm, but they are probably there. The intuition is simple: if a company has a competitive edge from an ESG issue, this should become visible in its value drivers. That is, it should in the end have higher sales growth, higher margins, a more efﬁcient use of capital, or lower risk. These value drivers in turn drive the firm’s return on invested capital and valuation.
Since January 2014, our analysts are required to explicitly quantify the impact of the most material ESG issues on the value drivers in their discounted cash ﬂow (DCF) analysis. Therefore, the average impact of ESG analysis on the target price can be systematically calculated. It also allows us to map which ESG issues turned out most material. Our team does this because we ﬁrmly believe in the impact of ESG factors on the valuation of companies. In addition, the team is in a unique position to quantify this impact as it has access to extensive, high-quality data obtained from RobecoSAM’s Corporate Sustainability Assessment. This assessment is based on questionnaires sent to approximately 3000 companies each year. Over time, this will allow us to say much more about how important individual ESG factors are.
During 2014 and the ﬁrst two months of 2015, our Global Equity team produced 127 investment cases in the VDA framework. The initial results are that the average target price impact of ESG factors is 5% overall. Put differently, ESG accounts for on average 5% of the target price an analyst arrives at - 10% if we take out zero adjustments. Note that dispersion is wide as target price changes range from −23% to +71%.
Showing the alpha we obtain from sustainability alone is not really possible: ESG analysis is integrated just like other parts of fundamental analysis, such as strategic analyses and the application of valuation models, which cannot be separated out either. However, we do have signs that ESG integration improves our decision-making.
First of all, it brings us a better long-term focus. We had deeper discussions between analysts and portfolio managers on long-term value creation potential; and a better picture of what kind of characteristics and intangibles we are looking for. Secondly, it has provided us with warning signals. In spite of their often long-term character, ESG factors can sometimes pay off surprisingly soon. For example, in the quarter after our SI Healthcare analyst had ﬂagged it as a high Corporate Governance risk company, a Japanese pharmaceutical company made an expensive acquisition. Similarly, a US company saw rising expenses on a risk highlighted by our SI Industrials analyst.
For more detailed information, please read the working paper ‘Integrating ESG into valuation models and investment decisions: the value-driver adjustment approach’ by Willem Schramade on SSRN
This article was published by Taylor & Francis in Journal of Sustainable Finance & Investment, 2016, Vol. 6, NO.2, 95-111, available online.