Robeco has long believed that embracing sustainability investing can lead to a better risk/return profile. But we had not publicly quantified it until analysis of our flagship Global Stars Equities fund showed the contribution ESG had made over the past two years.
A study of returns over 2017-2018 revealed that integrating environmental, social and governance (ESG) factors into portfolio construction explains about 22% of the outperformance of the strategy. ESG accounted for about 180 basis points of its 800 basis point outperformance over that time.
So, how does it work? The fund invests in global stocks and had EUR 2.7 billion in assets under management at the end of March 2019. The team starts with an investible universe of about 2,000 stocks, and uses research to narrow it down to the 25-40 best picks.
What makes the ESG integrated is that it forms one part of a wider three-step process to find the best stocks; the strategy also focuses on companies with high free cash flow, and a high Return on Invested Capital (ROIC). This is shown in the chart below:
Five value drivers will be routinely identified for the company – revenue growth, profit margins, invested capital, the cost of capital (as defined by a discount factor), and something that Robeco introduced in 2017 – adjusting the Competitive Advantage Period (CAP). This is the number of years that the company is expected to generate excess returns on new investments, a timeframe in which the ROIC is higher than the Weighted Average Cost of Capital (WACC). A company’s sustainability strategy directly impacts any of these value drivers.
“In quantifying ESG, the starting point is that we know how much ESG contributes to the intrinsic value of a company, because in integrating sustainability in our valuation model, we calculate how much ESG impacts our share price target,” says Portfolio Manager Chris Berkouwer. “This is an important instrument, since price targets broadly signal what we expect the company share price to be at a set date in the future. If the price target is much higher than the current share price, it represents a buying opportunity.”
“For example, on the back of the ESG analysis of a leading European renewable energy company, we found that the most material ESG factors make up about 16% of the intrinsic value of the company. Subsequently, we looked at the performance contribution of the company in the portfolio, which was +44 basis points (bps) during 2017-2018. Multiply both figures and you get a proxy for the ESG attribution to performance; in this case, this is 16% x 44 bps = +7 bps excess performance attributable to ESG.”
“A further breakdown of the results showed that in 2018, which proved to be a very difficult year for stock markets, the positive ESG tilt in our portfolio acted as a performance cushion, contributing 98 bps of excess performance in addition to the 158 bps of outperformance made on stocks where ESG did not impact company valuation.”
Of course, the fund is judged on the returns of the companies it invests in, but exclusions are also an important part of sustainability investing. This can cause a dilemma because some of these sectors with excluded companies can be profitable, which means the fund is missing out on potential returns.
A good example can be seen in the aerospace and defense sector. Robeco routinely excludes many of these companies because they make controversial weapons such as nuclear warheads. In its 2017-2018 analysis quantifying the positive impact that integrating ESG made on the Global Stars Equities strategy, the team was also able to quantify the negative impact that excluding defense companies had made. By not owning these stocks, the portfolio incurred 27 basis points of opportunity costs over 2017 and 2018.
‘In 2018, which proved to be a very difficult year for stock markets, the positive ESG tilt in portfolios acted as a performance cushion’
“The main reason for this is that aerospace and defense companies generally have high financial returns, healthy balance sheets and good shareholder returns, which still makes them an attractive investment from a fundamental point of view,” says Berkouwer.
“Fortunately, this opportunity loss was more than offset by selling all tobacco holdings in the portfolio in early 2017, contributing 85 bps to overall performance after the sector underperformed. The net effect of the exclusions was positive.” This is shown in the chart below.
The 2019 study done by the Global Stars Equities team included 134 investment cases written in 2017 and 2018 and endorsed the results of an earlier study that ESG integration impacts valuation about half the time.
In total, 43 investment cases (32%) saw a positive adjustment to the price target; while 18 cases had a negative adjustment (13%), and no adjustment was made in 74 cases (55%). This is shown in the chart below. The fact that more positive rather than negative adjustment were made, makes sense given the focus on the higher0quality companies that the fund invests in.