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Comparing Static Scores to Score Improvement (1Q 2021)

Stewardship Insights | 1Q 2021

01 April 2021

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Which has a stronger relationship to investment performance: static ESG scores, or ESG score improvement? We offer our observations, along with an integrated approach to engagement that can help value investors capitalize on ESG controversy.

One of the most intense areas of interest in the investment world today is how practitioners are integrating the consideration of environmental, social, and governance (ESG) issues into their investment process. Some managers have taken a quantitative approach, incorporating an evolving set of tools to invest in companies with high ESG scores. While others, Pzena included, have focused on the integration of ESG issues into the investment process and working with companies, as active owners, to address those issues.

An integrated approach appreciates the contribution ESG data providers have made to improving the availability and quality of data in the marketplace, but does not use overall ESG scores to make investment decisions. From our perspective, an ESG score is simply one of many inputs to our investment process and by no means the arbiter of investment decisions. That is something that will always be the purview of our bottom-up, fundamentally-driven research team.

Nevertheless, we are committed to furthering our understanding of the utility of ESG scores, particularly as it relates to positions or issues that clients have challenged us on. We therefore embarked on an intellectual exercise, making use of MSCI’s ESG ratings, to examine three questions. The findings, while interesting, should be considered directional at best, given the limitations of this analysis1.

  1. Are stocks with lower ESG scores cheaper?
    While there is no conclusive evidence, in general, lower ESG-rated stocks appear slightly cheaper than the overall universe.

  2. Is there a relationship between ESG scores and investment performance?
    Contrary to popular opinion, we found a weak relationship here. While cheaper companies may have lower ESG scores, this does not necessarily mean performance suffers.

  3. Is there a relationship between ESG score improvement and investment performance?

This was where we saw the significantly stronger relationship (Figure 1). This implies that ESG improvement may be more important than a high ESG score per se. If true, weak ESG scores themselves would not automatically be a bad thing. In theory, investing in stocks with room for improvement is a win-win because stakeholders and society are better served when a company improves its ESG prudence, while shareholders are best served when the company mitigates its risks and provides strong shareholder returns in the process. If discarded by investors, a company may be starved of capital and therefore struggle to improve ESG credentials.

The benefit of sticking with a company through the tough times where we see the potential for turnaround and ongoing engagement is familiar to us as an ESG-integrated value investor.

The palm oil industry is notoriously controversial, garnering negative media attention for its inherent environmental and social risks. However, when done right, palm oil is a leader in supporting food affordability. Our investment in Wilmar, a leading Asian agribusiness, was made after accounting for these risks, and with the conviction that the company is run with franchise longevity in mind. As such, it is our belief that management has a vested interest in proactively addressing these business risks.

We identified several ESG risks for Wilmar as part of our investment research, specifically: deforestation for palm plantations, allegations of child labor and human rights in the supply chain and the complexity of supplier management. We have engaged extensively with the senior management and the Chief Sustainability Officer to: fully understand the associated investment risks; highlight the gravity of these issues; and emphasize the importance of proactive management.

In our view, Wilmar has been making steady progress and this has only accelerated over the last 5 years. For example, Wilmar has had a zero-tolerance ‘no deforestation, no peat, no exploitation’ policy in place since 2013, and recently enhanced its supply chain compliance and monitoring. This culminated in an immediate de-listing of suppliers with suspected transgressions, as well as education programs to help a supplier re-gain its standing. Being the first major player to make this commitment positioned Wilmar favorably among buyers, leading to improved volume, pricing, and strengthened competitive advantage. This also helped to draw a line under a reputationally damaging report from Amnesty International in 2016 that alleged widespread occurrence of exploitative labor practices.

The timeframe of these improvements broadly mirrors the performance period we examined (2015 to 2018) where Wilmar experienced a 41% 3-year return and was simultaneously upgraded by MSCI from a BB to BBB rated stock. While we cannot claim that all performance gains can be attributed to ESG improvement, at a minimum, good ESG is better for business at Wilmar.

While directional only, these findings are encouraging in that they start to challenge the commonly held perception that a value investment approach and ESG prudence are in conflict. It points to something we have always believed: value investors capitalize on valuation dislocations while working with companies to help improve E, S, and G issues. This is, of course, predicated on the importance of a strong research process to figure out which companies have real improvement potential.

The combination of deep research and engagement can help value investors capitalize on ESG controversy within the singular goal of generating superior returns.

Figure 1: Stronger Relationship Between Improving ESG Scores and Performance

Performance by IAS2 ESG Score Improvement Quintiles
5th Quintiles is Lowest ESG Improvement

Global3 Universe
IAS ESG 
Improvement Quintiles5		 Average IAS Improvement Amount Average 3YR USD Return6
1 (best improvement quintile) 2.27 28.9%
2 1.03 26.7%
3 0.33 24.1%
4 -0.28 23.0%
5 (lowest improvement quintile) -1.51 18.6%
Overall Global Universe 0.35 24.2%
U.S.4 Universe
IAS ESG 
Improvement Quintiles5		 Average IAS Improvement Amount Average 3YR USD Return6
1 (best improvement quintile) 2.31 37.3%
2 1.06 33.9%
3 0.35 30.6%
4 -0.28 30.6%
5 (lowest improvement quintile) -1.42 27.8%
Overall Global Universe 0.38 32.0%

Data tables display 3-year quarterly averages (15 data sets each table).
Source: Capital IQ, MSCI, Pzena analysis. Past performance is not indicative of future returns.

Footnotes

1. Limited timeframe of data (January 2014- July 2020) which was also one of the worst periods on record for growth vs. value divergence; ESG ratings are still evolving in terms of depth and sophistication and there is still a lack of consistency among different ESG score providers; and, finally, as with anything, correlation does not necessarily imply causation. (END FOOTNOTE)
2. Based on MSCl’s Industry Adjusted Scores (IAS).
3. The largest 2000 names globally ranked by market cap.
4. The largest 1000 names listed in the US ranked by market cap.
5. Analysis was performed using sector-neutral quintiles — i.e., we divided companies in each GICS sector into 5 equal quintiles to ensure proportionate sectoral representation in each IAS improvement quintile.
6. Cumulative total shareholder return in US dollars.

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Wilmar International Ltd. was held in our Emerging Markets Focused Value, Global Focused Value, Global Value, International Focused Value, and International Value strategies during the first quarter of 2021.

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