Can We do Well by Being Good?

Classical capital allocation theory suggests constraining a portfolio must be sub-optimal. Imposing a higher cost of capital on ‘bad’ companies, by definition, increases the return hurdle and as such the return generated by these stocks. Ergo, penalising bad governance practices through a higher discount rate and removing them from your portfolio you must be willing to accept a lower return.

This may hold in theory, where the market is static and all actors are rational with fixed preferences, however we think dynamic markets, reflexive behaviour, shifting investor preferences and the transition period of adjusting discount rates mean the reality we observe (and are currently observing) may be very different. This may also explain why results from a back test conducted during a transition period may be misleading and why we are currently observing outperformance from ESG factors where theory suggests the reverse.

We have built a simple toy model to explore these issues.
Let us assume we have three companies – average, good and bad as measured by their ESG behaviour but in every other way the same. To date, the market has not cared about ESG and is only interested in financial performance. As such, the equity discount rate for each is the same (10%) and the discounting of their compounding free cash growth of 5% per annum results in all three being valued at $14.

Exhibit 1: ESG impacts through the valuation channel

Source: Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance. Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltán Nagy, and Laura Nishikawa July 2019

The market state then changes, where the marginal investor values the ESG behaviour and allocates capital using discount rates reflecting this view – in our model this reduces the discount rate for the ESG Good company (from 10% to 8%) and increases the discount rate for the ESG Bad company (from 10% to 12%). This doesn’t happen immediately as only the marginal investor has changed their allocation model, but we assume it does occur gradually across all investors over a 15 year period.

The result by year 15 (remembering we have the same expected free cash flow stream forecast for all companies) the value of Company B (ESG Good) has increased by 2.3% per annum faster than Company A (Average) and Company C (ESG Bad) has increased by 1.7% per annum slower. This 4% per annum spread between Company B and Company C is what is observed by investors over 15 years as the market adjusts to the new discount rates.

So yes, assuming the market currently has not already completely adjusted to new, ESG aware discount rates, investors can for a long period of time do well by doing good.

The argument about higher returns (due to higher discount rates) from the bad ESG company may hold true – but it is true from year 15, not year one if we are starting at a lower discount rate.

Cash flow impacts

Exhibit 2: ESG impacts through the cash flow channel

Source: Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance. Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltán Nagy, and Laura Nishikawa July 2019

There are other factors potentially influencing company cash flows over time. Company B (ESG Good) may see improved financial performance through less fraud, lower employee turnover, increased consumer demand etc. Company C (ESG Bad) may suffer from increased regulation, fines for malfeasance, higher employee turnover and decreased consumer demand etc. As investors start to appreciate the relationship between ESG and financial performance, investor cash flow forecast expectations may also shift.

If this resulted in a 1% per annum increase in the FCF growth of Company B and a 1% per annum decreased for Company C, the difference in annual valuation shift (from Company A) goes from 4% per annum to over 8% per annum.

This is not novel. We have observed many times in markets where significant changes in investor preferences, expressed through discount rates, has a meaningful impact on returns through long transition periods. Think about the change in demand from long term, non-tax paying superannuation funds and the impact they have had on how illiquid property and infrastructure has been priced over the past 25 years. Or perhaps how the share of assets invested passively has changed the marginal pricing of securities included in vs excluded from indices.

Exhibit 3: The impact of a transition in discount rates through time.

Source: Longwave Capital Partners

Exhibit 4: Valuation impact of transitioning to ESG influenced discount rates

Source: Longwave Capital Partners

Exhibit 5: The impact of a transition in discount rates and changes in cash flow growth through time.

Source: Longwave Capital Partners

An alternative explanation: ESG performance reflects sector tilts

Because the time period of available ESG data is so short, there are plausible alternative explanations to the marginal discount rate theory for the performance we are currently observing.

Exhibit 6: Sector representation in ESG portfolios

Source: FactorResearch

One reasonable explanation over the past decade may be sector skew. The way ESG factors are currently calculated is far more punitive to certain sectors. An ESG tilted portfolio would be long technology, industrials, healthcare and consumer staples and short energy, real estate, financials and materials. The long sectors have happened to outperform the short sectors over the past 5-10 years.

Exhibit 7 below highlights factor based research which initially looks like ESG is a new source of excess return once exposure to traditional factors has been accounted for (value, size, momentum, quality, low volatility). However once the sector tilts are controlled, the residual returns from ESG are pretty much zero.

Exhibit 7: Residual ESG Performance

Source: FactorResearch

Download the complete ESG Observations and FY2021 Proxy Voting Report