DETERMINING ESG SIGNALS IN THE
SA EQUITY MARKET
We have long been interested in better understanding the
various factors driving stock market returns – as we recognised
the subjectivity involved in the fundamental valuation of stocks.
This led to us researching the drivers of returns on the JSE,
and subsequently evolved into providing the framework that
we now use in selecting shares.
In building this framework, we tested around 300 factors
that influence stock market performance. Using 25 years of
data, we looked for factors that delivered consistent, longterm
outperformance as well as those having no or a negative
correlation with each other (to reduce downside volatility). The
end result is that, in addition to our analysts’ calculation of
intrinsic value, we now include 11 factors in constructing our
While the fundamental calculation of intrinsic value remains
the most important factor in considering a share for inclusion
in portfolios, the final weighting is influenced by considering
the multifactor ranking of a share. These factors are grouped
into three themes:
1. Quality: companies with strong cash flow and improving
returns on assets, margins and asset turns.
2. Growth: companies showing potential to deliver stronger
earnings growth than the market.
3. Sentiment: short- and longer-term market sentiment
indicators give us a sense of the market’s attitude towards
a specific company.
These three themes provide important insights that improve
portfolio management conviction, assist in guarding against
excessive single-theme exposure (such as potential “value
traps”) and alert our analysts by highlighting various market
information, including sentiment.
KEEPING IT RELEVANT
While the success of this well-researched process is evident
in the relative outperformance of our funds, it is by no
means a static model. We constantly monitor market trends
and evaluate the robustness of our model. One trend that
is gaining increasing global attention is the inclusion of
environmental, social and governance (ESG) factors into
investment processes. This involves, amongst others, looking at
a company’s environmental impact, the health and well-being
of its employees (social) and the alignment of management
with its shareholders (governance).
Governance and an assessment of management’s stewardship
of shareholder capital plays a prominent role in both our
investment selection process and ongoing engagements
with company management. We have also built the MSCI
Intangible Value Assessment (IVA) scores, rating environmental
and social risk factors, into our share screening tool.
However, while South African listed companies have
comprehensive and standardised financial data, insightful
ESG data is not widely available nor is there a consistent
reporting framework. As such, we are aware of the need to
monitor the potential longer-term impacts of these factors as
well as motivate management to provide relevant E, S or G
data, where necessary.
It is worth highlighting Credit Suisse’s research conducted in
the Australian listed market. Titled Finding Alpha in ESG, the
research aimed to determine the value of integrating ESG
factors into an investment process.
The research used MSCI’s data and ranked the performance
of companies across five measures:
The research used data from May 2008, the time from which
the MSCI has been providing quantitative ESG ratings for the
S&P/ASX 200 Index. At the end of every month, stocks were
ranked from highest to lowest for every one of the five factors
listed on the previous page, and split into five quintile portfolios
of 40 stocks each.
Broadly, the research rankings showed that “strong management
of environmental issues ‘pays’ and weak management of
environmental issues ‘costs’ at the portfolio level”. Governance
analysis revealed similar results, while social data showed
“that companies which have overall the weakest management
capabilities and highest exposure to social issues significantly
underperform all other companies, i.e. poor social performance
‘costs’ at the portfolio level. However, we find that there is no
benefit from a strong social pillar score at the portfolio level.”
Ranking companies on an industry basis provided insight into,
for instance, optimal industry diversification as well as the best
stocks within poorly rated ESG industries.
The emerging wisdom from this research suggests that
ESG ratings are a good proxy measure for a company’s
management quality. Simply put, management teams that
handle ESG issues well are typically also responding well to
many other strategically important business issues.
This was further reinforced in a meta-analysis that referenced
over 200 global studies reviewing ESG issues. The 2014
report entitled From Stockholder to Stakeholder was compiled
by Arabesque Asset Management in partnership with Oxford
University. The key outcome was that 88% of reviewed
sources find that companies with robust sustainability practices
demonstrate better operational performance, which ultimately
translates into cash flows. The second part of the report builds
on this, where 80% of the reviewed studies demonstrate that
prudent sustainability practices have a positive influence on
BRINGING IT HOME
One of the challenges of undertaking similar research in the
South African market is the lack of comparable year-on-year
ESG data. Recognising this, four years ago Old Mutual
Investment Group partnered with the MSCI to start building
up the ESG coverage in both the South African and broader
African markets. Since 2012, the MSCI ESG coverage has
been extended from 4 659 securities to now well over
6 153 stocks.
Using this limited ESG data, Old Mutual conducted similar
quantitative research to what Credit Suisse did in Australia.
South African shares were ranked into quintiles on a monthly
basis using equally weighted rolled-up ESG scores. The
spread between highly rated ESG companies and lower-rated
companies is significant, as indicated in the chart below. While
the timeframe is still too short to see these as definitive trends,
the results appear to mirror those of international findings that
suggest ESG as a factor through which risk premia can be
assessed and captured.
With four years of data being insufficient for the ESG factor
to be formally considered in our investment process, we will
nevertheless continue to pursue our ESG research agenda in
the local market using MSCI ESG data. As the depth of data
deepens and we are able to assess the ESG factors through
different investment cycles, our goal would be to develop a
level of confidence in the ESG signals that could be used as an
input into the “Quality” theme of our investment process. This
accords well with our thinking that ESG is a proxy measure
of management quality and thus the overall quality of the
This further aligns with our overarching view that sustainability
(ESG) is a macro-thematic trend that is reshaping the competitive
landscape, and that companies that are able to respond to
this trend and innovate early, will reap the benefits of stronger
growth prospects, enhanced operating efficiencies, stronger
social licence to operate, enhanced staff retention, lower cost
of capital and, ultimately, stronger and longer competitive
We will continue to look for material trends in the data and
incorporate relevant factors into our investment process.
SOURCES: CREDIT SUISSE (June 2015), Finding Alpha in ESG.
ARABESQUE ASSET MANAGEMENT (March 2015), From the Stockholder to
the Stakeholder. Retrieved from www.arabesque.com