E for the short-term, S and G for the long-term

When it comes to ESG investing, an open question is whether it leads to higher returns (My view: I don’t think so) or lower risks (my view: yes, it does). But are bold enough to claim that it is possible to forecast equity markets with ESG factors alone. Yet, that is what a study with the US equity market between 2009 to 2018 claims to do.

This study used 14 different ESG metrics to construct the average annual change in environmental, social, and governance criteria for the US market and then checked how good one-month and one-year forecasts were based on these metrics. Note that the time span covered is the last decade, so it covers a time when ESG concerns were becoming increasingly popular amongst investors. I wonder if the results would have been the same in the ten years before. But at least during the most recent decade, the results of this forecasting exercise are surprisingly good. They explain about 20% of the variation in the returns of the stock market and the ESG factors remain significant even if one adds macroeconomic variables. To put this into perspective, the forecasts were about as reliable as forecasts of future market returns based on P/E-ratios, dividend yields, or other traditional forecasting methods. And they not only work historically but remain reliable out of sample, not something g that can be said for every traditional forecasting model.

So, if we take the results of this study seriously, we can infer that ESG variables as a measure of risk are able to indicate future stock market returns. Reduce the risk t a company by reducing its harmful impact on the environment or society and you improve the returns of your stocks. But, and this is where things get interesting, we can deduct from the results of the study, which ESG factors matter most.

And here we get an intriguing result. When the authors of the study tried to forecast one-month-ahead returns, the environmental factors mattered most. Environmental factors explained about twice as much of the variation in one-month ahead stock market returns than social or governance factors and stock market returns were about 1.5 times as sensitive to improvements in environmental factors than social or governance factors. But if one looks at one-year ahead returns, environmental factors become less important. Over that time horizon, social and governance factors explained practically all the variation in returns that could be explained with this approach, and stock market returns reacted about two to three times more sensitive to improvements in social and governance factors than environmental factors.

For companies this would mean – and I agree with this hypothesis intuitively – that companies can enhance their long-term share price performance more by focusing on improving their governance and their social impact factors rather than improving their environmental credentials. Why does this intuitively make sense to me? Simply because good governance is the foundation of every successful business and improving the social impact factors usually means treating your employees and your customers better and reducing risks to these two stakeholder groups. And if there is anything every successful entrepreneur will tell you it’s that your employees are your biggest asset and your customers are who will decide whether your business will be successful. Treat both these groups well and you will succeed.