How to deal with bad ESG news
ESG factors are becoming increasingly important for investors (as they should, in my opinion) and stock prices are reacting more and more to the disclosure of bad ESG news by companies. A study of the companies in the S&P 1500 index from 2000 to 2018 showed that the cumulative abnormal return (CAR) of these stocks in the 20 trading days around a bad news event is -0.8% while the CAR after good events is 0%. CAR was in this study defined as the difference between the actual return of the stock in the days around the announcement of an ESG event and what could have been expected based on a 4-factor model calibrated on the year before the event. In other words, good ESG news is largely ignored by the market, while bad news depresses share prices by 0.8% over four weeks.
Not all bad news events lead to statistically significant share price reactions, so the chart below shows only events that have a statistically significant stock price reaction. It might well be a spurious effect, but I find it telling that bad ESG news lead to negative stock price reactions, except executive scandals, which seem to be rewarded with higher share prices.
Honi soit, qui mal y pense.
Share price reaction to bad ESG news
Source: Cui and Docherty (2020).
But the problem for investors is a more practical one. ESG risk analysis can help identify risks before they materialise and given the strong share price reaction to bad ESG news, it is clear that ESG analysis can add value to a traditional investment process. After all, ESG risks are not independently distributed. Companies with a bad track record in ESG matters tend to have a higher likelihood of future failings.
However, as ESG becomes a more prominent topic in investor circles, stock markets are increasingly overreacting to bad ESG news. Just like an earnings miss creates a negative overreaction in share prices and a partial recovery afterward, bad ESG news now increasingly leads to the same pattern. Members of the S&P 500 experience an average CAR in the 20 trading days around a bad ESG event of c. -0.5%, but then recover this negative CAR over the subsequent 80 trading days. Small-cap stocks, on the other hand, experience a much stronger hit to the share price of c. -2% but then a stronger recovery over the subsequent 80 trading days. Yet, even after 90 trading days the CAR is still negative.
Cumulative abnormal returns around bad ESG news
Source: Cui and Docherty (2020).
This behaviour provides guidance for investors on how to handle bad ESG news.
First, bad news tends to have a long-term negative effect on share prices, particularly for small- and mid-cap stocks. Hence, avoiding companies with a poor track record on ESG matters is likely to improve performance in the long run. Because the impact is stronger on small- and mid-caps, investors in these smaller companies should be particularly attuned to ESG risks.
Second, if your investment gets hit by a bad ESG event, don’t panic and sell right away. Wait for a couple of months until the dust has settled down and then sell. Investors who actively engage with company management on ESG issues can use these months to talk to management and push them to take measures to prevent these events from happening again. If management isn’t responsive, then divest and look for other opportunities elsewhere.