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On the sell side, the good ones use ESG news, too
Almost a year ago, I wrote about how the best fund managers use news about ESG events and risks to improve their performance. If ESG information really provides information about company risks it should not only help fund managers, but also sell-side analysts. For example, if a company had an ESG-related event like an oil spill or the labour standard violations of Boohoo, then analysts who are tuned in to these risks should adjust their forecasts for future earnings and share price returns accordingly and hopefully have better forecasts than analysts who ignore such nonfinancial risks.
A team from HEC in Paris and the University of Geneva collected RepRisk ESG incident data and IBES analyst estimates for EPS and target prices for thousands of US stocks between 2008 and 2019. In total, the researchers analysed 2.6 million changes in EPS from analysts, 600,000 changes in price targets and 7.3 million ESG incidents over that decade. The chart below shows that in reaction to an ESG incident, earnings forecasts for one, two and three years ahead all start to move. Typically, the forecast for earnings two and three years in the future start to move more than near-term forecasts. But not every analyst is moving her earnings forecasts. Only the analysts who are tuned in to ESG risks do while many analysts who don’t care about ESG risks leave their forecasts unchanged or change them only minimally.
Change of EPS forecasts in response to ESG incidents
Source: Derrien et al. (2021)
The same happens to target prices. Target prices are lowered by analysts who incorporate ESG risks into their analysis. The chart below shows how target prices are on average reduced by 3.5% in the six months after an ESG incident compared to a company with similar valuation and size but no ESG incident. What the chart below also shows is how the actual share price reacts to these ESG incidents. On average the share price drops by about 2.5%, or about one percentage point less than what analysts expect.
Reaction of share price to ESG incidents
Source: Derrien et al. (2021)
This indicates that analysts who incorporate ESG risks into their analysis may be overreacting. But it turns out that while their target prices may be more pessimistic in response to ESG incidents their forecasts for earnings and target prices were becoming more accurate, not just vs. their own previous forecasts they made before an ESG incident, but also vs. analysts who did not react to ESG incidents. Their earnings forecasts were still off because nobody can have a perfect track record in forecasting earnings or share prices, but their errors were smaller and their recommendations to investors were better and more reliable.
There clearly is information in ESG data and ESG news and the really good analysts, just like the really good investors learn how to incorporate this into their analysis and forecasts.