Environmental, social and governance (ESG) analysis has become integral to our investment process. Until recently, most finance professionals were trained to rely chiefly on company-specific financial analysis when making investment decisions. But the majority of studies show that sustainability factors, from climate risk to worker welfare and executive pay, can have a material impact on long-term profitability and, in turn, investor returns.
We have therefore integrated ESG considerations across our investment franchises over the past three years, in addition to launching a range of strategies for specific themes such as water and waste, and carbon reduction.
Creating forward-looking ratings
Dozens of ESG rating systems have sprung up over the past few years to help investors better understand the substance of companies’ sustainable characteristics. Many of these providers deliver a solid, high-level overview of an issuer’s sustainability. But every system has its own methodology, which can lead to different ratings for the same companies over different time horizons. Data is often self-reported, broad-brush and based on backward-looking disclosures.
We created our own ESG ratings because we needed a forward-looking assessment that could evaluate the opportunities that sustainability factors can create in detail, in line with our active approach. Our proprietary ratings focus on the core sustainability topics for each sector, explicitly tying these to our investment decision-making. Critically, these forward-looking ratings also link directly to our active engagement policy.
Our ratings are based on systematic analysis at the sub-industry level by our 150 equity and fixed-income analysts. Our investment teams interact with around 20,000 company management teams a year, working closely with our Sustainable Investing team to engage with companies on material issues. Our analysts combine these company-specific insights from those meetings with industry analysis, competitor analysis and perspectives from many external data providers. Together these demonstrate the impact of non-financial factors such as reputational issues, supply-chain management and regulatory change.
Fidelity analysts also formally indicate whether they think a company ESG’s performance is improving, deteriorating or stable. This enables a thorough analysis of a company’s likely future prospects, as action on these issues becomes increasingly correlated with financial performance.
This proprietary system has been used to rank 4,020 issuers for ESG since its launch in June 2019 and, significantly, recent research found that higher-rated companies outperformed their lower-ranked peers in the first broad-based market crash of the sustainable investing era.
Strong sustainability indicated better resilience during the Covid-19 crash
In the 37 days between 19 February and 27 March 2020, the S&P 500 fell 25 per cent. The shares of companies with the highest Fidelity ESG rating of A dropped, on average, by 23.1 per cent. Those rated B fell a bit more – in line with the broader market - while those rated C, D and E fell further still in a remarkably linear fashion (see table).
Source: Fidelity International, May 2020
On average, among the 2,689 companies analysed, each ESG rating level was worth 2.8 percentage points of stock performance versus the index during that period, demonstrating a strong correlation between sustainability factors and returns. The trend was similar across fixed income markets, where securities with higher ESG ratings performed over 10 percentage points better during the Covid crisis period.
While this research only captures a very brief period, it bears out our hypothesis that companies with strong sustainability characteristics are likely to demonstrate greater resilience during downturns. We intend to carry out further analysis as the Covid-19 crisis evolves, and gradually build a more detailed picture of how each rating category performs.
Moving beyond “cheapest is best”
Incorporating ESG measures provides our analysts with a 360-degree stakeholder view that allows them to move beyond the idea that “cheapest is best”. This is especially true in the era of coronavirus, in which the social element of ESG is in the spotlight.
For example, a financial-only perspective of two grocery companies would favour one that was cutting costs, even if that meant making employees work long hours without PPE equipment, over another that prioritised worker and customer welfare through robust social-distancing policies and PPE provision. Yet, as more customers opt for quality and safety during the pandemic, the second company’s long- term prospects look brighter.
A recent high-profile example of where our forward-looking ESG ratings have anticipated potential risks is Wirecard. Our analyst rated the issuer an E (the lowest possible) many months before the public scandal broke, on account of significant failings in corporate culture, the management of ethical risks and stewardship at board level. Another has been boohoo.com, whose stock fell on revelations of poor working conditions in its factories. Our analysts rated it a D in 2019 due to concerns about labour standards, low wages and fast fashion wastage. A third-party provider had rated it a double A.
As the world evolves, so our ESG ratings will evolve with it. Over time, we will expand our ratings process and offer this capability to clients to use across their portfolios. Our range of sustainable ETFs deploy our ratings, and we are looking at other ways to harness their qualitative power within systematic, as well as active, portfolios.
Investors and society are more focused than ever on ESG, and in a manner that seems likely to last. As a result, we expect more capital to be allocated to companies and sectors that deliver both financial and social returns. With sustainability no longer an optional extra but embedded in investment analysis, Fidelity’s ESG ratings provide our investment teams with a much richer data set that they can use to make better, more informed decisions on behalf of our clients.