Market Perspectives April 2019
Find out our latest key investment themes. And with volatility set to stay elevated in 2019, can markets head higher still this year?
Paying attention to sustainability in the current markets
05 April 2019
As the cycle ages and investors face a period of lower returns, a focus on non-financial data and sustainability factors can help build more resilient portfolios.
At any point in the economic cycle, investors seek to select the best-performing companies. During its later stages, this challenge is accentuated with the dual aim of capturing the final upside momentum and being well-positioned for any downturn. Achieving both requires deep insight into systemic and company-specific risks and opportunities.
We believe investors who incorporate non-financial data can gain an information advantage to identify these assets and use these sustainability factors to help position portfolios for the forthcoming changes.
New, non-financial data reveals how companies operate
Access to extensive non-financial data is a relatively new occurrence in the investment industry. Following the financial crisis, regulators and stock markets have begun to require companies to report greater detail about their operating practices. Additionally, global initiatives have encouraged data on specific factors, such as the Taskforce of Climate Related Financial Disclosure, driving companies to report on their exposure to, and mitigation plans for, climate change.
Non-financial data is generally split into three categories: environmental, social and governance (ESG) information. By understanding the ESG policies and practices on topics such as climate change, human capital and labour management, corporate governance, gender diversity, privacy and data security, investors can look deeper than traditional financial reporting to better understand an organisation’s long-term risk and return prospects.
While all data may be helpful, it is not of equal value for investors. Material ESG issues differ substantially between industries. For example, resource-intensive industries such as utilities have different exposure to key environmental and social factors (such as energy efficiency and labour management) than the pharmaceutical sector, where social and governance factors (such as product safety and business ethics) are primary.
| Environment | Social | Governance |
|---|---|---|
| Carbon emissions | Labour management | Corporate governance |
| Energy efficiency | Diversity and discrimination | Business ethics |
| Natural resource use | Working conditions | Anti-competitive practices |
| Hazardous waste management | Employee safety | Corruption and instability |
| Recycled material use | Product safety | Anti-bribery policy |
| Clean technology | Fair trade products | Anti-money laundering policy |
| Green buildings | Advertising ethics | Compensation disclosure |
| Biodiversity programmes | Human rights policy | Gender diversity of board |
Note: List is representative and non-exhaustive. Source: Barclays Impact series 1 - Sustainable investing and bond returns (November 2016).
Sustainability and improved financial performance
Academics have led the research to identify any link between corporate financial performance and sustainability practices.
One of the foremost studies1 paired companies with similar characteristics and one key difference – whether they had embedded sustainability into their business model and operating practices. When compared over an 18-year period, the high-sustainability businesses outperformed their low-sustainability counterparts in both accounting terms and share price performance. Their overall conclusion - sustainability can be a source of long-term competitive advantage.
Looking more broadly, Oxford University and Arabesque Partners conducted a review of the existing research through 20152. Across the 200 academic studies and sources, they found a clear indication of how financial performance aligns with good governance, environmental stewardship, and social responsibility, notably:
- 88% of the research shows that solid ESG practices result in better operational performance of firms
- 90% of studies on the costs of capital show that sound sustainability standards lower the costs of capital of companies
- 80% of the studies show that stock price performance of companies is positively influenced by good sustainability practices.
While acknowledging there were some negative and even non-existent correlations between ESG factors and performance in these studies, the majority highlight the value of sustainability practices to corporate financial performance.
From sustainability data to financial returns
The investment industry is also seeking to use this new sustainability data to generate financial outperformance.
As one of the largest data providers of both financial, and now non-financial information, MSCI researched how ESG characteristics can lead to financially significant effects in the equity markets. Their findings3 show benefits across three mechanisms for companies with higher ESG ratings:
- Idiosyncratic risk – better management of company-specific risks, and so lower probability of incidents that affect share price, so stocks display lower tail risks
- Valuation – lower exposure to systematic risk factors, so higher valuations
- Cash-flow – more competitive and can generate abnormal returns, so higher profitability and dividends.
The more sustainably-managed companies showed a variety of characteristics – higher profitability, higher dividend yield, lower tail risks, less systematic volatility and higher valuations – that investors assessing prospective investments would likely find attractive.
Using these insights in current market conditions
As wage growth and interest rate rises start to put pressure on profit margins, operational performance becomes more important. For instance, well-managed companies typically maintain their profit margins at higher levels and for longer than weaker companies. This, in turn, can aid their valuations and credit-worthiness.
As the support from central banks’ quantitative easing programmes diminishes, the additional liquidity that has helped lift returns for risky asset classes is likely to wane. In these times, we would expect lower correlations between single stocks and more potential for idiosyncratic risk. Sustainability factors can be valuable to indicate which organisations are less susceptible to these risks.
Overall, we strongly believe in the potential that integrating sustainability data into financial analysis holds for investors at any time to better manage risk and generate long-term returns. At Barclays, we are among a growing, global body of institutional investors that have committed to incorporate these factors into our investment decisions.
In the current environment, we expect investors will need to position for lower market returns, more volatility and tail risks. That said, there will be opportunities for those who use insight from sustainability factors effectively to find attractive investment opportunities and build more resilient portfolios.
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