Our investment universe is defined by our positive and exclusion criteria. Fundamental analysis lets us further characterize investable assets and assign them a score. Given an industry sector, assets with the highest score are identified as best-in-class.
We believe that financial report alone is no more likely to effectively perform the informative function of corporate reporting. Over the last two decades, criticism of how well financial reporting informs investors emerged: our economy is getting more knowledge- and information-based on the one hand, less machinery- and physical properties-based on the other. It follows that a growing proportion of intangible assets is not entirely or partially captured in the balance sheet.
Our need of integrating sustainability reporting into fundamental analysis arises from the deteriorated value relevance of accounting numbers, from economic reasons and from ethical reasons. We believe that integrating reporting fills the “information function” gap, accurately affects corporation´s access to finance and is a better proxy of the risk-return profile of a portfolio.
We agree that the status quo of corporate sustainability reporting has a significant margin of improvement to achieve filling the accountability vacuum. Evaluation of the level of corporation´s sustainability is problematic: firstly, sustainability itself has a qualitative nature, therefore it sometimes still lacks rigorous measurements, reporting standards comparisons and audit processes. Secondly, sustainability is a multidimensional measure: the same company might be environmentally-friendly but, at the same time, behave irresponsibly on other issues, and still getting a decent ESG score.
We did some research on the relation between company´s sustainability score and portfolio performance. Among others, we found the outcomes of Fetsun and Söhnholz interesting. These researchers asked themselves how to improve portfolios through ESG parameters. According to their findings, total ESG scores themselves do not improve portfolio, and neither do scores of single E-S-G dimensions. The authors tried to explain portfolio performance through different numbers of ESG factors, and they discovered that ten most statistically significant factors can optimize the portfolio. Most of these factors are Governance-parameters. From these authors we were warned that considering too many ESG factors could potentially damage our analysis. What is more, a particular focus on the Governance dimension significantly integrates the informative function of corporate reporting.
The next step was to compute and to differentiate weights of each E-S-G dimension among sectors: for example, it does not make sense to give the same weight to environmental criteria when it comes to assess banks and oil companies. How should weights be calculated and how should they differ among sectors? Capelle-Blancard and Petit proposed a new weighting scheme to aggregate E, S and G criteria across sectors and to provide a composite sustainability score. Sectors considered were six: banks, basic resources, chemicals, consumer goods and services, industrial goods, technology. Relying on the hypothesis that the number of ESG news reflects the level of public concern, they used a large database on ESG news to build a weighting scheme that was proportional to media and NGO scrutiny. Specifically, for each sector they defined weight as a number of articles on a specific dimension of ESG, divided by the total number of news on ESG.
The first outcome was that the number of ESG news follows a growing trend of 21% per year. Secondly, authors noted that ESG issues play different roles across sectors: the range goes from a significant importance in consumer goods and service sector and technology, to the least concerned banking sector. Picture of this second remark, however, changes completely if we divide news between good and bad and consider only bad news: in this case, the sector under the closer scrutiny is Basic resources, followed by consumer goods and services. Banking sector remains the least concerned. The paper observed that bad news has a more negative impact on the market than good news, so the hypothesis of asymmetry of news was introduced. Table 3 reports the proposed weighting scheme under media and NGOs scrutiny of bad news across the above mentioned sectors. Results show that for social concerns the highest weights, almost 50%, are for the traditional industries and services, e.g. consumer goods and services, industrial goods and chemicals. For corporate governance, the weight is the highest for industries that employed high-skill workforce, in particular the banking sector. Environmental issues are weighted more strongly for oil and gas firms than for other sectors.
We could draw three conclusions from the paper of Capelle-Blancard and Petit: firstly, the relevance of ESG issues follows a dynamic path and increases every year. Secondly, ESG contribution on assessing corporate´s performance varies among sectors. Last, the weight of each single ESG dimension strongly depends on the sector considered.
The bibliography collected drove us to the following in-house definition of integrated report lines and portfolio structure:
Company analysis must contain both financial and sustainability data. For the sustainability part, we rely on quantitative figures according to the GRI G4 framework;
Each company is given a final score. Relevance of sustainability is assessed according to the sector. Each single dimension of ESG should be weighted according to the sector;
Company analysis results in a score. As long as the score is below our minimum acceptable level, the asset is no more investable. This means that fundamental analysis itself can further restrict the investable universe defined by our investing criteria;
For the Environmental dimension, a particular focus has been devoted to the company´s carbon intensity. This measure must be recorded and compared with the benchmark and with the company´s track record itself;