ESG at a Reasonable Price

Editor's note: Read the latest on how the coronavirus is rattling the markets and what you can do to navigate it.

Ruth Saldanha: Recently Sustainalytics released the first report of a portfolio research series about where investors can get the biggest ‘ESG bang for their buck’ as they navigate the COVID-19 market recovery. Sustainalytics applies an ‘ESG at a reasonable price’ score that helps investors find stocks with low levels of ESG risks that also trade at a relatively low price to earnings ratio. Doug Morrow, Director and Head of Portfolio Research at Sustainalytics, is here today to talk about the report and the findings.

Doug, thank you so much for being with us today.

Doug Morrow: You're welcome, Ruth. Happy to be here.

Saldanha: What is ESG at a reasonable price? How exactly does this metric work?

Morrow: Yeah. So, as you mentioned, really, what the metric is designed to do is to help investors identify precisely what you said, to identify the markets where they can get the biggest ESG bang for their buck. So, we came up with it. So, ESG GARP, it's a portmanteau of ESG and ESG risk and obviously growth at a reasonable price or the GARP investment strategy. And essentially what we do is we calculate these scores by looking at the one hand ESG risk levels among companies in different markets around the world. And then, we also, at the same time, look at how expensive these companies are relative to their same sector global peers from a P/E perspective. So, the higher an ESGarp score, it means the greater the likelihood that an investor can find stocks in that market that have a good ESG risk profile but also trade at reasonable valuations.

Saldanha: So, how would an investor be able to identify ESG leaders from their response to the overall COVID-19 pandemic?

Morrow: Yeah. I mean, the scores themselves, the ESG GARP scores, are driven by Sustainalytics ESG Risk Ratings scores. So, obviously, they're not centred explicitly around COVID-19. It's a much broader measure that takes into account all material ESG issues. So, from that perspective, it's more general. But certainly, there are a lot of issues that have been brought to investors' attention as a result of COVID-19 and these would be reflected in the scores.

So, for instance, as we've all seen, the pandemic has really shone a light on ESG issues ranging from biodiversity loss, habitat loss, all the way to how management teams engage with their employees, as well as supply chain strategies. So, just two quick observations in terms of what we're seeing from ESG leaders during the pandemic.

One would definitely be on the human capital side. So, in industries that have been a little distanced you might say from the front lines, for example, financial services or some of the knowledge industries, we have seen a differentiated management response in terms of how they are dealing with workforce management. So, we've seen lots of companies step up, for instance, and commit to a zero layoff or a postponing layoff model. Some top-of-mind examples would be Marsh & McLennan (MMC), Morgan Stanley (MS), Bank of America (BAC) and others. So, certainly, not all of their peers are doing this. And we would argue that companies that find a way to retain their workforce even in a slow-growth environment would be better positioned to compete in the rebound.

And the second example would be product innovation. So, we've seen lots of companies strategically retool their manufacturing capacity to try and build products that are needed during the pandemic response. So, for instance, Cascades (CAS) here in Canada is working to produce the type of plastic material that's required in medical visors, so part of the personal protective equipment. So, that's another example of what we like to see in terms of, or as a result of the pandemic.

Saldanha: Let's talk about Canada in particular. There's been a rapid growth in ESG funds, both ETFs and mutual funds in Canada, leading some to ask if this is overall a bubble, the ESG fund bubble. Is there one?

Morrow: We don't believe there's a bubble, no, not systematically, not at the global level. Our analysis suggests that there is a small premium attached to low ESG risk stocks relative to their higher risk peers. But we certainly would not call it a bubble. And indeed, one of the findings from this paper is that there are corners of the equity market globally where investors can still get access to good ESG companies at reasonable valuations. So, on balance, I don't think we're seeing a bubble right now.

Saldanha: The report shows that healthcare materials in Canada have the lowest prospects for ESG companies at a good price. Why is that?

Morrow: Yeah, the issue there is that in the Canadian healthcare industry, partly is that it's relatively small compared to – certainly compared to the U.S. pharma healthcare industry. And there's also a concentration of companies involved in the medical marijuana segment. And that segment tends to be associated with higher levels of ESG risk. So, that's pushing up the risk scores on the one hand. And then, on the other hand, from a valuation point of view, the P/E ratios tend to be relatively high due to some struggles that that segment has had with profitability. So, that's coming together to be relatively unattractive in our model. And then, on the materials side, it's mostly about risk, so ESG risk. So, the Canadian materials sector is dominated by mining plays and things like that which historically have been associated with high levels of ESG risk, just given the high impact nature of the business, implications for communities and things like that. And then, on top of that, what we've seen with the gold sub-segment is price appreciation during the COVID sell-off. So, it has pushed up P/E ratios, which means that it's not attractive in our model.

Saldanha: Finally, the only sector in Canada that seems to have strong prospects is telecom. What has worked for this particular sector?

Morrow: Yeah, it's actually a real Canadian success story, actually. The trio of Telus, Rogers and Bell stack up relatively well against their global peers on ESG risks. They've got some really, really advanced management programming in place, lots of other things that we like. So, these companies score well on ESG relative to their same sector peers. And at the same time, they trade at relatively low P/E multiples compared to their same sector peers. So, it's a win-win, which is one of the reasons why it kind of floats to the top in our model.

Saldanha: Thank you so much for joining us today, Doug.

Morrow: You're welcome. Thanks for having me, Ruth.

Saldanha: For Morningstar, I'm Ruth Saldanha.