New York – All components of ESG are not equal, and corporate governance practices are most important for stock returns, according to an article published yesterday in The Finance Professionals’ Post.
The article, titled “Are All Components of ESG Scores Equally Important?”, questions whether all aspects of responsible investing, including environmental factors, social factors, corporate governance, and presence in sin areas, are equally important for stock analysis. Focusing on stock returns and return on equity (ROE), the study concludes that corporate governance is the best predictor of medium to long run stock returns and that the social scores have a greater positive impact on ROE.
Methodologically, the article analyzes three sub-scores (corporate governance, environmental impact, social practices), and an overall score (the sum of the three sub-scores and the absence-from-sin score). The three sub-scores and the absence-from-sin score are the four independent variables in the analysis. The dependent variables are stock returns and return on equity (ROE) over the subsequent one, three, and five years.
After controlling for time, industry sector, and market cap, the article is conclusive in what pertains to the relationship between stock analysis and ESG factors – corporate governance in particular:
“ESG scores have predictive power over total stock returns and financial performance measured by ROE. Good companies, defined as those having more strengths than weaknesses in the various ESG fields, tend to have higher medium to long run (three-to five-year) returns and ROE. These results hold even after controlling for the size effect.”
“Among the subcomponents of the overall ESG score, corporate governance scores are the best predictor of stock returns, and the predictive power of the corporate governance scores was highest over the longer three- to five-year horizons. Even controlling for the sector effect, corporate governance scores had the highest predictive power for stock returns in the medium to long run, followed by the overall ESG score. This indicates that all sub-components of overall ESG scores are not equal, and corporate governance practices are most important for stock returns. The social scores have a greater positive impact on subsequent operational results in terms of ROE. The same predictive relationship continues even after controlling for the well-known size effect.” (Bolding added)
One interesting finding in the article is that for the environment score, the bad companies did best in terms of returns. This is not surprising given the lack of significant environmental regulations at the national or global levels, which allowed companies with bad environmental records to profit without having to repair or to actively avoid environmental damages. Various efforts might change this situation in the near future, making environmental performance a key component in stock analysis, as corporate governance is today.