Big-improver ESG laggards show to outperform

Highlights:

• Equity portfolio managers have become increasingly conscious of the importance of ESG factors  in portfolio con- struction.
• We notice that traditional and ESG indices are quite similar in terms of both total return and  Sharpe ratio, but focusing on single stocks, things can be different.
• In this respect, does the level and/or the momentum of a single company’s score drive  overperformance? To answer this question, we look at the return from improving ESG laggards among  the biggest 400 European listed companies (MSCI Europe index) in the last 10 years. We try to gauge  if there is any overperformance generated by an increase in ESG  scores  of low  and  very low-ESG  rated  companies.
• We find that combining current ESG level and its momentum can be a winning strategy. Companies  with a low but improving ESG profile tend to outperform the market and their industries, even when  corrected for the respective relative earnings revision momentum.
• This can be useful in building portfolios, by including, among others, also companies that are  left behind in the score ladder but, crucial assumption, are judged by the specialised analyst or  fund manager to be on the right path to step it up.
• A stock screening can be implemented to identify potential targets for activist campaigns, in  order to gain from the improve- ment of the score, should such campaign be successful. An activist  investment approach towards ESG laggards has the potential to create a tangible reduction in their  ecological and social footprint, while also creating financial overperformance.
• A broad, experienced, collaborative ESG team that is integrated across the investment process is  crucial for identifying the ESG laggards on the verge of improving, while avoiding the ones that  will not. 
   

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