29 April 2020
We expect not only investors, but society in general will require firms to consider the welfare of their employees, communities and suppliers - ahead of short-term profits - as part of ensuring the long-term sustainability and resilience of their businesses.
“The silver lining to this unfortunate crisis is that society’s focus on sustainability is about to go parabolic,” says Ned Salter, Head of Equities - Global Research & Asia ex Japan Investment, “not just in relation to dealing with climate change and reducing poverty, but in how companies treat all stakeholders, and critically their own employees.”
Fidelity analysis shows higher-rated ESG companies outperform during sell-off
ESG is integral to our bottom-up investment approach. Just as we rate securities based on financial metrics, so too do we rate them on ESG measures. We use a forward-looking proprietary ESG rating system that scores companies from A to E, with A being the best and E the worst.
Adjusting for market dynamics, our analysis of the March sell-off found that, of the 2,600 companies we looked at, those rated higher for ESG outperformed those rated lower, on a relative basis. So companies with an A rating outperformed those with B, which outperformed those with C etc. For equities, the performance differential between best and worst rated company was around 10 percentage points, and in credit, the gross difference in spreads was around 300 basis points.
“Companies that took a more active approach, that engaged more, and had a resilience that was reflected in their performance, led to the dispersion of returns between those with A and E ratings being considerable,” says Andrew McCaffery, Global Chief Investment Officer, “This gave us a degree of confidence and comfort that the approach we have taken is creating value.”
While bond ratings in the study were adjusted for beta (or risk level), for equity ratings, there was a quality element at play. A proportion of our A-rated stocks were aligned with some of the highest quality companies in the portfolios. However, our bottom-up approach goes beyond 'quality' as a style factor and evaluates companies holistically, meaning those with higher ratings should outperform over the longer term, not just when quality as a style is in vogue.
For more on how companies with different ESG ratings fared during the sell-off, listen to our latest ESG podcast:
Dispersion persists as markets rally, but energy is an outlier
While most sectors demonstrated a robust linear regression in performance from best to worst rated companies, in one sector - energy - lower quality companies did perform better on a relative basis during the sell-off. This was due to several factors, including some companies having more or less exposure to the oil price as the oil supply shock hit alongside the Covid-19 demand crisis.
But the linear relationship between the ratings held up as markets rallied again, following huge central bank intervention, though not as neatly as on the way down. This highlights the biggest issue faced by asset managers at this pivotal moment in the adoption of sustainable investing.
“We need to encourage portfolio managers to fight back against the muscle memory that 'cheap' is good enough to find a place in a client portfolio. Valuation will always play a role in delivering returns for our clients, but while we are near the market trough, we need to think carefully about the quality and the full 360 degree stakeholder view of companies, because it’s not just asset owners, regulators and asset managers who are going to demand a focus on sustainability. Society at large will demand it too,” says Salter.
ESG outperformance during the crisis could also incentivise more managements to consider ESG factors, and more investors to direct capital towards companies with greater resilience. Indeed, sustainability remains high on the agenda for many companies we speak to. Since mid-March, our portfolio managers and analysts have conducted around 1,400 company meetings. And, despite the dislocations caused by the coronavirus outbreak, social responsibility and the treatment of staff are consistently mentioned. Many companies recognise that if employees are not looked after today, their company may no longer exist tomorrow.
Greater focus on supply chains could lead to better employee welfare
Even before this crisis, supply chain management had been a key ESG theme for us. Peak globalisation and the US-China trade conflict had already begun to alter global supply chains. Now the pandemic has laid bare their vulnerabilities and pushed them up the national security agenda.
Consumers and governments are much more concerned about where goods come from, so we expect greater emphasis on the “S” in ESG, in the coming years, specifically on employee wellness. Companies will no longer be able to arbitrage relative disparities in wages around the world and will need to adhere to local standards as supply chains shorten and border restrictions increase. As human capital often becomes more highly valued after a pandemic, wages overall could rise once we are through the worst of the deflationary shock - eventually translating into higher prices.
“Upward pressure on prices is likely to build, and the proportion of capital going towards labour and human activity will increase, but it will take time. Events have occurred very rapidly in recent weeks, but the effects will take many months and years to play out,” says McCaffery.
Winners and losers in the new paradigm
As we move through this crisis, it is becoming clearer which sectors and companies are likely to be the winners, and which the losers in the post-Covid world. The most obvious winner, given so many people are working from home, is the technology sector. And the losers will be those zombie companies now struggling to access financing. But those in the middle are harder to assess. Their survival depends on how quickly they can reorient their business models towards new patterns of behaviour, the level of government support and the slope of the recovery across different countries.
Innovative funding methods to maintain solvency
The sheer scale of government intervention is likely to bring new ways of funding it. Policy measures to date have dealt primarily with the liquidity crisis, and must now address how to maintain solvency. We expect greater engagement with individual investors, whether for example in Italy, where investors are used to buying government bonds but could now be encouraged to buy equities, or in the UK, where the government may seek to broaden stock ownership across the country via discounted share sales as companies are transitioned from levels of public support and ownership.
For now, regional initiatives such as ‘coronabonds’ in Europe appear to be off the table, but countries with free floating currencies will continue to issue bonds at very low rates. Nonetheless, even averting widespread corporate insolvency through heavy intervention could play back into country risk. Therefore, sustainability and community engagement will remain paramount for governments and companies in order to emerge from this crisis - they are no longer a nice to have, but a need to have.
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