From alchemy to gold – how ESG adds value in a Robeco fund

Sustainability was responsible for 20% of the outperformance in a Robeco fund over three years, new analysis shows.

The use of environmental, social and governance (ESG) factors in the investment process added a cumulative 210 basis points of the 1,107 bps of gains for the Sustainable Global Stars Equities strategy from 2017-2019, the calculations reveal.

On an annualized basis, about 70 bps of gains can be directly attributed to integrating ESG into the stock selection process, says portfolio manager Chris Berkouwer in an update to earlier research. The analysis means that ESG factors can be shown to aid returns and not detract from it, debunking a common myth that sustainable investing costs performance. This is shown in the chart below:

“In the Sustainable Global Stars strategy, we have been integrating ESG into our decision-making process since its inception, but only actively measuring its impact to performance since 2017” he says. “The most important approach in doing so is through our ‘bottom-up’ ESG integration process, adjusting the valuation model on the back of the most financially material ESG factors.”

“Academic research has shown that companies investing in sustainability are shareholder-value enhancing. Therefore, we strongly believe that ESG directly impacts the value drivers of a company. Whether it’s through the discount rate, sales growth, margins, investment needs, or through the so-called competitive advantage period, company valuation and ESG go hand in hand.”

The calculations are made by finding out how much ESG factors contribute to the price target set for a company under analysis when deciding whether or not to buy its shares. For example, the fund owns a German industrial company that scores highly on sustainability, as it is involved in the transition to a low-carbon economy.

On the back of the ESG analysis, the price target was lifted from EUR 155 to 185. This EUR 30 increase effectively means that ESG makes up about 16% of the company’s perceived value. As the company added 59 bps of outperformance to the portfolio during 2017-2019,  16% of this means 9 bps of excess performance is attributable to ESG.

When this process is applied to all 201 investment cases in the portfolio over 2017, 2018 and 2019, a total tally can be arrived at. “While this isn’t hard science (yet), it is a scientific, research-based attempt to proxy the importance of ESG factors to investment performance,” says Berkouwer.

“We now have a full three-year track record for our analysis. Interestingly, with 2018 being a very difficult year for stock markets, ESG acted as a performance cushion, explaining 38% of the excess performance. However, in 2017 and 2019, stocks rallied and the ESG component ‘only’ explained about 15% and 10%, respectively, of the excess performance. It was albeit a lower impact, but for sure a positive one nonetheless.”

The process also takes into account the effect of exclusions, which can both positively and negatively contribute to the fund’s overall performance. Over the 2017-2019 time period, the negative effect of excluding aerospace and defense companies for making contentious weapons was more than offset by excluding tobacco companies.

“By not owning aerospace and defense stocks, the portfolio incurred 33 bps of opportunity costs over 2017 to 2019,” Berkouwer says. “The main reason for this is that these companies generally have high financial returns. Fortunately, this opportunity loss has been more than offset by selling all tobacco holdings in the Sustainable Global Stars portfolio early 2017, contributing 91 bps to overall performance since then.” This is shown in the chart below:

Standard financial analysis such as profit margins, market share or revenue streams also applies when deciding whether to buy a stock – it’s not just about the ESG elements, he says. “The portfolio is focused on companies having a high return on invested capital, high free cash flow generation, and a strong sustainability profile,” he says.“The emphasis is, therefore, more on the opportunity side that ESG provides. This not only explains the tilt in positive adjustments made to valuation, but also the positive contribution ESG has made in realizing the excess performance of our investment strategy.”

“In all, at Robeco Fundamental Equities, we’ve come up with a proxy to turn alchemy into research-based evidence of the importance of ESG in investment portfolios. Although by no means meant to test the law of physics, it provides good insight into the importance of ESG in portfolio decision making.”

Read the full report here

Chris Berkouwer, Equity Analyst Robeco

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