ESG shopping? Do your homework
Investors seeking to integrate environmental, social and corporate governance (ESG) factors into their investment decision-making process have some homework to do. The reason? There is a scarcity of clear ESG disclosures for small and midcap companies, meaning promising opportunities could be missed if only off-the-shelf ESG ratings and investment screens are used.
Even for large companies, ESG disclosures are consistently inconsistent. Researchers have identified four key failings of commonly used ESG ratings, all of which are amplified when applied to smaller companies:
- Market-cap bias Companies with more communication resources tend to score better.
- Disclosure/geographic bias National regulatory disclosure requirements drive scores, and scores reward disclosure (not necessarily performance).
- Industry bias Ratings do not discern between very different business models in the same industry, with more mature and regulated industries generally scoring higher.
- Reactivity Ratings are dragged down for an extended period of time following a controversy, despite the high likelihood that the companies responsible have consequently implemented changes that could improve their performance relative to peers.
Why does this matter? Investors may miss out. For example, consider Brunswick Corp., a U.S. marine engine and boat manufacturer and one of the holdings1 in the Federated Hermes SDG Engagement Equity Fund. Despite having a below-average ESG rating, after meeting with management and doing in-depth ESG and fundamental analyses, we believe it is a high-quality company for these reasons:
- Brunswick has improved aspects of its corporate governance, including declassifying its board to ensure all directors faced election each year.
- Its manufacturing facilities are cutting-edge in terms of energy usage, air quality and waste reduction. Indeed, its principal Fond du Lac facility in Wisconsin has been winning sustainability awards since 2014.
- The company has a strong culture evidenced by very low employee turnover as well as high referral rates and a high proportion of female employees.
Had we not done our homework, we never would have uncovered these positives. Luckily, the company has been open to our engagement on ESG topics and has committed to expanding its sustainability strategy and reporting. As its disclosures improve, its ESG rating should rise as well, even if it continues to lag large-caps.
In sum, we believe investors should not depend on ESG ratings alone, but instead seek strategies that thoughtfully consider credible and meaningful ESG analysis.
1 As of 6/28/2019, Brunswick Corp. shares valued at $568,302 represented 2.0% of Federated Hermes SDG Engagement Equity Fund’s portfolio of $28,906,304.