Quant Concepts: Filtering for sustainable success

Companies with strong books and well-managed ESG risks make for timely outperformance, CPMS's Emily Halverson-Duncan finds

Emily Halverson-Duncan 24 April, 2020 | 1:23AM

 

 

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Emily Halverson-Duncan: Welcome to Quant Concepts' virtual office edition. In light of this being Earth Week, today's video is going to focus on one of the rising trends in investing, ESG. Recall that ESG stands for environment, social and governance and when referencing investments can also be known as sustainable or socially responsible investing.

ESG investing continues to grow in popularity as investors become more concerned with actions companies are taking with regard to sustainable issues. These issues can include things such as their carbon footprint, willingness to work with regulators and relationships with their employees. There are many ways to measure whether or not a company is considered to be ESG friendly.

In today's video, we're going to take an existing Canadian model and add on a couple of different ESG screens which eliminate companies that are more controversial in nature and have higher exposure to ESG risks. This is known as negative screening or screening to remove companies which have poor sustainable characteristics. So, let's take a look at how to build that.

Take a look at CPMS here. So, the strategy that we're using as our base was the technical overlay strategy which we've looked at previously and we're adding an ESG screen on top of that. So, first off, as always, we're going to rank our universe of CPMS stocks in our Canadian universe which today holds 695 names. In that ranking step, the original model had three different factors. So, that would be quarterly earnings momentum. So, that's looking at the growth in earnings quarter-over-quarter, and you want higher values for that. Quarterly earnings surprise looks at whether or not a company beat or missed on their earnings once they report and again, you are looking for higher values. And five-year price beta, which is looking at how sensitive a stock is to the index, which in this case is the S&P/TSX Composite. In this case, you want lower values. And the additional factor we added on here is overall ESG risk rating. So, what that's looking at is how a company is able to manage its ESG risks. It's scaled from 0 to 100, 100 being the worst, so meaning, they are not actually managing any risks and then a lower score indicates they are managing their ESG risks very well.

On the screening side, the original screens that we had on the model before adding the ESG screen were on quarterly momentum we want to see a positive value for that. So, we want to see that they are growing their earnings. Quarterly earnings surprise, same thing. We want that to be positive so that they are actually beating or at least meeting the expected earnings. That five-year beta, we want that to be less than or equal to 0.7. At a value of 1 what that indicates is it has the same sensitivity to the index, again, the S&P/TSX Composite. So, setting it at less than or equal to 0.7 indicates we want it to be quite a bit less sensitive than the index. In addition, the last factor here, latest total debt to equity, we wanted that to be less than or equal to 1.1 to ensure a company didn't have too much debt on their books.

The ESG factors that we had in the screen – overall ESG risk rating, we wanted that to be in the lowest third of peers which today had a score of 23 or lower and remember a lower score is better. And then, the other ESG factor that we added on is something called highest controversy level. So, what that's looking at is on a scale of 1 to 5 how well a company is managing any controversial issues. So, a 5 would indicate that there's something very controversial out in the news right now whereas a 1 would indicate that there isn't. So, what we're putting on on our screen here – so, we want that value to be less than or equal to 3, so basically neutral in terms of a controversy level or better.

On the sell side, we're going to sell when that overall ESG risk rating falls into the worst or the highest half of peers and that's a score of 29 or above. And when that highest controversy level rises above a 3, so has a score of a 4 or a 5.

You can see today there's not a lot of names that quality. There's only 5. So, what that indicates is that based on the screens that we have set, there's not a lot of companies that currently qualify for the model and meet all those different screens that we had set up.

So, jumping into the back test to see how the model did. One thing to note here, the back test timeframe is from August 2009 until March 2020 and consisted of 15 names. One thing to be aware of though is the overall ESG risk rating has history from November of 2019 whereas the controversy level score has data across the entire back test. So, one thing to be aware of is the overall ESG risk rating would have been ignored until November 2019 in this back test and then jumped in at that point once the data started. So, these numbers aren't exactly taking into account how both those factors would have screened but there still is an ESG component across the whole timeframe and then we're seeing how that additional ESG screen would have added in the latter few months here.

So, performance was 13.9% across that timeframe, which was also an outperformance of 8.8%. One thing I did want to drill down though is, on how the model did this year. The reason for that is the markets have been very volatile and I'd like to see how that ESG acted in a volatile market. So, if we drill down on that level a little closer, we're looking at end of December 2019 until end of March 2020. Here we can see the model returned minus 15.9%, not surprising, markets have been very volatile. But that actually outperformed the TSX by 5%. So, having those ESG screens actually did result in a pretty good outperformance.

And one other thing to check would be comparing the same model without the ESG screen to this version with the ESG screen. So, if we take a look at that, we can see again, our model with the ESG screen returned minus 15.9% and that actually outperformed the model without the ESG screen by 1.6%. So, even adding in those two ESG screens, they might seem insignificant, but they did add an additional outperformance in what's been a very turbulent market so far this year.

So, for yourself, if you're not looking at ESG, it might be worthwhile to consider it and take a look and see how you can incorporate that into your portfolio.

For Morningstar, I'm Emily Halverson-Duncan.

About Author

Emily Halverson-Duncan  Emily is Director, CPMS Sales at Morningstar

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