Quant Concepts: Best ESG Stocks for Kids

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Emily Halverson-Duncan: Welcome to Quant Concepts' virtual office edition. Last week, we talked about how best to introduce your kids to investing by looking at more recognizable names in the first of a two-part series. Today, for the second and final part of the series, we're going to look at another way to discuss investments with young savers.

The younger generation continues to be more and more focused on sustainability. This can have an impact on where they shop, what products and services they use, transportation and much more. One great way to incorporate this trend while still teaching about financial responsibility is to work ESG into your discussion. There are a lot of great ways to integrate sustainability into your investment portfolio, whether you're exploring individual stocks, ETFs or funds. Today, we will be looking at the same dividend focused strategy from last week but with ESG factors incorporated to provide a more sustainably friendly portfolio. So, let's go ahead and take a look.

So, first off, we're going to go ahead and see how we ranked our universe of stocks. So, in this first step, some of the factors that we're using – expected dividend yield, so stocks with the higher dividend yield will rank higher than stocks with the lower dividend yield. Five-year dividend growth, so stocks with the longer track record of growing their dividends, again, would rank higher than stocks with the track record of not growing their dividends as much.

Some of the newer factors that are ESG specific. Highest controversy level – so, what that's looking at is on a scale of 0 to 5 how controversial a company currently is based on what's out there in the news and any publications. So, 5 is considered to be the most severe and 0 is considered to be the least severe. So, in this case, we want a lower value. And then, of course, overall ESG risk rating. So, this is scaling from 0 to 100, with 100 being the worst, 0 being the best. And what this is looking at is how much risk is associated from an ESG lens for a particular company. 100 means they've got a lot of risk that's associated with them overall, and 0 means that they would have no or little risk associated.

On the screening side, once we've organized that universe, some of the screens that we're applying here. So, dividend yield, we want that to be in the top half of peers, which is roughly 3.31% or higher as of today. We want to have a positive five-year dividend growth just to make sure that the company is actually growing their dividends over the long term. We want a five-year price beta, which is looking at the sensitivity of companies compared to the S&P/TSX, we want that to be less than or equal to 1, indicating they are as sensitive as the market that's a value of 1, or less sensitive, which is when it's below 1.

Highest controversy level, one of our two ESG factors, we want that to be less than or equal to 3. So, again, recall 5 is the most severe, 0 is the least severe. So, less than or equal to 3, we want it to be, call it, neutral to less controversial. And then, the overall ESG risk rating, we want that to be in the lower half of peers, which is the better half, because again, a lower score is a positive from an ESG standpoint, and today that has a value of 36% or below.

On the sell side, some of the factors we've got set up. If that five-year dividend growth rate falls below 0, we're going to go ahead and sell the stock from the model. If the price beta goes above 1.2, again, we're going to sell the stock out of the portfolio. And then, on the ESG side, if the controversy level rises above 3, or if the overall ESG risk rating goes above a 36, then we're going to sell stocks out of the model because they're no longer considered ESG friendly enough.

So, let's see how this looks from the back-testing perspective and how it did across the long term.

So, across this time period, we tested from August 2009 to July 2020. The benchmark was the S&P/TSX Composite Total Return. And across that timeframe, the model returned 11% annualized, which is an outperformance of 4.1%. The strategy held up to 10 stocks at any time and had turnover of about 19% annualized across that timeframe. Turnover is looking at how often you are trading. So, on a portfolio of 10 stocks, that's looking at about just shy of two trades on average per year, just about two trades.

Some of the key metrics to look at here, because I always like to see how ESG has an impact on risk. If we look at downside deviation, which is the volatility of negative returns, the strategy has a downside deviation of 5.7% and the benchmark has a downside deviation of 8.2%. So, a pretty big difference here, indicating that the strategy is quite a bit less volatile during down markets. And then, of course, looking at the green and blue chart here, I can see that the model outperformed 46% of the time in up markets and outperformed a very impressive 87% of the time in down markets. So, we can see, just adding ESG in here, this is going to be something that will hopefully align with what your children are hearing about in school and what they are hearing about from their friends and just their own values, but it can still have a really great impact on their investments and certainly without taking on excessive risk and if anything, actually managing it a little bit better.

For Morningstar, I'm Emily Halverson-Duncan.