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Firms that neglect social ESG criteria ‘underperform’

Fund selectors should avoid the lowest-ranked companies in terms of social indicators, according to Hermes


Jassmyn Goh

Companies that have neglected the ‘social’ aspect of ESG – environmental, social and governance – criteria have underperformed their peers by 15 basis points each month since 2009, according to Hermes Investment Management.

Hermes head of global equities, Geir Lode, said that ‘governance’ was usually the first factor companies sought to improve when they began to consider ESG criteria. The ‘social’ and ‘environmental’ aspects typically followed three to four years afterwards, he said.

However, as it becomes more important for companies to build positive brand recognition, improving labour relation issues – a key ‘social’ consideration – have increased in importance.

Hermes’ latest report on ESG investing found that that firms with good or improving environmental, social, or governance characteristics in the top decile had, on average, outperformed companies with negative characteristics in the lowest decile.

“There is some volatility among the highest ranked companies,” the Hermes report said. “This suggests that we should focus on avoiding the lowest ranked companies rather than seeking the highest ranked stocks.”

Need for reality check

An obvious starting point for fund selectors assessing a company’s social criteria is its policies on health and safety, and human rights.

“However, just looking at policies is not enough,” Lode adds. “You also have to look at what actually happens.”

Lode said it’s important to check if the company has labour conflict, whether there is high staff turnover, or even fatalities, to develop a clear understanding about whether a company is improving in these areas.

“A company might claim they have excellent labour relations – but use a child labour factory in Bangladesh,” he said, adding that ESG scores might not show this.

Lode said the best way to measure social indicators was to multiply indicators and look for the weakest points in exposure rather than taking an average of scores when analysing firms.

Lode noted that the North American market lagged behind Europe and Australia in terms of social focus over the last decade as the influence of labour unions had declined and staff turnover at many companies had increased.

Sector analysis

The Hermes report found that there was a negative relationship between social scores and shareholder returns in sectors such as consumer staples, healthcare and real estate.

For example, tobacco firms typically scored poorly on social factors, but often delivered strong shareholder returns.

Meanwhile, regulatory changes, discrepancies, product recalls and mis-selling scandals within the healthcare industry have clouded efforts to analyse ESG data and better understand the sector, Hermes said.

In terms of real estate, the data available on the effectiveness of ESG factors in the sector was still in development compared to other industries, the report said.

Social challenges

Lode said that the biggest challenge in the development of effective and actuate ‘social’ ESG data was the quality of data as many databases were not regularly updated.

“We have to make sure that what we have measured reflects reality,” he said.

“Some databases lag and are too focused on the past and not enough on the future.”

“We like to find more reliable sources to get a better measure of the various indicators. It is not enough to rely on one database.”

Lode said as a fund manager he relied on a variety of databases – in addition to Hermes’ in-house database – to collate as in-depth and as forward-looking analysis as possible.