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How ESG and value investing can complement one another

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By Ernest Yeung
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6 minute read

On the face of it, value investing and environmental, social, and governance (ESG) investing are unlikely bedfellows.

The very concept of value investing could be seen as contradicting some of the fundamentals associated with strong ESG credentials. Yet an increasing number of investors now acknowledge that ESG and value investing are not mutually exclusive. In fact, if ESG integration is implemented properly, it can be a crucial component to unlocking value — depending on where investors look.

Value investing focuses on selecting stocks that appear undervalued or overlooked by the market and are trading for less than their intrinsic value. This means that stock pickers often come across distressed opportunities. These opportunities — or the adoption of a “deep” value-investing approach — take investors closer to corners of the market where ESG controversies are rife and in sectors that do not always cover themselves in ESG glory.

Many of the stocks that value investors consider mispriced are found across so‑called “old economy” industries, such as energy and utilities. Companies within these industries tend not only to be high carbon emitters but are also experiencing significant disruption due to digitalisation, the global energy transition, and other challenges. As such, it is no surprise that the market has bought into the misplaced yet convenient and simplistic association of ESG with certain investment styles. It is easy to link “green”, or ESG‑friendly, stocks with growth‑oriented strategies, while many investors have long associated value with “brown”, or ESG‑unfriendly, stocks.

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This way of thinking was all well and good when growth stocks were in vogue, but attitudes began to change when value first started to show signs of outperformance in Q4 2020 — when COVID‑19 vaccine progress was announced — and even more so when the rally proved more durable than some investors had initially assumed. Interestingly, we are now increasingly seeing the emergence of a new and long‑overdue narrative: that ESG does not restrict itself to growth stocks.

With this in mind, it is important to remember that ESG integration is about incorporating ESG factors into fundamental analysis for the purpose of maximising investment performance. This works across all styles, sectors, and geographies. In other words, it does not discriminate. Crucially, ESG integration is very different from exclusionary screening, yet the two approaches are still regularly conflated. Moreover, both ESG integration and exclusionary screening should not be confused with sustainable and impact investing — where investors seek to promote sustainable outcomes as well as delivering financial returns. This can include investing in companies that look to reduce inequalities or promote affordable and clean energy, for example.

The importance of ESG integration in value investing

In practical terms, ESG integration plays an important role across several areas when it comes to value investing. One of the risks that value managers face is the value trap — where a stock misleadingly appears to trade at very low valuation metrics but then continues to drop further once the investment has been made. Sometimes, integrating non-financial analysis can help to explain why a stock deserves to remain cheap. This is where ESG engagement can play a big part in identifying companies that are genuinely improving their ESG credentials — especially those that might have faced severe controversies in the past and are credibly cleaning up their acts.

ESG‑related thematic knowledge is also invaluable when ascertaining which companies may do well out of ESG disruption. Moreover, active stewardship can be incredibly powerful in terms of unlocking unrealised value. For example, perennial value territory can be found in Japan, a country where we have amplified our ESG stewardship and proxy voting efforts to shift the agenda with regard to gender board representation and excess capital tied in cross‑shareholdings.

Long-term emerging opportunities to watch

One of the long‑term emerging themes that could provide significant opportunity for value investors is the green transition. Most of the revaluation of assets has so far concentrated on a narrow pool of renewables and electric vehicles. However, there is potentially much more compelling value to be found in less glamorous sectors — such as utilities, materials, and capital goods, where their price‑to‑book value sits toward the low end of their historical range.

While the world cannot achieve net-zero goals without a clear decarbonisation of these more traditional and value‑oriented sectors, investors need to be able to separate the wheat from the chaff. A sound understanding of how the transition could play out in terms of timing and investment is critical when assessing the impact on profitability and identifying companies that can adapt their business models to be truly future proof. For example, emerging markets are generally perceived to have weaker ESG standards, but this is often reflecting poorer ESG disclosures and an area where robust ESG analysis and engagement can help spot the improvers and leaders.

Although value strategies have lagged growth for the past decade, the playing field is levelling out — with multiple tailwinds supporting the investing style going forward. These range from the end of very low inflation and the normalisation of monetary policy to the green transition and an increased focus on food and energy security. As such, plenty of opportunities lie in emerging markets and higher‑emitting value sectors that are integral to addressing these issues, and to fully unlock that value‑investing potential, ESG integration is one of the key tools to help investors avoid potential value traps, spot the ESG improvers, and identify unappreciated opportunities amid the disruption.

Ernest Yeung, portfolio manager for emerging markets discovery equity strategy, T. Rowe Price