We’ve already seen how identifying companies that are improving on the dimension of responsibility—before these behavioral changes have been “priced in” to their stocks by the market—can lead to opportunities. But that’s not the only reason for an active, hands-on approach. Fundamental research can enhance responsible portfolios in other ways, too.
Building High Conviction Portfolios
The ability to include or exclude stocks from a portfolio—or to adjust their weights—is particularly important in values-based investing, where investors expect results on the dimension of responsibility, as well as risk and return.
While a passive approach can provide investors with market exposure, active investing gives managers the flexibility to make specific investments with an eye toward outperforming a benchmark or target return. And for investors who wish to build portfolios with specific environmental, social, and governance characteristics—such as lower carbon intensity—active management can help meet those objectives while mitigating the unintended consequences of restricting the investment universe.
Finding Unrecognized Growth Potential
While there are many ways to invest responsibly, a thematic approach focused on long-term, sustainability-related trends can reveal opportunities that might otherwise be overlooked. That’s because firms that are well positioned to deliver on sustainability-related investments often maintain higher growth rates than the market expects.
Consider access to clean water—a necessity, and priority, in both developed and emerging markets. Four of the seventeen United Nations Sustainable Development Goals (UNSDGs) relate to this challenge. Companies answering the call include private water utilities, beverage manufacturers, wastewater treatment firms, water engineering firms, agricultural producers, and energy companies.1
In the aggregate, there are dozens if not hundreds of companies around the world whose products and services address the threat of water scarcity. But which ones belong in your portfolio? Fundamental research that combines traditional investing with a rigorous analysis of environmental, social, and governance (ESG) concerns is likely to paint a more complete picture of the drivers of growth and valuation over time. In short, ESG integration can help investors differentiate between stocks that are compelling and those that are not.
Besides improving return potential, active managers can also use ESG factors to manage risk. For instance, our research shows that stocks that rate poorly on ESG concerns also tend to be riskier2 —CC-rated stocks were nearly 3% riskier than AAA-rated stocks (Display).
What’s driving these differences? There are two plausible explanations. Third-party ratings agencies tend to favor companies that disclose more information. The more investors know about a stock, the less likely they are to experience a downside surprise. Plus, ESG risks can be “red flags” for low probability/high impact events that investors tend to underestimate—like environmental damage, product safety concerns, and data security breaches. In these cases, active managers can use poor ESG ratings as a proxy for such perils.
But the effectiveness of these approaches depends on how they are implemented. The challenge—and opportunity—for active managers is distinguishing between companies that are persistent poor performers and those likely to progress.
Active management helps identify investment opportunities, manage risks, and mitigate unintended consequences of responsibility-related portfolio restrictions. It’s one tool responsible investors shouldn’t be without.
1 The UNSDGs are an important set of principles that influence public policy, capital allocation, and investment decisions. The UNSDGs, also known as the Global Goals, are a universal call to action to end poverty, protect the planet, and ensure that all people enjoy peace and prosperity. The 17 SDGs address issues relating to climate change, economic inequality, innovation, sustainable consumption, peace, and justice, among other priorities. For more information visit www.undp.org.
2 As measured by stock-specific risk, which tracks the idiosyncratic risk inherent to a specific company.
For more ways to pursue good returns and good values in your portfolio, check out the related blogs here.
The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.