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Quest Equities active quant ESG

August 2019

The link between defensive stocks and ESG

Why financially robust companies also tend to have strong ESG credentials.

How can investors build a portfolio of stocks that can withstand tough economic conditions?

Fig. 1 A close relationship
Snapshot (in % index weight) of the most and least financially robust companies in MSCI World Index, ranked by their ESG profile
the most and least financially robust companies in MSCI World Index

Financially robustness measured using 4P framework. Source: Pictet Asset Management, Refinitiv, Worldscope, ISS, Sustainalytics. Data as of 12.07.2019

We believe companies with stable profitability, healthy balance sheets and whose shares trade at attractive valuations – firms that we describe as 'financially robust'  –  should fare better in periods of market turbulence, which means they can deliver superior returns over the long run.

But there is more to a company’s “robustness” and resilience than financial factors.

For firms to be sound long-term investments, they also need to embrace environmental, social and governance (ESG) considerations in their decision-making.

Interestingly, our analysis shows that the most financially robust companies are already doing this – they tend to score better on ESG criteria (Fig. 1).

There is something intuitive about the relationship between a companies’ financial robustness and its commitment to ESG.

Firms that have spent years building their financial strength will go to greater lengths to preserve it.

They devote more time to analysing how extra-financial factors might threaten profitability and balance sheets over the long run, and are therefore more likely to take appropriate action.

All-round robustness

In order to identify the world’s most financially robust companies, we use a proprietary “4P” framework which focuses on four key determinants of defensiveness – profitability, prudence, protection and price.

The Profitability score gauges how reliable and predictable a company’s earnings is. Those that rank highly on this measure have steady earnings growth, low operational leverage and high cash generation. Prudence is our gauge for assessing a company’s operational and financial risks. Prudent companies pursue organic and manageable growth and maintain a sound financial profile, and thus have a lower risk of default.

With the Protection metric we scrutinise how sustainable and resilient a company’s business model is to shifts in economic cycles. We also analyse a stock’s volatility and its correlation with other equities to judge its impact on the risk-return profile of the overall portfolio. Finally, we don’t want to overpay for our investments. Here, we use our Price screen to identify the most attractive-priced stocks.

This 4P framework provides a lens through which we identify companies capable of delivering good returns irrespective of economic conditions. 

Fig. 2 4P, a multi-dimentional framework
4P a multi-dimentional framework

Source: Pictet Asset Management

We then take into consideration firm's ESG credentials as an extra factor, both to mitigate risks and identify the most promising long-term investments.

Gone are the days when it was enough for companies to simply abide by the law. Firms with weak ESG characteristics expose themselves to wide-ranging operational risks ranging from unethical accounting to environmental scandals that can damage their long-term business performance.

To analyse each company’s ESG performance, we use a proprietary scoring tool which draws extensively on our discretionary analysis and incorporates external sustainability research, focusing on reputational, operational and governance risks.

As Fig. 1 shows, most financially robust firms tend to score well on ESG matters. However, there is still a minority of "financially robust"companies that perform poorly on this dimension.

Fig 3. Robust and defensive 

Corporate governance profile of stocks held in the strategy vs benchmark by weight %*

Robust and defensive

* Strategy refers to Pictet-Global Defensive Equities-I USD, benchmark is MSCI World index USD. Source: ISS, Pictet Asset Management, data as of 30.06.2019

Companies whose ESG risks are deemed to be high do not make into our investment universe, irrespective of their financial strength.

For instance, we have removed certain companies from our investment universe, even though they have strong 4P scores, after we identified product-related and governance-related ESG risks. These risks include – but are not restricted to – product safety incidents, bribery allegations and illegal marketing practices.

ESG: Up on the agenda 

The portfolio of Pictet-Global Defensive Equities has a higher proportion of stocks whose corporate governance profile is “robust”, compared with the benchmark MSCI World Index (see Fig. 3).1

What's more, over half of the portfolio’s stocks are have zero, low to moderate ESG risks – measured by the extent to which companies are affected by controversies such as bribery, corruption, product recalls, pollution incidents and conflicts with local communities.2 This is lower than the benchmark.