Today, valuations for ‘good’ ESG companies (i.e., those with high ranks based on a variety of data vendors) hardly look bubble-like, especially relative to the recent past.
By Savita Subramanian & Marisa Sullivan
Admittedly, extreme asset inflows can create bubbles, and flows into ESG investments in recent years have been extreme: So far in 2021, nearly $3 of every $10 of global equity inflows has been in ESG funds. Assets under management (AUM) in the 1,900-plus global ESG funds we track hit a record $1.4 trillion in April—more than double the AUM of a year ago and growing at nearly 3x the pace of non-ESG assets.
For those worried about overpaying for ESG attributes, we recommend combining ESG signals with valuation. Today, valuations for ‘good’ ESG companies (i.e., those with high ranks based on a variety of data vendors) hardly look bubble-like, especially relative to the recent past. While stocks with top quintile ESG scores based on MSCI data traded at a 20-30% premium to bottom quintile stocks several years ago and as high as a 50% premium at the onset of Covid-19, that premium has shrunk to merely 5% today. Sustainalytics and Refinitiv datasets yield similar results. This is likely a result of investors taking what appears to be a more nuanced approached to ESG investing: No longer looking at a company’s overall ESG rank, but considering companies relative to their peers based on underlying metrics, and identifying companies best positioned to improve on ESG characteristics, where many of these carry lower-than-average ranks.
While the overall ESG score has seen de-rating, some aspects of ESG remain frothy: Clean energy companies trade at a 70% premium to traditional energy peers on EV/EBITDA, down from highs earlier this year but still well above the 5-year average of a slim 10% premium. We prefer less expensive traditional energy companies that are setting goals and making strides to improve their business models. Another area commanding a higher premium is the ‘S’ in ESG. While not in bubble territory, companies with top quintile Social scores based on MSCI data trade near a 10% premium to poorly ranked peers, as investors shift focus to Social factors post-Covid-19. We think this may be a more sustainable premium as investors tend to pay consistent premia for characteristics that would have helped in a prior crisis, and one can argue that Covid-19 was a social (healthcare) crisis rather than one characterised by governance or environmental risks.
Understanding ESG fund positioning can help avoid crowding risk. We find ESG funds in all major regions (the US, Europe, Asia) are overweight the industrials, technology and materials sectors relative to the benchmark, but are most underweight energy sector. And so far this year, it pays to avoid the crowds: ESG factor performance has been strongest in the most underweight sectors like energy (+15ppt long/short), and weakest in crowded sectors like industrials (-8ppt L/S) and tech (-4pp L/S).
Co-authored with Panos Seretis & Jure Jeric (MLI UK) & Girish Nair, Merrill Lynch (Australia)
Edited excerpts from BofA Global Research’s report dated June 1
Authors are equity & quant strategists, BofAS