Morningstar - Q1 2022 - 9

When I ran the study in late November, for
companies with negligible ESG risks, the average
star rating was 2.75 and the average stock
traded for a bit less than fair value (0.97 to be
precise). For low ESG risk companies, investors
were paying a 7% premium to fair value.
At the other end of the spectrum, by contrast,
the stocks of severe and high ESG risk companies
traded for 16% and 8% discounts to fair
value, respectively, and boasted average star
ratings above 3.0.
If our analysts are correct, investors stand to
outperform by investing in bad ESG stocks.
Companies with High and Severe ESG Risk
Ratings were undervalued
ESG Risk Rating
Negligible
Low
Medium
High
Severe
Average
Star Rating
2.75
2.70
3.07
3.13
3.30
Source: Morningstar Direct. Data as of 11/21/2021.
If we flip the analysis and ask what are the
ESG characteristics of 5-star versus 1-star stocks,
we see that a basket of 5-star stocks currently
has more ESG risk than a basket of 1-star
stocks. Here, we use the numerical version of
Sustainalytics' ESG Risk Rating, where a lower
number means lower ESG risk.
5-star stocks carry more ESG risk than 1-star stocks
Star Rating
QQQQQ
QQQQ
QQQ
QQ
Q
Source: Morningstar Direct. Data as of 11/21/2021.
Among the severe and high ESG risk companies
that currently receive 5-star ratings are
Energy Transfer ET, Nissan Motor 7201:JP,
ESG Risk Rating (Lower = Better)
1.89
1.53
1.49
1.45
1.45
Another caveat is that the ESG Risk Rating from
Sustainalytics represents just one way to
rank companies by good or bad ESG characteristics.
Several ESG rating services exist, each with
different methodologies and, therefore, different
rank orderings of companies. Determining
which risks are most material for a company's
future is difficult; determining how material is even
more difficult. In the academic literature, there
are even more varieties of ways to score ESG.
If we somehow had access to a Platonic ideal of
an ESG risk measure, perhaps it would give
us even a different conclusion as to whether good
or bad ESG stocks are more expensive.
It Comes Down to Valuations
The broader lesson here is that the impact
of ESG on investing returns is a question that
has no definitive answer. At some points in
time, good ESG companies-however defined-
will be relatively cheap as a group. At other times,
as appears to be the case now, assuming you
governance and exposure to environmental
risks, the better.
But it's one thing to say credit or ESG metrics are
great inputs to investment analysis, and another
to assume there's a simple translation that takes us
from good fundamentals to good investment
returns. After all, a bond with a high credit rating
may be a less attractive investment than a
bond with a low credit rating-the low-quality
bond just needs to be cheap enough. Likewise, the
stock of a 1-globe company might offer a better
risk/reward trade-off than a 5-globe company's
stock. It all comes back to the old truism that good
companies-no matter how you define good-
aren't automatically the best investments. K
Haywood Kelly, CFA, is head of global research
at Morningstar. He is a member of the editorial board
of Morningstar magazine.
Average Price/
Fair Value
0.97
1.07
0.96
0.92
0.84
If our analysts are correct, investors stand to
outperform by investing in bad ESG stocks.
AGL Energy AGL:AU, China Gas Holdings
00384:HK, and Groupon GRPN. A motley crew,
to be sure.
A Caveat
That brings me to one huge caveat. It's entirely
possible that our equity analysts are wrong about
their fair values. Perhaps they aren't penalizing
bad ESG companies enough when forecasting
cash flows or assessing uncertainty and
economic moats. Many companies with high or
severe ESG risk reside in the energy sector,
and that's a notoriously difficult sector in which
to make long-term stock calls. (Forecasting
oil prices is hard!) We've been burned on our
energy calls in the past.
believe our equity analysts, good ESG companies
command a premium.
That's why it's dangerous to think there's
any one-to-one correspondence between ESG and
investing returns that holds for all market
environments. It all depends on relative valuations.
I often draw a comparison between ESG
ratings and credit ratings. Fundamental investors
value the kind of balance sheet and
liquidity analysis embedded in credit analysis,
whether they do that analysis themselves
or rely on a credit-rating agency to do the work
for them. It's similar with ESG analysis.
The more metrics we have about a company's
morningstar.com/products/magazine
9

https://www.morningstar.com/stocks/xasx/agl/quote https://www.morningstar.com/stocks/xhkg/00384/quote https://www.morningstar.com/stocks/xhkg/00384/quote https://www.morningstar.com/stocks/xnas/grpn/quote https://www.morningstar.com/authors/36/haywood-kelly-cfa https://www.morningstar.com/stocks/xnys/et/quote https://www.morningstar.com/stocks/pinx/nsany/quote http://www.morningstar.com/products/magazine

Morningstar - Q1 2022

Table of Contents for the Digital Edition of Morningstar - Q1 2022