One of the most contentious issues in business revolves around the role of for-profit companies in addressing social and environmental problems. Should a business be driving a “conversation” about race or pressuring U.S. states to reform discriminatory laws? And as investors inevitably ask, does engagement on such issues detract from generating profits?
The answer to that last question is no, according to a study we recently completed. We find that firms making investments and improving their performance on environmental, social, and governance (ESG) issues exhibit better stock market performance and profitability in the future. For companies, this suggests that their efforts to do good are rewarded. For investors, this suggests that there is substantial value from analyzing non-financial data and incorporating it into their decisions.
However, not all such initiatives are equally beneficial. My research, with Mozaffar Khan and Aaron Yoon, suggests companies should stick to social and environmental issues that
strategically important for their business if they want such efforts to contribute to the valuation. The results of this paper provide support to an earlier article (“The Performance Frontier: Innovating for a Sustainable Strategy”) where we described a framework that companies could use to create value by doing good.
For instance, managing environmental impact is a very important element of business strategy for firms in the fossil fuel or transportation industries. Less so for financial institutions or healthcare companies. In contrast, fair marketing and advertising of products are very important for companies in these sectors. With this intuition we could hypothesize about the ESG investments that would be financially important for different industries, but until recently we had no objective and systematic way of making those judgments.
Our study was made possible because of data infrastructure that was created only recently by the Sustainability Accounting Standards Board (SASB). SASB develops industry-by-industry accounting standards that identify the material ESG issues that could have financial implications. SASB uses the U.S. Supreme Court’s definition of material information as information presenting “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Going industry by industry, we hand-mapped the standards to data items that codify the investments that hundreds of companies in the US make each year over the last twenty years. (Interestingly, across industries, on average, only about 20% of the ESG issues were classified as material.) This allowed us to construct an index ranking companies based on investments on material issues and another index ranking companies based on investments in immaterial issues. Using models that control for other systematic risk factors (market, size, value vs. growth, momentum, and liquidity) we constructed portfolios of companies that score high in ESG investments versus those that score low.
The results are very consistent: firms making investments on material ESG issues outperform their peers in the future in terms of risk-adjusted stock price performance, sales growth, and profitability margin growth. In contrast, firms making investments on immaterial ESG issues have very similar performance to their peers suggesting that such investments are not value relevant on average.
Importantly, our study ruled out reverse causality – it is not the case that more profitable firms simply choose to invest more in ESG. We accounted for this by controlling for the correlation between the level of investments with current firm profitability, valuation, size, and financial leverage, and by examining stock price performance and implementing a trading strategy that any investor could implement in real time.
The results of our study suggest that companies need to analyze which ESG issues are strategically important to their business. Improving performance on those will likely lead to better financial performance in the future. At the same time, they need to be able to inform their investors how they are performing on those issues by communicating credible key performance indicators. In turn, investors need themselves to analyze what are the important ESG issues for the companies in their portfolio and manage hidden risks. Not all social and environmental initiatives are created equal. But if companies stick to the ones most related to their businesses, they can drive social and financial performance simultaneously.