Dangling the ESG Carrot

Up until now, we have evaluated companies that have been “bad actors” when it comes to ESG. For this week’s Factor Spotlight, we’ll take a look at how the institutional investment community is forcing positive change in company behavior and influencing practices that align with growing shareholder interest in broadly recognized ESG principles. We will turn the tables on the outdated belief that although investors say they support ESG, they rarely act accordingly, and show concrete examples of how certain companies have been rewarded by “good” behavior.

Believing that responsible investing is important is by no means universal in the investment community, but it is clear that there is an exponentially growing number of allocators who are taking these initiatives seriously. During Climate Week in NYC at the end of last month, we weer fortunate to meet one such investor, Hiro Mizuno, the CIO of GPIF Japan’s Government Pension Investment Fund which manages $1.6 trillion in assets, or roughly 10% of the entire Japanese stock market and 1% of the world’s stock market. With Hiro at the helm, GPIF has become the leading example of how the financial sector can force companies to adopt or improve positive ESG behaviors. Hiro has made brave and radical changes in the way that the pension fund allocates capital and deserves the title of “ESG Pioneer”, as he has created a prototype for other asset owners to follow.

GPIF’s program is an outstanding achievement given the substantial obstacles that Hiro faced in a country that historically placed little value in investor opinion, probably to corporate Japan’s longer term detriment. The country has the most issues in the “E” & “S” and it in these two categories that the push-back has been hardest to overcome. Japan’s reliance on fossil fuels is enormous compared to the rest of the world and the country lags considerably in developing alternative sources of energy, perhaps hindered by the painful memory of the Fukushima incident. Another strong cultural hurdle that Hiro has had to tackle is in the area of gender diversity and the dearth of women represented in the workplace. This is deeply embedded in the culture, given the traditional role of men in the family coupled with an extreme work ethic which demands many long hours at the office, relegating women to household and childcare duties.

So how did Hiro obtain his reputation as the hero of ESG? He used the massive investment power of the pension fund to create substantive tools of influence pushing sustainability throughout every aspect of the firm’s investment program. For example, he took control of index construction and excluded companies that were not compliant with his defined minimum threshold of ESG adherence and disclosure. Those companies, more often than not, made changes in order to spare the negative label of being excluded as well as to avoid the more practical implications of a higher cost of capital. For active managers, he made it clear that ESG is part of the selection process and instituted longer term incentives and performance based structures which support adoption of positive behaviors.

Let’s turn now to some concrete examples and analyze one US large cap name that has made significant strides and examine the company through the Omega Point platform using Owl Analytics ESG data.

A household name in the shipping and logistics business, UPS (UPS: NYSE) has had highly positive ESG momentum in recent years and has made some groundbreaking changes in how it conducts its business activities to show greater commitment to sustainability.

In 2016, UPS announced a series of major efforts to reduce its carbon footprint, and set long-term targets for improving these metrics across the spectrum of ESG KPI’s. It also reiterated its pledge to be fully transparent in disclosing data to the public on how well it achieved these goals.

Management made aggressive moves to reduce its environmental footprint putting together near and longer term plans. The first step was to announce that it would deploy, as a start, 50 plug-in electric delivery trucks as part of target to reduce carbon emissions by 20% in 2020. In 2018 alone, the company ordered 950 Workhorse Group electric delivery vans (made in Ohio, USA) and 125 Tesla electric semi-trucks to complement its 1000+ global fleet of electric and electric-hybrid trucks.

There has been a huge divergence in performance between UPS and Fedex (FDX: NYSE) as investors have rewarded the former. In February 2018, the company started what can be considered a remarkable turnaround, and it went from being an underperformer in its sector to being an outperformer.

Performance: UPS vs. FDX - 1/1/18 - 10/3/19

Here, we see that UPS has outperformed FDX by 45% since the beginning of 2018. If we look at the relative performance during that time, we can see that UPS' has been mostly driven by alpha, not factors, since the turnaround.

Relative Performance: UPS vs. FDX 1/1/18 - 10/3/19

UPS was awarded the prestigious A-list rating by CDP (the Carbon Disclosure Project). CDP performs research on over 5,600 companies and 533 cities across 90 countries and focuses on risks associated with climate change, forests, greenhouse gas emissions, and water. CDP tracks and measures the degree to which entities have assessed, disclosed, and engaged with their environmental impact. In making this list, UPS is considered in the top ranks of global companies in environmental performance and is considered a pioneer in ESG. The company was also named to the Dow Jones Sustainability World Index (DJSI World) for the sixth consecutive year along with a number of other important recognitions.

Although there are a number of factors that are responsible for UPS’s performance vs. its peers such as FedEx, we can argue that the forward looking views of the management team have significantly helped stock performance. The company’s ESG friendly investments in innovation have resulted in increased efficiency resulting in a positive impact to the bottom line.

Although the largest asset owners such as GPIF are clearly in the best position to lead the charge, there is a broader sea change underway and the collective power of the investment community will be important. We may accuse many companies of “green-washing” rather than implementing meaningful ESG practices, but investors are becoming increasingly sophisticated in their evaluation and can see beyond the talk. Companies in turn are becoming more attuned to integrated thinking in how to manage their financial, social, natural and human capital.

We expect that more robust ESG metrics will develop over time in response to this, as the interests of the investment and the corporate world converge. Omega Point is excited about collaborating with asset owners and asset managers in building upon our ESG analytics capability and developing innovative ways to combine fundamental inputs, ESG data and a quantitative framework, similar to what we do in the traditional factor space.

Market and Factor Update

US Market (9/27/19 - 10/3/19)

• The market ended lower this week, mostly suppressed by economic data that showed US manufacturing activity had fallen to a low not seen since 2009. The broader indices rallied on Friday (not captured in above chart), driven by the Labor Department’s monthly report.
• Nonfarm payrolls increased by 136,000 in September, short of the consensus of 145,000, while the jobless rate was 3.5% - the lowest seen since 1969.
• According to the ISM, US manufacturing activity dropped to a more than 10 year low in September as the precarious trade environment weighed on exports.
• On Tuesday, the World Trade Organization cut its forecast for growth in 2019 global trade by more than half.
• Fed chairman Powell gave sanguine comments about the economy on Friday, but noted the long-term challenges from low growth, low inflation, and low interest rates. He declined to say anything material about future rate moves.

‍US Model

• Profitability hit a trough of -0.27 standard deviations below the mean on 9/24 and has since reverted back, now sitting at +0.42 SD above the mean.
• Momentum also continued to revert from a nadir of -2.98 SD below the mean, and still has a way to go at -2.47 SD below the mean.
• Growth appears to be bouncing off of a low of -1.88 SD below the mean on 10/1.
• The initial rotation into Value has slowed after the factor hit Extremely Overbought territory last week, and appears to now be reverting back to the mean.
• Market Sensitivity and Volatility both saw a trend reversal as they started to drift back downwards after a couple of weeks of positive movement.
• US Total Risk (using the Russell 3000 as proxy) saw a slight decrease of 13 bps.

‍Worldwide Model

• Momentum continued to revert after hitting a floor of -2.51 SD below the mean on 9/23.
• Profitability surged from a bottom of -1.34 SD below the mean on 9/24, and has crossed over into positive space.
• The relative strength that Value had seen has started to slow, although it remains Overbought in the worldwide model.
• Earnings Yield continued to see sizable gains on a normalized basis
• Similar to the US, Market Sensitivity and Volatility started to see declines in normalized return.
• Global risk (using the ACWI as proxy) saw a very slight tick up to 13.08%.

Regards,
The Omega Point Team