What are we looking for?
Canadian stocks with low levels of ESG risk that are favoured by analysts.
As the debate around the merits of ESG investing rages on, investors are reminded that the heart of most ESG scores (by companies like Morningstar Sustainalytics) centre around financially material risk. In other words: How much can a company stand to lose from issues that arise from climate change, social impacts and, classically, poor corporate governance practices?
Regardless of where you stand on ESG, as a prudent investor it is worthwhile considering risks that are not spelt out in traditional financial statements. To help with this task, today I use Morningstar CPMS to create a strategy that looks for profitable Canadian companies that have gained the favour of Street analysts and exhibit a low degree of ESG risk. To do this, I ranked the 333 companies in our Canadian database that have active ESG risk scores (courtesy of Morningstar Sustainalytics) on the following factors:
- Three-month earnings per share estimate revisions (today’s median Street estimate on EPS compared with what it was at month end, three months ago), higher figures preferred;
- Expected EPS growth rate (today’s median Street estimate on the upcoming fiscal year’s earnings, compared against the prior fiscal year’s), higher figures preferred;
- Latest quarterly earnings surprise (a comparison of the latest reported EPS against the Street estimate just prior to the company’s report), higher figures preferred;
- Five-year average return on equity;
- Five-year deviation of return on equity (a volatility metric measuring the consistency of ROE), lower figures preferred;
- Three-month price momentum (a measure of short-term market sentiment, calculated as the average price over the past six months as a percentage change from the average price over the six-month period ended three months ago), higher figures preferred.
To qualify, stocks must have an ESG risk score less than 15. For reference, Morningstar Sustainalytics methodology associates scores with the degree of unmanaged ESG risk inherent in a company. Those with a score from zero to 10 have negligible ESG risk, from 10 to 20 have low risk, 20 to 30 medium risk and those scoring between 30 and 40 have high ESG risk. Scores exceeding 40 pinpoint companies with severe degrees of ESG risk.
What we found
I used Morningstar CPMS to back-test the strategy from November, 2018 (when ESG Risk ratings became available) to March, 2022, assuming an equally weighted 15 stock portfolio with no more than four stocks per economic sector. Once a month, stocks were sold if they fell below the top 35 per cent of the universe based on the above metrics, or if the ESG risk rating exceeded 20 (signifying a transition from low to medium levels of ESG risk).
When sold, stocks were replaced with the next qualifying stock not already held in the portfolio, considering the aforementioned sector limits. On this basis, the strategy produced an annualized total return of 29.2 per cent, while the S&P/TSX Composite Total Return Index advanced 15 per cent on the same basis. Given the relatively short time frame, I also tested the strategy from December, 1991, to March, 2022. This expanded test (which ignores ESG risk until November, 2018) showed that the strategy produced 15.3 per cent annualized, while the index rose 8.9 per cent. Today, only eight stocks meet the requirements to be purchased into the strategy and are listed in the accompanying table.
This article does not constitute financial advice. Investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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