Best way to screen governance scores? Improvers vs. decliners

This analysis is by Bloomberg Intelligence Senior ESG Strategist Shaheen Contractor and Bloomberg Intelligence Quantitative Equity Strategist Christopher Cain. It appeared first on the Bloomberg Terminal.

Screening for momentum in companies’ governance scores — those that are improving vs. those declining — has benefited portfolios more than just screening for the best vs. worst absolute scores, our analysis suggests, particularly in the US. While US equities with the highest scores for governance, or the ‘G’ in ESG, don’t show any substantial implications for returns over a roughly six-year period, they typically tilt toward higher profitability and lower valuations — suggesting fundamental strengths.

Good governance: Guide to returns

Investors might be better off screening for momentum in governance scores (i.e., improvers vs. decliners) rather than just the absolute scores. Four of the seven regions we analyzed showed some kind of return benefit on the scores’ momentum, where companies with the greatest improvements (Q1) outperformed those with declining scores (Q5) from June 30, 2017, to April 27, 2023. Only two of the seven showed a benefit when using absolute scores. Return differentials on both across regions are mixed, with some seeing greater benefits with others small or negative.

Our analysis uses Bloomberg’s governance scores and looks at absolute levels (best vs. worst) and momentum (year-to-year change). Our analysis is lagged by six months to reflect the window between the year-end and data being reported, and is sector and beta neutral.

 

In US, momentum in governance scores shows benefit vs. absolute

Our analysis suggests that in the US, the equities showing the greatest improvements in governance scores (Q1) outperformed those that declined the most (Q5) by 3.3 percentage points annually, based on a returns analysis from June 30, 2017, until April 27, 2023. Companies in Q5 experienced an average ‘G’ score decline of 0.35 out of a maximum score of 10 across our time period. An analysis based on the best vs. worst absolute scores, however, showed little return implications.

Our return analysis is based on the Bloomberg 1000 Index.

 

Profitability of US governance scores, value tilt show strength

While US companies with high governance scores (Q1) showed little return implications for the period analyzed, we think their high profitability and low valuations tilts or exposure could provide fundamental support. The Q1 group shows a tilt toward profitable stocks, as suggested by an average return on invested capital (ROIC) of 11.6 vs. 7.1 for Q5. Equities in Q1 also show a value tilt as suggested by lower EV/Ebitda vs. Q5. While the profitability and value tilt of those in Q1 may have resulted in some underperformance during parts of 2020-21, which we detail next, it could provide fundamental benefits as such factors typically provide support.

Relative equity underperformance for those with the best governance scores (Q1) in the US during parts of 2020-21 might be due to the exposure to stocks that have profitability and value characteristics, as such factors underperformed during similar periods. While profitability and value underperformed during parts of 2020 and 2021, these factors typically provide support — meaning companies with strong governance could benefit from these exposures. Our chart shows the relationship between the return spread (Q1-Q5) of our governance scores and BI’s value and profitability factor, with trends being directionally similar.

The value factor remains atop the BI Strategy team’s US Factor Scorecard, which might continue to provide support to our Q1 Governance portfolio.

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‘G’ underperforms on profitability and value, but has benefits

Relative equity underperformance for those with the best governance scores (Q1) in the US during parts of 2020-21 might be due to the exposure to stocks that have profitability and value characteristics, as such factors underperformed during similar periods. While profitability and value underperformed during parts of 2020 and 2021, these factors typically provide support — meaning companies with strong governance could benefit from these exposures.

 Our chart shows the relationship between the return spread (Q1-Q5) of our governance scores and BI’s value and profitability factor, with trends being directionally similar.

The value factor remains atop the BI Strategy team’s US Factor Scorecard, which might continue to provide support to our Q1 Governance portfolio.