Ch 7 Analysis Valuation Integration Flashcards
What are the objective that an investment firm may have
for integrating ESG into an investment process?
An investment firm may have several different aims and objectives
for integrating ESG into an investment process. These may include:
A. meeting requirements under fiduciary duty or regulations;
B. meeting client and beneficiary demands;
C. lowering investment risk;
D. increasing investment returns;
E. giving investment professionals more tools and techniques to use in analysis;
F. improving the quality of engagement and stewardship activities; and
G. lowering reputational risk at a firm level and investment level.
What is the top reason ESG information is integrated into investment decisions
according to the survey conducted by the Finance Analysts Journal?
According to the survey conducted by the Finance Analysts Journal, the top reason ESG information is integrated into investment decisions is that
ESG information is considered material to investment performance.
What primary functions do asset managers serve, regarding ESG analysis?
Regarding ESG analysis, asset managers serve a few primary functions, namely they
RELAY ESG criteria and analysis to clients, and
use this data to ENGAGE with corporations on behalf of their clients.
What do quantitative approach tends to use?
In terms of investment strategies, quantitative (sometimes contracted to ‘quant’) investing can be known as ‘systematic investing’. It can include strategies such as:
▶ high-frequency trading;
▶ use of algorithms based on news or factors and statistical arbitrage;
▶ trend-following;
▶ risk parity; or
▶ use of beta strategies.
The quantitative approach tends to use
heavy mathematical modelling, computing power and data analysis potentially including machine and natural language learning processes. Some firms solely use these approaches and some use them to supplement human decision-making.
Typically, computer and mathematical models are built and then back-tested. Where these models use ESG data or information (for instance, through raw data or ratings agencies), this is considered a form of ESG integration. This produces many challenges, as the length of time series for ESG data (usually between 7–15 years depending on the series) is much shorter than for financial data.
This typically might be viewed as a quantitative investment form of integrating ESG technique.
What characteristics should investors consider when choosing ESG service providers?
What are the broad styles and techniques of ESG service providers?
The considerations that investors could take into account when choosing providers include:
▶ the number of companies covered;
▶ the length of history of datasets;
▶ the languages used;
▶ the stability of methodology;
▶ the regularity of updates;
▶ asset class coverage;
▶ the quality of methodology;
▶ the range of datasets; and
▶ the range of tools and services offered.
One way to think about these ratings and data providers is through their broad styles and techniques:
▶ raw or partially transformed data
(e.g. absolute carbon emissions, or carbon intensity which is emissions or sales);
▶ ratings based on backward looking reported data;
▶ ratings or information based on internet, third-party and web-reported data, aiming to be current; or
▶ aggregators of data or ratings.
The board of an energy company that uses coal, natural gas, solar, and wind sources to produce energy decides to task the CEO to develop a plan to eliminate all coal-fired power plants in the next 10 years. Which two components of the ESG score would improve by the greatest amount?
A) Environmental and social.
B) Governance and environmental.
C) Governance and security.
D) Social and governance.
Explanation
While the social component score may improve as a result of this decision, the fact that the board instigated the change to close coal-fired plants would most likely improve the governance and environmental scores.
(Reading 7.3, LO 7.1.6)
Pipedream Software Co. recently went through a very public scandal over the mistreatment of their female employees. Investment analyst, Steven Premmel, recently downgraded Pipedream’s social (S) score in his comprehensive ESG score for the company. Because Pipedream has not enacted any policies to remedy this scandal, which of the following would most likely be true regarding Pipedream: the company has:
A) a high level of reputational risk.
B) higher sales growth than their competition.
C) a high level of customer satisfaction.
D) a higher valuation than their competitors.
Explanation
A)Because Pipedream Software Co. is not active in addressing the issues that resulted in the corporate scandal, the company’s stock faces a great deal of challenges, namely a high level of reputational risk and potentially longevity risk. All other aspects are generally associated with positive outcomes from a strong social (S) score.
(Reading 7.3, LO 7.1.8)
Is ESG scoring largely recognized as a proven valuation technique for investments?
What are challenges that Asset Management Firms may face when judging materiality?
ESG scoring is largely recognized as a proven valuation technique for investments and ought to be used by Asset Management Firms.
The challenges that Asset Management Firms may face are
judgments may differ between analysts. rating agencies use varying scoring methods. many ESG terms are difficult to interpret.
(Reading 7.3, LO 7.1.14)
What are challenges of integrating ESG analysis into a firm’s investment process?
There remains a significant number of investment professionals who do not integrate ESG or believe ESG has limited financial impact; this can be challenging for teams and within firms.
Firms may not have significant resources to buy third-party ESG data, or a firm’s global nature may make culturally different attitudes to ESG factors difficult to integrate globally across the firm.
ESG integration is often different across asset classes, which can make it difficult to be consistent or to explain across a firm.
Investors are likely to make differing judgments on materiality or weight factors, which causes a lack of comparability or a difference of opinion, even within firms.
There are typically additional resources needed for ESG integration, finances and personnel, which raises both financial and operational challenges within firms.
ESG integration techniques have only recently started to become part of the curriculum at business schools and within universities. Typically, this means that investment professionals would not have had as much detailed training on how to deal with the challenge of integration.
What are TANGIBLE ASSETS?
What are INTANGIBLE ASSETS?
What are items APPLICABLE TO BOTH TANGIBLE AND INTANGIBLE ASSETS?
TANGIBLE ASSETS
• Land. • Manufacturing plants. • Inventories.
• Furniture. • Machinery. • Goodwill.
INTANGIBLE ASSETS
• Patents. • Copyrights. • Intellectual property and know how.
• Software and innovation assets. • Corporate culture.
• Incentives. • Employee productivity.
• Other forms of social and relationship assets.
APPLICABLE TO BOTH TANGIBLE AND INTANGIBLE ASSETS
• ESG analysis techniques. • Materiality.
EXAMPLE MATERIALITY MAP OF HIGH-LEVEL SECTORS
Environment:
Greenhouse gas (GHG) emissions; Air quality; Energy management; Fuel management
Water and wastewater management; Waste and hazardous materials management
Biodiversity impacts
Social capital:
Human rights and community relations; Access and affordability: Customer welfare
Data security and customer privacy; Fair disclosure and labelling
Fair marketing and advertising
Human capital:
Labour relations; Fair labour practices; Employee health, safety and wellbeing
Diversity and inclusion; Compensation and benefits;
Recruitment, development and retention
Sectors;
HEALTH CARE; FINANCIALS; TECHNOLOGY AND COMMUNICATIONS
NON-RENEWABLE RESOURCES; TRANSPORTATION SERVICES
RESOURCE TRANSFORMATION; CONSUMPTION
RENEWABLE RESOURCES AND ALTERNATIVE ENERGY; INFRASTRUCTURE
What services are offered by firms specializing in ESG-related services?
Advisory services – ESG strategy, integration, investment process, reporting and corporate advice.
Within this there are also many specific ESG-related services, for instance:
» class action litigation;
» Sustainable Development Goal (SDG) reporting and alignment;
» carbon and water analysis;
» norms and sanctions;
» policy development;
» real estate assessment;
» factor databases;
» supply chain assessment; and
» assurance services.
A company’s ESG management processes and policies are usually judged as being strong or weak. Discounted cash flow (DCF) input adjustments can be on a country- or sector-basis, where a country or sector ESG risk factor may contribute to a change in a cost of capital or terminal value growth assumption.
A prime example of this might be:
A) the coal sector being judged for having a negative environmental impact.
B) the retail sector being judged for having a positive environmental impact.
C) the oil and gas sector being judged for having a negative governance impact.
D) the software sector being judged for having a positive governance impact.
Explanation
A company’s environmental management processes and policies are judged strong or weak. After this judgment, the cost of capital used to discount cash flows in a DCF analysis is adjusted down or up by 1% to account for this.
This can also be on a country- or sector-basis, where a country or sector ESG risk factor may contribute to a change in a cost of capital or terminal value growth assumption.
For example, the coal sector may be judged to have a negative environmental impact.
With the other examples, these are typically not considered a standard judgement for those sectors.
(Reading 7.3, LO 7.1.9)
How Adjustments can also be made to valuation ratios?
How ESG analysis can complement traditional financial analysis?
Valuation ratio adjustments with ESG integration Adjustments can also be made to valuation ratios.
▶ An investor may decide a company is worth a certain PE ratio premium or discount versus its peers due to ESG factors.
▶ Alternatively, an investor may only be prepared to invest in a company with, for example, a 50% discount on a PE ratio versus an index benchmark because the company is judged to have a high ESG risk.
▶ Conversely, an investor may be willing to invest in a company at a 50% premium on a PE ratio due to strong ESG characteristics.
The adjustment may also be absolute. For instance, the investor may assign a ‘fair value PE’ of 16x to a strong ESG company versus 14x for an average ESG company and 12x for a weak ESG company.
How ESG analysis can complement traditional financial analysis
A few theoretical examples can now be examined. (These examples might be useful for thinking about how ESG factors affect industry and company performance. They show how integrated many ESG techniques and thinking are.)
One theoretical concept in fundamental analysis might be:
Weak or strong ESG factor:
→ weak or strong business driver or moat; → up or down sales or margins;
→ up or down long term cash flow; → up or down intrinsic value; → up or down share price.
This might be expressed as:
High employee engagement or satisfaction (proved by being number one versus competition on surveys or X% higher score against a threshold):
→ high customer satisfaction (judged by high net promoter score);
→ higher sales growth than competition; → higher valuation than competition.
The judgment of an intangible ESG factor, such as employee relations, complements an analysis of customer satisfaction and the assumptions that lead into a model of sales growth (a traditional financial factor). Alternatively:
High carbon intensity (proved by scope 1 and 2 carbon intensity being both absolute and relative to sector):
→ increased risk from carbon taxes; → increased cost of debt for new project financing; → higher taxes;
→ increased balance sheet risk of default on debt; → change in debt rating;
→ lower value of corporate debt.
Here, the judgment of an E factor, such as exposure to carbon, leads to analysis on the risk to debt pricing. It complements a traditional take on default risk.
Alternatively: Weak governance identified in a private company (proved by board with poor skills, not independent, non-diversified thinking):
→ increased risk of negative capital allocation decisions; → lower future cash flows or difficulty in initial public offering (IPO) to capital markets; → lower valuation or increased bankruptcy risk.
Here, a judgment on a G factor in a private company impacts both a valuation and possible exit for a private equity investor.
What are likely limitations of using ESG integration databases?
Each provider uses a different scoring methodology.
Limited consensus between databases.
Identification of specific ESG factors varies by provider.
Some providers will use raw or partially transformed data when developing their ratings. This would not be considered a limitation, but rather a style or technique used by providers.
Providers use different scoring methodologies based on varying ESG factors. This results in limited consensus between databases.
What are many hurdles and challenges for ESG integration?
▶ Disclosure and data-related challenges, such as:
» data consistency; » data scarcity; » data incompleteness; and
» lack of audited data.
▶ comparability difficulties, such as:
» lack of comparability between ESG ratings agencies;
» comparing across different accounting and other standards;
» comparisons across geographies and cultures; and
» inconsistent use of jargon terminology.
▶ materiality and judgment challenges, such as:
» judgments that are difficult and uncertain; and » judgments that are inconsistent.
▶ ESG integration challenges across asset classes:
» different types of assets and different strategies integrate ESG using different techniques.
In the municipal space (region, state or city) both the issuer’s governance and management practices can be assessed,
what other factors should be assessed?
Municipal credit ESG analysis can differ as well. In the municipal space (region, state or city) both the issuer’s governance and management practices can be assessed as well as their:
▶ overall transparency;
▶ reporting;
▶ corruption levels;
▶ budgetary practices;
▶ pension liabilities; and
▶ contracts.
Some investors will view municipals investing for inclusive communities as lower risk investment due to the social benefits. Alternatively, there can be co-primary outcomes, where market rate returns are expected alongside social impact. This differs from social impact, which is not always expected to make market rate (risk-adjusted) returns.
Environmental factors (such as the region’s air quality and associated health risks for its constituents) and the quality of public infrastructure (such as wastewater treatment plants) can all pose risks that may affect an issuer’s ability to repay its debt.
Stances on racial equality would be considered a qualitative approach and would fall under the social, rather than the governance, umbrella of analysis.
ESG data sources could be direct or indirect, what are they?
Many ESG databases provide secondary ESG data or ratings. These are assessments transformed by a process of scoring or a formula from a primary data source. Some providers (e.g. Bloomberg) will provide primary data sourced from company reports in an easier or consistent form to digest, along with a secondary rating (e.g. Bloomberg Disclosure score).
Primary data can be sourced from companies directly:
▶ surveys; ▶ direct company communication; and ▶ company reports, presentations and public documents.
These public documents may be sourced from non-profit organisations, such as the UN Global Compact or the GRI, as well as the companies’ own websites. A primary source may be audited or not audited, but as of 2020, many ESG performance indicators are not audited (although the number has increased since 2018 and is expected to continue to increase – verification and auditing of carbon emissions being one important data point that is increasingly audited).
Alternatively, the source may be indirect, via:
▶ news articles; ▶ third-party reports and analysis; and ▶ investment and consulting research.
Indirect assessment can be via a third-party source (such as Glassdoor for employee satisfaction data and scores, which are directly sourced from employee surveys). They could also come from government, regulatory bodies or non-governmental organisation (NGO) reports into different segments of ESG.
What is Credit Risk Analysis?
What can be used to determine the suitability of a bond investment?
A combination of investor research, analysis and judgment determines the suitability of a bond investment based on a range of factors, of which credit ratings may be one. Other factors may include proprietary indicators and recommendations by security analysts. It is notable that not all credit will have a rating.
Typically, Credit Risk Analysis (CRAs) assess the predictability and certainty of an issuer’s ability to generate future cash flow to meet its debt obligations. To this end, they look at whether companies can sell their assets to cover obligations (and certain assets might be impaired through ESG concerns, e.g. coal assets).
The levels of litigation risk are often analysed as well, including:
▶ environmental litigation; ▶ employment litigation; or ▶ human rights violations (e.g. modern slavery laws).
To that degree, ESG risk, which comes to litigation, has always been incorporated into CRA analysis.
On the quantitative side, CRA analysis focuses on:
▶ the issuer’s overall bankruptcy risk; ▶ the strength of its balance sheet; and ▶ how it compares to other issuers.
Using standard credit ratio analysis, CRAs may test:
▶ how ESG factors affect an issuer’s ability to convert assets into cash (profitability and cash flow analysis);
▶ the impact that changing yields – due to an ESG event – may have on the cost of capital, depending on the share of debt used in the issuer’s capital structure (interest coverage ratio and capital structure analysis);
▶ the extent to which ESG-related costs dent the ability of an issuer to generate profits and add to refinancing risks; and
▶ how well an issuer’s management uses the assets under its control to generate sales and profit (efficiency ratios).
In summary, a CRA rating is typically:
▶ based on analytical judgment (both quantitative and qualitative), using all the information deemed material by the analysts;
▶ forward-looking with a varying time horizon;
▶ composed of dynamic and relative measures; and
▶ a statement of the relative likelihood of default.
An interested fixed income investor may conduct different materiality assessments or judgments to a CRA (see case studies). This is considered true of equity ESG ratings by many investors as well.
Indeed, credit investors typically use the information provided by credit ratings to help them price, trade and assess the credit risk of fixed income securities, and to determine whether these are suitable investments, but ratings are not the only input.
A combination of investor research, analysis and judgment determines the suitability of a bond investment based on a range of factors, of which credit ratings may be one. Other factors may include proprietary indicators and recommendations by security analysts. It is notable that not all credit will have a rating.
With that said, credit ratings have an important role in the credit risk assessment of a bond issue and are typically used to define and limit investment mandates set by a wide range of institutional investors. Many investors in investment grade credit have limited or no ability to invest in high-yield speculative-grade credit.
What is Real-time dynamic analysis?
Real-time dynamic analysis
The analysis at the frontiers of data science is being extended to real-time analysis. For instance:
▶ using geospatial data to track:
» de-forestation; » mining; » construction; » shipping; and » traffic; or
▶ using natural language processes to track social sentiment on the internet.
Overall, ESG investment analysis does not occur in a vacuum. The techniques and analysis are intersectional with the real world, as well as with the impact and risk on companies and countries.
Certain qualitative techniques may be more suitable for different industries and asset classes.
What are some examples for qualitative ESG assumptions that pair appropriately with the respective industry?
Business ethics and culture concerns being addressed at banks and financial firms.
Access and affordability among healthcare providers.
Climate change being addressed by utility companies.
Not this General product pricing being addressed at large retail shops.
Examples show how integrated many ESG techniques and thinking are.
One theoretical concept in fundamental analysis might be: Weak or strong ESG factor:
→ weak or strong business driver or moat; → up or down sales or margins;
→ up or down long term cash flow; → up or down intrinsic value; → up or down share price.
This might be expressed as: High employee engagement or satisfaction (proved by being number one versus competition on surveys or X% higher score against a threshold):
→ high customer satisfaction (judged by high net promoter score); → higher sales growth than competition; → higher valuation than competition.
The judgment of an intangible ESG factor, such as employee relations, complements an analysis of customer satisfaction and the assumptions that lead into a model of sales growth (a traditional financial factor).
Alternatively: High carbon intensity (proved by scope 1 and 2 carbon intensity being both absolute and relative to sector):
→ increased risk from carbon taxes; → increased cost of debt for new project financing;
→ higher taxes; → increased balance sheet risk of default on debt; → change in debt rating;
→ lower value of corporate debt.
Here, the judgment of an E factor, such as exposure to carbon, leads to analysis on the risk to debt pricing. It complements a traditional take on default risk.
Alternatively: Weak governance identified in a private company (proved by board with poor skills, not independent, non-diversified thinking):
→ increased risk of negative capital allocation decisions; → lower future cash flows or difficulty in initial public offering (IPO) to capital markets; → lower valuation or increased bankruptcy risk.
Here, a judgment on a G factor in a private company impacts both a valuation and possible exit for a private equity investor.
What are materiality assessments?
The research stage typically contains a materiality assessment to identify the ESG issues that are likely to have an impact on the company’s financial performance.
Materiality is typically measured both in terms of the likelihood and magnitude of impact.
The materiality assessment is considered important as there is evidence that non-material factors do not impact financials, valuations or company business models. It is distinguished from some exclusionary socially responsible investing (SRI) strategies, which may also consider non-material factors, e.g. exclusion of pork-based product companies for certain religious stakeholders, which a typical investor would not deem a material ESG factor.
Investors who primarily see ESG analysis and ESG integration as a way to enhance investment processes are likely to focus on ESG issues they consider financially material, i.e. a factor that they consider is likely to have a financial impact in the future, either positive or negative.
