Originally published on Kellogg Insight.
Based on the research of George Serafeim and Aaron Yoon.
By Roberta Kwok.
You know the drill: a well-known firm is caught polluting or disregarding consumer safety. The media is all over it, and the company’s stock value falls. So it makes sense that investors have become increasingly interested in tracking these environmental, social, and governance (ESG) issues.
But what about when a firm does good—for instance, pledging to obtain raw materials from more sustainable sources or launching a program to increase employee diversity? Does the market reward such efforts? And do certain types of initiatives boost stock value more than others?
Aaron Yoon, an assistant professor of accounting information and management at Kellogg and George Serafeim at Harvard Business School recently examined this question by analyzing data on more than 3,000 companies. They found that stock value did tend to rise after positive ESG news about a firm emerged, but only if the news was financially material—that is, related directly to the company’s sector.
For example, a tech firm’s decision to serve only sustainably farmed food in its buildings’ cafeterias wouldn’t be considered material. But a coffee company’s commitment to paying farmers a fair price for their beans would qualify. “That’s when the market is rewarding these companies,” Yoon says.
The researchers also looked at what categories of ESG news elicited the biggest reaction from investors, given that ESG covers a huge range of company activities. In looking at both material and nonmaterial news, they found that investors didn’t respond to every type of positive development. But they did react strongly to news about how products affected customers, such as changes in safety, affordability, or consumer privacy. So, if companies are looking for a positive market response, it might make sense for them to invest more resources in those areas. Improving labor practices and lowering products’ environmental footprints also were linked to modest bumps in stock prices.
Overall, the study suggests that investors see at least some ESG improvements as worthwhile, not just as costly initiatives that drain the company’s coffers without adding much financial return.
“The market is not viewing ESG as a value-destroying issue,” Yoon says.
Scattered Focus
Companies are paying more attention to ESG issues these days because customers and employees demand it. For instance, some people may stop buying products or services from a firm where sexual harassment is revealed to be common. And companies with environmentally unfriendly practices may struggle to attract millennial employees, many of whom are highly concerned about sustainability, Yoon notes.
Figuring out which ESG issues merit the most attention, though, can be difficult. In an ideal world, a firm would address all of them. But with limited time and resources, which initiatives should be prioritized?
“That’s the key question,” Yoon says.
And while making ESG improvements is the right thing to do from an ethical point of view, at least historically, it hasn’t been clear that investors actually reward these efforts. One study of 100 companies from 2002 to 2010 suggested that stock prices fell in response to bad ESG news but didn’t budge after good news. “[W]hile shareholders seem to penalize bad corporate social responsibility, they do not really reward positive behaviors,” the authors wrote.
Another study of about 750 firms from 2001 to 2007 found a similar negative market reaction to poor corporate social responsibility. In some cases, even positive news in this area drove stock prices slightly down, perhaps because investors considered such initiatives a waste of shareholder money or had trouble quantifying the long-term benefits.
But the data used in those studies were collected before the importance of ESG in investing really took off, Yoon says.
Indeed, research Yoon and Serafeim conducted a few years ago suggested that investors would respond positively to ESG programs as long as they were material to that company’s business. In that research, they created two hypothetical portfolios: one of firms that ranked high in terms of the materiality of the companies’ ESG programs, and one that ranked low. They found that over a 20-year horizon, the high-materiality portfolio delivered higher returns than the other.
So in a new study, they set out to see if this trend would hold in the real world.
Material or Not?
The researchers turned to Truvalue Labs, a company that uses artificial intelligence to analyze data relevant to ESG investing. The firm’s software combed news articles every day for information about ESG developments at companies, which included the views of sources such as analysts and regulators. Its algorithms then classified each news item as financially material to the firm or not. The software also categorized each story as positive or negative.
The data set covered 3,126 companies in sectors such as energy, healthcare, communication, finance, and consumer goods from 2010 to 2018. For each firm, Yoon and Serafeim tracked its stock prices five days before to five days after each news item came out. Then the researchers calculated the daily market-adjusted return—that is, how the stock performed relative to the market’s overall movement each day.
To ensure that each event had enough news coverage to be accurately classified as positive or negative, the team started by examining developments reported in at least three articles. When the news was material and positive, the company’s stock price outperformed the market by an average of 0.6 percent, or 60 basis points, on the day the news emerged.
But when positive ESG news was not material, the stock price didn’t seem affected at all.
The more articles people had written about the topic, the larger the response. For instance, if at least five articles about a positive material ESG development had been identified, the company’s stock price rose by an average of 2.2 percent, or 217 basis points, relative to the market that day.
Investors also seemed to penalize companies for negative material news, but only when these developments were widely covered. Bad news reported in three or four articles didn’t elicit a significant reaction. But events covered by at least five articles were linked to a drop in value of 0.7 percent.
Customers First
Next, the researchers took a more granular look at whether the market responded differently depending on the type of ESG development.
The team divided the news (which included both material and nonmaterial developments) into five categories:
- Social capital, which meant items related to the product’s effect on customers—for instance, whether it was safe, high-quality, and truthfully advertised.
- Natural capital, which included issues such as the firm’s impact on air quality and whether it properly disposed of hazardous waste.
- Human capital, which encompassed labor practices and employee safety.
Sustainability leadership, which essentially included issues related to business ethics.
- Business model and social innovation, such as efforts to make a product’s life cycle more efficient and less environmentally damaging. For example, a food company might decide to start using biodegradable packaging.
The researchers found that social-capital issues elicited the strongest responses, generating an additional stock price increase of 1.9 percent, or 190 basis points, for positive news and a decrease of 1.1 percent, or 110 basis points, for negative news. “The market had a very significant reaction,” Yoon says. Investors also tended to reward good news in the business-model and social-innovation, as well as human-capital, categories.
Interestingly, the researchers found that for natural capital, stock prices fell in response to bad news but didn’t move much when good news emerged. This result might be partly due to the fact that most natural-capital news is negative, Yoon says. For instance, an oil spill will generate a huge amount of media coverage. But a company’s efforts to put safeguards in place to prevent oil spills may not get as much attention.
That doesn’t mean that firms shouldn’t invest in better environmental practices. While they might not get a pat on the back from investors, their proactive efforts will decrease the chances of a controversy later.
“It’s still important for companies to work on natural-capital issues to avoid bad news,” Yoon says.
The team saw little reaction to governance and leadership news, such as corruption scandals. But Yoon suspects this is because information about a firm’s executives tends to be well-known, so the market has already priced those factors into a company’s value. For instance, if a CEO has a reputation for being volatile, investors may shrug if that executive makes another inflammatory statement.
Overall, the study’s results show that “the tide has turned,” Yoon says. The market is “acknowledging ESG is a very important investment.”