As Sustainable Stocks Rally, Valuations Grow Fatter
But cheap names remain, including Salesforce.com, Adobe, and Disney.
Sustainability minded investors were rewarded with a favorable 2021, as the Morningstar indexes focused on stocks facing the lowest environmental, social, and governance risk outperformed the broader market. (The risk metrics are supplied by Sustainalytics, a Morningstar company.) All this came despite a rally in the oil and gas stocks that many sustainable investors try to limit in their portfolios.
But, as the mantra goes, the past doesn't predict the future; yesterday's outperformance could lead to tomorrow's overvalued stocks. To that end, the Morningstar Ratings assigned by our equity research analysts can provide guidance to whether companies with positive ESG credentials also fit the bill for long-term investment at current prices.
Based on the average star ratings of the Morningstar US Sustainability Leaders and Morningstar US Sustainability indexes, both look overvalued versus the broader U.S. market. The weighted average star ratings for the sustainability indexes were 2.78 and 2.74, respectively, as of Jan. 21, 2022, compared with an average 2.94 across our U.S.-listed coverage. A rating below 3 stars suggests overvaluation.
Morningstar US Sustainability Index and Morningstar US Sustainability Leaders Index averages calculated based on weighted average of underlying holdings as of Dec. 31, 2021.
This follows a broader trend of the lowest-ESG risk companies screening as expensive versus their higher-risk counterparts. In November 2021, as Morningstar's head of global research Haywood Kelly noted, our equity analysts saw less attractive valuations for companies with low ESG risk ratings. That conclusion remains true in late January 2022, as evidenced by average price/fair value estimate ratios above 1.0 for securities with Sustainalytics ESG Risk Ratings of Negligible and Low, and below 1.0 for stocks with higher ESG Risk Ratings.
Source: Morningstar, Sustainalytics. Data as of Jan. 21, 2022.
We don't mean to pick on positive-ESG rated stocks; the discussion of price versus value isn't unique to them. And no, we don't view oil and gas companies as particularly cheap today: After its meteoric rise in 2021, the industry looks only slightly undervalued, with an average star rating of 3.17.
But average valuations only tell one part of the story. In our view, we still see opportunities to invest in individual stocks at attractive prices within the Morningstar US Sustainability indexes, particularly after the latest market tumble. Pairing these positive ESG Risk Rating credentials with pockets of undervaluation, three particularly cheap names within these indexes include Salesforce.com CRM, Adobe ADBE, and Disney DIS.
Morningstar Rating: ★★★★ We believe Salesforce.com represents one of best long-term growth stories in software. Even as revenue growth is likely to dip below 20% for the first time at some point in the next several years, we believe ongoing margin expansion should lead to compound earnings growth of more than 20% annually for much longer. Simply put: After introducing the software-as-a-service model to the world, Salesforce.com has assembled a front-office empire that it can build on for years to come, in our view.
We also see minimal ESG risks. While we note that Salesforce faces strong competition for software engineers on the hiring front, and also faces risks arising from potential data breaches within its data centers, Sustainalytics rates the company has having a Low ESG Risk Rating.
Morningstar Rating: ★★★★ Despite mixed fourth-quarter 2021 results, we believe the outlook for wide-moat Adobe is better than it appears. The company has come to dominate in content creation software with its iconic Photoshop and Illustrator solutions, both now part of the broader Creative Cloud, which is offered via a subscription. We see Adobe's expanding portfolio and unencumbered dominance supporting further growth, and we view shares as undervalued.
Like Salesforce, Adobe's primary ESG threats relate to human capital and data security. Nonetheless, the ESG Risk Rating is also Low for Adobe, owing to strong management of these issues through its internal sustainability committee.
Morningstar Rating: ★★★★ We believe Disney is successfully transforming its business to deal with the ongoing evolution of the media industry. The firm's direct-to-consumer efforts, Disney+, Hotstar, Hulu, and ESPN+ are taking over as the drivers of long-term growth as the firm transitions to a streaming future. Meanwhile, Disney's other components continue to rely on the world-class Disney brand, sought after by children and trusted by parents. Over the past decade, Disney has demonstrated its ability to monetize its characters and franchises across multiple platforms--movies, home video, merchandising, theme parks, and even musicals. While ongoing coronavirus limitations hurt the theme park business, we still view the parks as a prime vacation destination, supporting their rebound after capacity limits are lifted.
From an ESG perspective, labor relations remain one of the company’s largest risks. Disney and its subsidiaries have been subject to a number of lawsuits alleging racial and gender discrimination, sexual assault/harassment, and wage gap/discrimination. That said, we estimate the potential financial impact of these individual cases is relatively immaterial, a view that's supported by its ESG Risk Rating of Low.
Incidentally, both Salesforce and Adobe are on Morningstar's list of best sustainable companies to own, given their wide moats and solid management of ESG risks.
In all, we don't want to suggest that investors should ignore or otherwise shun ESG considerations. Sustainable investing through the lens of integration of ESG risks and opportunities is essential to long-term investment, in our view. But investors need to balance ESG credentials with valuation and expected return. After all, while companies may be able to reduce their overall risk by properly managing their potential ESG pitfalls, investors increase their own risk of poor performance by overpaying for such stocks.
Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.