New research shows that higher employee satisfaction leads to higher equity returns. That reinforces previous research showing that environmental, social and governance (ESG) principles should be an important aspect of advisors’ due diligence in fund selection.
ESG has been one of the fastest growing investment phenomena, and academic research has focused on this subject. As a result, companies and investment firms have taken notice. For example, in August 2019 the Business Roundtable, which represents nearly 200 CEOs of America’s biggest companies, announced the end of shareholder primacy and called for the role of a corporation to be redefined, suggesting that a large number of firms view sustainability issues as strategically important. In addition, BlackRock CEO Larry Fink sent a letter to investors in January 2020 detailing his plans to incorporate ESG as a new standard for investing. Investment managers who signed the UN Principles for Responsible Investment had over $90 trillion in assets under management in 2019. ESG investing now accounts for one out of every four dollars under professional management in the United States and one out of every two dollars in Europe.
The popularity of ESG investing has impacted the cost of capital of companies. Because ESG investors favor companies with high ESG scores and avoid those with low ESG scores, those with low ESG scores will tend to have higher costs of capital, putting them at a competitive disadvantage. Thus, one positive result of the popularity of ESG investing is that it is causing companies to focus on improving their ESG scores to lower their cost of capital.
For example, the research, including the 2019 study, “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk and Performance,” found that companies with higher ESG scores have above-average risk control and compliance standards across the company and within their supply chain management. Because of better risk-control standards, high ESG-rated companies suffer less frequently from severe incidents such as fraud, embezzlement, corruption or litigation cases that can seriously erode the value of the company and its stock price. Less frequent risk incidents ultimately lead to less downside, or tail, risk in the company’s stock price and thus higher valuations and lower costs of capital. However, the increased cash flows to companies with favorable ESG scores has two effects. It leads to rising valuations and thus short-term capital gains.
Ultimately, those higher valuations mean that investors should expect lower future returns over the long term.
Such findings provide companies with the incentive to improve their ESG scores. Kyle Welch and Aaron Yoon contribute to the literature with their June 2020 study, “Corporate Sustainability and Stock Returns: Evidence from Employee Satisfaction,” in which they examined whether ESG coupled with employee satisfaction can enhance firm value. They began by noting that prior research, including the 2018 study, “Crowdsourced Employer Reviews and Stock Returns,” has found that firms experiencing improvements in crowdsourced employer ratings significantly outperform firms with declines and thus is an important determinant of firm value. They hypothesized that, “firm engagements in ESG may instill a sense of purpose to employees and motivate them. In addition, motivated employees will be more productive, which may lead to enhanced firm value. In such a case, it is possible that ESG coupled with employee satisfaction may enhance firm value over and beyond the effect from employee satisfaction.”
Their data is from MSCI ESG Ratings and Glassdoor (for employee satisfaction) and covers the period between 2011 and 2018. Returns were benchmarked against the Fama-French five-factor model (beta, size, investment, profitability and value). Following is a summary of their findings:
- Firms with high ratings on both ESG and employee satisfaction significantly outperform those with low ratings on both, and with high employee satisfaction alone.
- When the ESG rating is the only signal, there was no meaningful alpha in the long/short portfolio.
- Using employee satisfaction as the only signal to create portfolios, the long/short portfolio generated an annual equal-weighted (value-weighted) alpha of 2.43% (2.44%).
- Ranking by quartiles, the equal-weighted (value-weighted) portfolio of firms with high ESG performance and employee satisfaction significantly outperformed the portfolio of firms with low ratings on both topics by 5.61% (5.83%).
- The equal-weighted (value-weighted) portfolio of firms with high ESG performance and employee satisfaction outperformed the firms with low ESG performance and high employee satisfaction by 2.75% (2.76%) and the firms with high ESG performance and low employee satisfaction by 5.64% (5.58%).
- The equal-weighted (value-weighted) long portfolio (firms with high ESG performance and employee satisfaction) outperformed the portfolio of firms with high ESG alone by 3.49% (3.33%).
- The equal-weighted (value-weighted) long portfolio of firms outperformed the portfolio of firms with high employee satisfaction alone by 1.60% (1.64%).
- Their results were robust to alternative factor models, different subsamples or subperiods, and alternative portfolio construction rules.
- Across all horizons, firms performing better on ESG and employee satisfaction produce superior future sales growth and return on equity.
Welch and Yoon noted, “Our results are driven by the firm social investments rather than environmental and governance related investments.” They also offered the important caution that while, “firm social investments drive our results, readers should be cautious and note that we are not claiming that ESG causes employee satisfaction and that this leads to firm value. Rather, we document that portfolio of firms that score high on ESG and employee satisfaction significantly outperforms those firms with high employee satisfaction alone, indicating that employee satisfaction is an important condition for ESG to enhance shareholder value.”
Summary
Their findings led Welch and Yoon to conclude that, “ESG’s role on shareholder value is incremental to that from employee satisfaction.” They added: “Overall, results suggest that ESG coupled with employee satisfaction enhance shareholder value and these findings have implications not only for asset managers who integrate ESG factors into their portfolios but also for firm managers who implement ESG practices.”
Summarizing, Welch and Yoon demonstrated that employee satisfaction may enable ESG to enhance value. Their results demonstrated that ESG coupled with employee satisfaction is a valuable signal to predict stock returns. These findings have implications for asset managers who integrate ESG factors into their portfolios.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
Important Disclosure: This information is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Certain information may be based on third party data which may become outdated or otherwise superseded. Third party data is deemed to be reliable, but its accuracy cannot be guaranteed. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. LSR-21-21
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New research shows that higher employee satisfaction leads to higher equity returns. That reinforces previous research showing that environmental, social and governance (ESG) principles should be an important aspect of advisors’ due diligence in fund selection.
