ESG approach finds Value in economic slowdown
• Economic slowdown: does it present headwinds for value investing? • Targeting sustainable dividends is key to outperforming the market
As signs of a slowing economy emerge, conventional wisdom dictates that a value investing strategy - one that centres on picking stocks that are under-priced relative to a company’s assets - will come under the most pressure. From this viewpoint, value investing is thought to work best during expansionary phases, bolstered by strong corporate profits, and that investors should turn towards growth stocks to provide returns at a later point in the cycle. However, this is not necessarily the case, according to NN Investment Partners, whose value strategies continue to perform well against the market.
Nicolas Simar, Lead Portfolio Manager, European Equity Dividend Strategies, discusses how value strategies focused on sustainable dividends can outperform the market late in the cycle.
The end of the monetary cycle is approaching, with central banks easing their supportive policies and beginning to unwind quantitative easing programmes. Due to this tightening, the cycle will begin to turn as the economy enters a slowdown phase. This poses many potential risks to investors, who may be exposed to asset bubbles that have built up over years of supportive liquidity injections, putting particular pressure on a value investing style that traditionally sees the strongest relative performance during expansionary phases in the cycle.
Value investing can also perform well in such a market environment, if it is tailored to the appropriate point in the cycle. Close attention must be paid to stock selection to allow investors to outperform the market despite value headwinds. By adjusting the selection criteria for stocks, a value investing approach can be tailored to suit any market environment.
During a slowdown phase, investors must focus on good quality, low risk stocks. This involves investing in companies that have good balance sheets and sustainable dividends The dividend sustainability angle will add a quality tilt to the stock selection process.
A sustainable dividend can be viewed from both a financial and an ESG viewpoint. In the first instance and from a financial perspective, the company must be robust enough to support such dividends. An investor must ask: does the company generate enough profit and cash-flow to maintain and grow its dividend?
However, this dividend must also be analysed from an ESG perspective to assess its sustainability. By focusing on ESG risk (e.g. the likelihood of a carbon tax in the future), investors can reduce the risk that dividends will fall in the future. Focusing on ESG in this way has been proven to imply a lower risk profile, maximising risk-adjusted returns.
One important caveat to this approach is that while some sectors are naturally biased, both positively or negatively, by an ESG approach, it is important not to systematically penalise certain sectors in terms of allocation.
To allow for this ESG differential, ESG scores must be normalised by sector and size, selecting the best ESG players from each. .
Once appropriate stocks have been selected, a value investor must not be afraid to make significant active decisions to outperform the market. This can lead to portfolios with a very high active share that a passive fund can’t offer.
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