Sustainable portfolios more expensive? Really?

Sustainable portfolios more expensive? Really?

Conventional wisdom has it that sustainable portfolios are more expensive. Indeed, those investing in high-quality companies and exhibiting more of a value bias may be seen as comparatively expensive. However, we need to ask ourselves two questions to address these statements.

First of all, does a portfolio invested in sustainable equities always mean a sacrifice in growth?

Secondly, are high-quality companies expensive across the board?

Sustainable investment pertains to companies that are committed to longer-term sustainability issues and offer solutions to current and future challenges.

Studies have demonstrated the advantages of companies which are better positioned in terms of environmental, social and governance challenges.

The main ones are as follows:

• competitive advantages in terms of products, labour and capital markets;

• lower volatility;

• lower capital costs;

• and increase of operational efficiency and easier expansion onto new markets.

Companies better positioned in terms of ESG may offer long-term investors greater stability with regard to price and earnings volatility, and in the case of US equities, may have even protected against the risk of default, some studies argue.

ESG criteria may have sound predictive powers with regard to future risks by isolating non-fundamental risks which may nonetheless have a real impact on corporate profitability, therefore making them a relevant indicator for the volatility of future profits.

High-quality companies don’t just refer to companies with an outstanding ESG profile.

Rather, it concerns profitable companies, active in a growth sector, particularly those with the objective of providing solutions to environmental, social and governance issues, which have a sustainable business model, and that have taken into account ESG challenges to ensure a competitive advantage and an edge on competitors.

Companies that think about their products in terms of life cycles and which make innovative and technological contributions to greater sustainability are growth companies.

Consider, for example, companies specialised in more efficient ventilation and heating systems, companies in the vanguard of the power semiconductors for electric vehicles market, or companies which work on innovations intended to replace petrol with fermentation enzymes as the preferred raw materials of the production processes.

Looking at DPAM’s World Sustainable Equity Strategy, we see that in terms of portfolio profitability, its return on equity is considerably higher than that of a reference universe. The same goes for the net profit margin. And the capex to sales ratio is only half as high, with superior cash conversion.


Characteristics of DPAM’s World Sustainable Equity Strategy vs. Reference Universe

World Sustainable Equity portfolio        Reference universe (MSCI World)

Return on equity                                     18.5%                                                            10.1%
Net profit margin                                     14.8%                                                            7.9%
Cash conversion                                       98%                                                             89%
Capex to sales ratio                                 6.7%                                                            15.1%

Source: Degroof Petercam AM as per the end of September 2017

Quality is not exclusive to individual companies, but also ought to be reflected on a global portfolio level in order to provide investors with risk-adjusted performance in the mid to long term throughout the market cycle.

With regards to the portfolio, quality has an impact on three levels:
• quality of the underlying assets, namely the quality of the individual stocks it contains;
• portfolio liquidity;
• portfolio profitability.

As DPAM’s World Sustainable Equity strategy is primarily focused on large caps, portfolio liquidity is not an issue here.

Moreover, the median market cap is nearly three times as high as the reference index (€33bn vs €11bn).

Finally, we address the claim that sustainable company portfolios are less diversified. While reducing the universe based on quality criteria for a company’s ESG profile continues to be seen as an impediment to portfolio diversification, it may also be seen as a risk optimisation tool that avoids the riskiest profiles.

Reinforcing the ESG properties of a portfolio, either top-down in terms of sustainable investment themes and sub-themes or bottom-up in terms of qualitative and fundamental selection of individual securities, has resulted in a 15% decrease in portfolio volatility in DPAM’s World Sustainable Equity strategy.

It is true that the allocation to sustainable themes and sub-themes may result in a kind of sectoral concentration. However, in the mid to long term, these are also the sectors that come out on top.

In sum, it’s a nuanced story. Both financial and ESG sustainability are crucial and risk mitigation is an important criterion to consider sustainable investments. The latter may result in lower portfolio volatility, potentially higher Sharpe ratios and decreased probability of drawdown risk during heavy periods of turmoil in financial markets.

Ophélie Mortier (pictured) is responsible investment strategist at Degroof Petercam Asset Management.