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How Futureproof AreYour Stocks?

Can a company survive and thrive in a world reshaped by environmental and social shifts? Global asset managers are changing the way they value stocks to find out.

For many investors it’s enough to sprinkle their equity portfolios with a few solar farms and good corporate citizens to give it an element of sustainability.

But those days are fading fast, at least for some of the bigger players.

Environmental and social changes forecast for the next decade are so significant, and the amount of money now in search of sustainable investing so enormous, that some of the biggest global asset management firms are realizing they need to rethink their approach to stock market value.

“We are increasingly responding to calls from fund managers asking us for ways to analyze Environment Social and Governance (ESG) factors and how to incorporate that analysis into their existing methods of valuing stocks,” says Jessica Alsford, Head of Morgan Stanley’s Sustainable and Responsible (S+R) equity research group.

Alsford isn’t only talking about portfolio managers of sustainable and responsible investment mandates. The main requests are coming from generalist portfolio managers at some of the biggest global asset management firms.

“They’re realizing that they need to respond to the demand for sustainable approaches to investing and also that it’s possible to enhance their investment analysis by incorporating ESG factors into their stock picking process,” says Alsford.

Paradigm Shift

It could be the beginning of a paradigm shift in the way asset managers determine whether a stock is under or over-valued.

If investors have the tools to incorporate ESG factors, such as carbon output or cyberattacks, into popular valuation models, then companies could find their stock price is at risk if they don’t adopt effective ESG strategies.

“It’s not enough anymore just to be a good corporate citizen,” says Alsford. “Increasing numbers of asset managers want to know that a company is managing the risks and seizing the opportunities arising from environmental and social changes in a way that drives shareholder value. Environmental and social sustainability equates with a corporate’s own long-term financial sustainability.”

Normally, typical stock valuation models look at key financial items, like a company’s ability to generate enough free cash flow and profits to expand organically, make acquisitions, buy back shares or increase dividends.

Very often, ESG issues are mistaken for peripheral, secondary concerns, and if they ever do come to the forefront, it’s usually after the damage to stock value has already been done. However, having watched how often stocks have plunged on news of cybersecurity lapses and the like, fund managers are now wondering whether those “unforeseen” risks can’t be gauged beforehand.

It’s a tall order, and something that raises a raft of questions. How many environmental and social risks and opportunities are there? How relevant are they, and to what sectors? Then, once the ESG pressure points are identified and analyzed, how is a value assigned and where does that fit in the typical valuation methodologies used by analysts and fund managers?

Morgan Stanley’s S+R group has developed a global framework that gives fund managers the tools to answer those questions for 29 different equity market sectors.

“Company valuations are typically based on an analysis of how financial capital is deployed to generate growth and returns,” explains Alsford. “We supplement this with analysis of three other types of capital: natural, human and social. Governance is also key.”

Carbon output, water and food scarcity are examples of “natural” capital, while supply chain controls to minimize reputational damage fall into the “social” capital bucket. The impact of an aging population on corporate pension costs and healthcare issues are “human” capital.

Placing a value on ESG

Morgan Stanley’s framework identifies which ESG risks and opportunities could pose significant positive or negative pressure on a company’s earnings or cash flow. It then shows where to incorporate those factors in a typical stock valuation model, such as discounted cash flow.

Take a carbon-intensive industry, for instance. “We would analyze how the profits and cash flow of a company in that industry may be impacted if new legislation introduced a carbon price,” Alsford says. “We then show where the issue of carbon output can affect stock value at various parts of a typical valuation model, for example, operating costs, capital investment or discount rate.”

The move toward more comprehensive stock valuation analysis that includes social and environmental factors will no doubt increase the pressure on companies to tackle the ESG exposures they face, good and bad. But ultimately the companies that rise to the call will be the winners in a world where corporates along with everyone else will be affected by pervasive water scarcity, demand for more food and an aging population.

As Alsford points out: “If we help investors allocate capital to companies that understand and act upon the environmental and social changes underway, then those companies will be receiving the financial support they need to ensure their own long-term survival in a world that’s going to look very different even five years from now.”

For more Morgan Stanley Research on global economic trends, ask your Morgan Stanley representative or a Financial Advisor for the full report, “Embedding Sustainability into Valuation” (Jan 27, 2015), and more continuing coverage.

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