Exploring Stock Performance Through an Enhanced Fama-French Model
Suppose you are presented with a choice between a blue pill and a red pill, just like in The Matrix, but this time Morpheus is wearing a navy blue Patagonia vest instead of a leather jacket. Take the blue pill and enjoy your traditional approach to investing, focused solely on generating high returns, or take the red pill and realize that we all have the power to create impactful change and venture into the landscape of responsible investing. These are both equally compelling options, but personally, I chose red. This led me to research the impact of incorporating Environmental, Social, and Governance (ESG) factors into the traditional Fama-French Three-Factor Model for my thesis.
Why ESG?
If you are familiar with the term ESG, you might have rolled your eyes along with many investors who initially dismissed it due to its politicization, performance concerns, or lack of standardized metrics. Yet, ESG investing has begun regaining momentum. ESG scores, which quantify a company’s environmental, social, and governance practices, have become vital as global efforts toward sustainability grow. These scores reflect a company's commitment to sustainable practices, covering areas such as climate risk mitigation, employee working conditions, ethical standards and corporate behavior, executive compensation, and so on.
Therefore, as investing regarding this metric accelerates, investors are increasingly prompted to choose between the comfort of the familiar and the challenges of integrating new and complex factors into their portfolios. But is embracing ESG truly the path to a better, more sustainable future, or does it come with trade-offs that could impact financial returns?
The Fama-French Model — A Recap
Now, if reading this makes you feel like you would rather just stay in the Matrix, do not worry, a quick recap of the fundamentals should prepare you to venture further.
Imagine you are Neo, our beloved protagonist looking for the best strategies to beat his nemesis, Agent Smith, while leveraging his ability to manipulate the simulated reality of the Matrix, or in this case financial markets. In the world of investing, one of those strategies would be called factor investing. Think of it as scouting for the specific qualities that make members —or factors— on your team more likely to succeed. You are not just picking members at random; you are choosing the ones with the best traits to give your team an edge. In your plan, the Fama-French 3-Factor Model helps you focus on three key members. Firstly, Market Risk: this is the overarching system, much like the Matrix itself. It represents the general ups and downs of the entire market, affecting all stocks to varying degrees. Market risk is the broad, systematic force that no company can escape. Next, The Size Member: think of this as Trinity, fast and agile, able to move nimbly through the financial landscape, much like how small-cap companies can outperform larger, more established ones. This factor captures the additional returns generated by smaller companies that can outmaneuver the larger giants. The Value Member: this is your Morpheus, the wise guide who sees value where others do not. This factor reflects the idea that undervalued stocks (value stocks) often outperform growth stocks over time. Like Morpheus helping Neo spot hidden truths, this factor helps you identify opportunities others might miss, capturing the additional returns from those often-overlooked companies.
Factor investing is all about assembling a team chosen for their specific strengths that have been proven to help win more battles over time (i.e., generate better returns). Now, you are adding a new member to the roster: The ESG Member. This member is all about doing the right thing—making sure the team fights with integrity, minimizes negative externalities, and ensures ethical judgment is used in all scenarios. By including ESG as a factor, you are exploring whether this new addition can not only help the team win more battles but also make a positive impact on the world.
My thesis explores this by extending the Fama French 3-factor model with an ESG component. We analyze how ESG scores affect the monthly returns of companies listed on the EURO STOXX index between December 1999 and January 2023. This component essentially captures the additional returns investors can expect from investing in companies with high ESG scores over those with low ones.
Therefore, by incorporating ESG into the model, I aim to quantify whether investing in companies that prioritize environmental, social, and governance principles can provide superior financial performance—offering both, returns and positive societal impact. In doing so, I hope to demonstrate how this "red pill" that is ESG investing can not only help decode the market but also lead to a more sustainable future!
Key Findings – The Big Reveal?
One of the central findings of the thesis revealed an interesting relationship between ESG scores and stock return, something your average Joe might have guessed, but this time there is actual research to back it up. The study showed that, on average, higher ESG scores are associated with lower stock returns. This suggests that while European companies with high ESG ratings are perceived as lower-risk investments due to their sustainable practices, they may not necessarily offer the highest financial returns compared to companies with lower ESG ratings. This trade-off highlights the complex nature of ESG investing: investors might accept lower returns in exchange for supporting companies that align with their ethical values or contribute to long-term sustainability.
Another key finding was that during periods of extreme market volatility, the influence of the ESG factor on portfolio returns diminishes. In such times, traditional financial metrics like earnings, cash flow, and valuation ratios take center stage, and investors focus on immediate financial stability over long-term ESG goals—much like characters in The Matrix reverting to survival mode when under threat. As fear sets in and stock prices drop, high-ESG stocks with premium valuations could tumble faster if their prices are not justified by their valuation multiples. In these moments, investors fall back on basics, looking for undervalued stocks through metrics like earnings yield and dividend coverage ratios that promise better risk-adjusted returns.
The Role of ESG in Risk Management
On a more granular level, despite the negative correlation between ESG scores and returns, the study suggests that ESG factors still play a significant role in risk management. Companies with high ESG scores tend to have lower operational risks, better brand loyalty, and a more stable investor base. These factors can make them more resilient during economic downturns, even if they do not always deliver the highest returns. For instance, during the 2007-2009 financial crisis, the findings showed that value stocks —categorized by high book-to-market ratios that also typically have higher ESG scores due to their stable nature— outperformed growth stocks, indicating that ESG factors can provide a cushion during turbulent market periods to an extent.
The Question You Actually Want The Answer To: Should You Invest Based on ESG Scores?
The decision to invest in stocks based on ESG scores should be guided by your investment goals and risk tolerance. For long-term investors who prioritize sustainability and are willing to accept lower returns in exchange for supporting companies that contribute to a better future, ESG-focused investments can be a good fit. However, if you are more concerned with short-term gains or are navigating a highly volatile market, it may be wise to balance ESG considerations with traditional financial metrics.
One way to achieve this is through sector-specific investing, focusing on areas where ESG factors are likely to enhance performance. For example, the upcoming EU Deforestation Regulation (EUDR) will impact companies involved in commodities like rubber, palm oil, cocoa, and livestock products such as beef. These new rules require stringent due diligence and traceability for raw materials, potentially causing financial and reputational risks for non-compliant companies. Given this heightened regulatory scrutiny, it may be prudent to shift part of your portfolio toward sectors and companies proactive in their ESG practices. Companies in industries like automotive, agriculture, and consumer goods may face increased costs and supply chain disruptions as they work to meet EUDR requirements. Thus, investors should carefully consider how these regulations will impact profitability and assess the risks accordingly.
The Bottom Line
If you are committed to sustainable investing, it is important to maintain a long-term perspective. While short-term returns may be lower, high-ESG companies often benefit from lower risks and stronger brand loyalty, which can pay off over time. The new regulations mentioned above are part of a broader trend toward sustainability that is unlikely to reverse. As such, investing in companies that prioritize ESG factors, beyond mere compliance, may offer better long-term returns. These companies tend to be more resilient to regulatory changes and can capitalize on the growing demand for sustainable products.
In the end, ESG investing may not always deliver the highest returns, but it offers a balance between profitability and ethical responsibility— a choice that resonates with the red pill, or should I say green pill mindset: to see beyond short-term gains and work toward a more sustainable financial future.
Opmerkingen