New research suggests that institutional investors might be pouring too much love on companies with high ESG ratings, leading them to be overvalued. One result? Activists and other large block holders are building positions in companies rated poorly on environmental, social, and governance metrics, hoping to improve their standing and boost their stock prices.
Even as institutional investors are highly motivated to add companies with strong ESG scores relative to other financial measures to their portfolios, large blockholders and activist investors are less motivated by these ratings, according to a paper, called “Institutional Investors and ESG Preferences,” from the European Corporate Governance Institute, a non-profit research association. Not only are the activists not motivated by high ratings, there is a negative relationship between the size of the ownership stake and ESG. Of course, companies underperforming on ESG scales may also be low financial performers.
There’s “a strong relationship” between institutional holdings and a company’s combined ESG ratings — institutional investors prefer to invest in companies with high-quality ESG characteristics, according to the paper’s authors, including Florencio Lopez de Silanes, a professor of finance at SKEMA Business School, and Joseph McCahery, a law professor at Tilburg University. The authors characterized institutional investors’ preference for these sustainable companies as strong, especially relative to other financial performance metrics. The authors constructed a data set for the study based on total ESG scores as well as information from Bloomberg, Sustainalytics, and Robeco.
Investors buy companies — and bigger positions in these firms — with strong ESG ratings, because they are willing to sacrifice some financial performance if they know that the companies are ethical and sustainable, the authors wrote.
“On the other hand, it may be that these investors are motivated not purely by ESG considerations but also by the possibility that ESG is correlated with firm financial performance,” De Silanes, McCahery, and Pudschedl wrote. “Indeed, the survey literature suggests that most institutional investors consider ESG factors because they believe them to be linked to financial performance.”
But large shareholders and activist investors feel less compelled by these ratings. The authors said while their sample of blockholders and activist investors is small, this finding is consistent with the historical literature.
The authors argue that this paradox — the negative relationship between the size of the ownership stake and the ESG score of a company — points to the idea that high-quality ESG companies are over-hyped by institutional investors. They argue that companies with high ESG scores are therefore in danger of being overvalued as a result of inflated attention from institutional investors.
“These results lend support to the claims that activist investors are increasing their stakes in companies with poor ESG performance” and are rarely interested in voting or backing environmental and social issue-related shareholder proposals, according to the authors.
However, while scores on environmental and social progress are important, both general institutional investors and large shareholders are more interested in and motivated by a company’s disclosure of ESG criteria.
The authors also found that institutional investors are generally more compelled by high governance scores than top marks on social and environmental factors.