ESG Investing: A Constraint or An Opportunity? Summary About the Authors

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ESG Investing: A Constraint or An Opportunity? Gautam Dhingra, Ph.D., CFA GDhingra@HighPointeCapital.com Christopher Olson, CFA COlson@HighPointeCapital.

Do Not Quote or Distribute without Permission. Summary ESG investing brings with it the hope of doing well by doing good.

High Pointe is in a unique position to contribute to this debate because its Franchise Quality Score methodology has put it at the forefront for observing the impact of ESG and other intangible

1 ESG Investing: A Constraint or An Opportunity? Gautam Dhingra, Ph.D., CFA GDhingra@HighPointeCapital.com Christopher Olson, CFA COlson@HighPointeCapital.com Presented at the CFA Society Chicago Symposium, tember 7, 2017 (Revised tember 2018) High Pointe Capital Management, LLC, All Rights Reserved. Do Not Quote or Distribute without Permission. Summary ESG investing brings with it the hope of doing well by doing good. An important debate among investors is whether data and evidence kindle this hope or dash it. High Pointe is in a unique position to contribute to this debate because its Franchise Quality Score methodology has put it at the forefront for observing the impact of ESG and other intangible factors on stock valuations over a long period of time. In this paper we demonstrate the efficacy of ten specific ESG factors. We conclude that ESG considerations do not act as a constraint on one s ability to maximize investment returns. At the same time, ESG factors, by themselves, do not generate additional returns. It is, therefore, incumbent upon the investor to apply ESG factors as part of a holistic investment process to extract the value inherent in them. About the Authors Gautam Dhingra is the Founder and CEO of High Pointe Capital Management, LLC. He developed the firm's pioneering investment approach based on the concept of Franchise Quality, and under his leadership, High Pointe has built an enviable investment performance record. Dhingra served as a faculty member at Northwestern University s Kellogg School of Management for two years. His research interests include ESG investing and valuation of intangible assets. Christopher J. Olson, CFA, is a principal and portfolio manager at High Pointe Capital Management. Prior to High Pointe, he was a portfolio manager at Columbia Wanger Asset Management in Chicago for 15 years and a partner at Brinson Partners for six years. Olson received an MBA from the Wharton School of Business with Distinction and an MA in International Studies from the School of Arts and Sciences, both at the University of Pennsylvania.

2 Introduction The term ESG investing refers to assessing individual companies Environmental, Social and Governance practices and incorporating that information for making buy and sell decisions. In its simplistic form it can mean buying only those companies whose practices exceed a certain threshold level. In a more holistic format, it means combining ESG factors into an investment process that also incorporates other relevant factors such as a company s valuation, growth and quality characteristics. ESG Data Over the last few years the availability of data regarding companies ESG practices has exploded. As a result, it is now feasible to study the efficacy of specific ESG factors for their impact on future stock performance. One of the most comprehensive ESG databases is the one compiled by Thomson Reuters. It covers 6000 public companies, measures more than 400 different ESG metric. The data are constantly updated by 150 content research analysts that are trained to collect ESG data. The data are categorized into ten broad factors listed below. Environmental Factors 1. Resource Use (e.g., water efficiency, use of renewables) 2. Emissions (e.g., CO 2 emissions, waste reduction initiatives) 3. Innovation (e.g., designing and using eco-friendly products) Social Factors 4. Work Force (e.g., health, training and development, diversity) 5. Human Rights (e.g., child labor safeguards) 6. Community (e.g., business ethics, community involvement) 7. Product Responsibility (e.g., data privacy, customer safety) Governance Factors 8. Management (e.g., board independence and diversity) 9. Shareholders (e.g., equal treatment, no takeover defenses) 10. CSR Strategy (e.g., sustainability reporting) The database also includes a composite ESG score for each company based on a weighted average of the ten component scores. An interesting feature of the dataset is that environmental and social scores for companies are assigned relative to other companies in their respective industries, and governance scores are assigned relative to all companies in the dataset.

Testing the Efficacy of ESG Factors We test the efficacy of ESG factors on the ubiquitous S&P 500 Stock Index using data starting on ember 31, 2007 and ending on e 30, 2018.

3 Testing the Efficacy of ESG Factors We test the efficacy of ESG factors on the ubiquitous S&P 500 Stock Index using data starting on ember 31, 2007 and ending on e 30, First, we show how many companies score well or poorly based on the composite ESG score. Excellent Companies are defined as those scoring 75 or higher, Good as those scoring between 50 and 75, Fair as those scoring between 25 and 50, and Poor as those scoring below 25. The area chart below is based on number of holdings in each category. It shows that over time, the scores of S&P 500 companies have improved as consciousness about the importance of such factors has increased. Next, to test the efficacy of ESG factors for future stock performance, for each of the ten ESG factors we create two portfolios. One portfolio consists of S&P 500 companies rated Excellent or Good ( High ESG Portfolio ) and the second portfolio consists of companies rated Fair or Poor ( Low ESG Portfolio ). In addition to creating two portfolios based on each individual factor we do the same based on the composite ESG scores as well. These portfolios are created on a monthly basis over the testing, from ember 31, 2007 to e 30, 2018 using the ESG score of the companies at the time of the composition of the portfolios. We then measure the future performance of each portfolio over the next month, and repeat the process for each of the 126 months. This exercise sets us up to perform a statistical test of the excess performance of the High ESG and Low ESG portfolios relative to the S&P 500 Index. We are cognizant of the possibility that our High ESG and Low ESG portfolio could have inherited some unintended biases in terms of investment style (value vs. growth) or size (small cap vs. large cap) compare to the broad market. To adjust for such biases, we perform our statistical test using the Fama-French three factor model which eliminates the impact of any style bias or capitalization bias that might have occurred during the portfolio creation process.

4 The result of the statistical testing using the Fama-French model are shown in the table below. The column labeled Alpha shows the excess return of the portfolio per month and the column labeled t-statistic measures whether the Alpha estimate is statistically significant. In order for the alpha estimates to be considered statistically significant, t-statistics should be 2 or higher in terms of absolute value. Efficacy of ESG Factors ember 31, 2007 e 30, 2018 High ESG Companies Low ESG Companies Alpha t-statistic Alpha t-statistic Composite ESG Score 0.00% % Environmental Factors Resource Use 0.02% % Emissions 0.00% % Innovation 0.00% % Social Factors Work Force -0.01% % 1.12 Human Rights 0.05% % Community -0.02% % 1.08 Product Responsibility -0.06% % 2.02 Governance Factors Management 0.02% % Shareholders 0.01% % CSR Strategy 0.02% % These results show that t-statistics are almost universally below 2 for each individual factor as well as for the ESG composite score. The only exception is the t-stat for the Product Responsibility factor, but only for the Low ESG companies, not for the High ESG companies. The implication of these results is that ESG factors, by themselves, are neither a constraint nor an automatic opportunity for enhancing returns. Advocates of ESG investing should be encouraged by the evidence that limiting the universe of securities to High ESG companies does not incur a performance penalty. At the same time, it should be noted that ESG factors by themselves cannot generate excess returns; they need to combined with other relevant factors in a holistic manner in order to be useful. In the next section, we show High Pointe s own experience in incorporating ESG and other intangibles in such a manner.

5 High Pointe s Historical Perspective on ESG Investing High Pointe s investment process was developed on the central premise that as the U.S. economy made its transition from the manufacturing era to the information era, more and more of the value of companies was going to shift to intangible assets such patents, brands, network effect, reputation, employee satisfaction, etc. rather than physical assets such as plant & equipment and inventory. This insight led the firm to create a metric called the Franchise Quality Score to measure a company s intangible assets and use it as a key component of selecting stocks for the firm s value-oriented investment strategy. This score is calculated by assigning a value to eight component factors on a scale of 1 to 5. As ESG data availability improved it allowed us to explicitly incorporate them in our evaluation framework. The eight components are designed to answer two all-encompassing questions: How good is the business? How well is it being managed for long-term success? The eight components of the Franchise Quality Score are listed below with a brief description of the 1 to 5 scale used for scoring each one. How Good is the Business? Factor Barriers to Entry High Medium Low Degree of Competition Benign Balanced Cut-throat and Oligopoly Fragmented Pricing Power vs. Customers Sellers Market Equilibrium Buyers Market Pricing Power vs. Suppliers Buyers Market Equilibrium Sellers Market How Well is It Being Managed for Long-Term Success? Factor Management Governance Engagement with Employees, Community and Government Sustainability of Competitive Advantage Excellent Track Record Unproven / Mediocre Poor Record Shareholder Mixed Entrenchment Oriented Mentality Partnership Average Short-term profit orientation Long Lasting Medium Short / Unpredictable High Pointe derives the composite Franchise Quality Score derived from this framework and uses it as an independent variable in a regression model that uses valuation, quality and growth factors to identify undervalued stocks. We believe that evaluating the merits of a stock in light of its valuation, quality and growth characteristics is not only logical but also mathematically consistent with the Discounted Cash Flow approach to stock valuation. (For more on this mathematical comparison, please see our paper entitled Franchise Quality Score A Metric for Intangibles available via the link below). High Pointe's Intangibles Paper published on CFA Institute's Blogsite

6 The components of Franchise Quality Score that address the question How well is the business being managed for long-term success automatically tilt High Pointe s portfolios towards companies that are good stewards from an ESG perspective. It is not surprising, therefore, that compared to its market benchmark, Russell 1000 Value Index, High Pointe s value-oriented strategy shows dominance of such companies in the portfolio as demonstrated in the two charts below. These charts show the percentage of companies that were ranked Excellent, Good, Fair and Poor in terms of their ESG score. The left-hand side chart shows the data for the benchmark, Russell 1000 Value Index, and the right-hand side chart shows the data for High Pointe s portfolios from ember 31, 2007 to e 30, % 80% 60% 40% 20% Russell 1000 Value Holdings by ESG Category 0% Excellent Good Fair Poor High Pointe's Holdings by ESG Category 100% 80% 60% 40% 20% 0% Mar Mar Mar Excellent Good Fair Poor These data show that the ESG scores of companies have improved on average as consciousness about their importance has increased. The proportion of companies in the Russell 1000 Value Index with a rating of Excellent or Good has increased from 18% to 56% over the last ten years. High Pointe s portfolios have been consistently overweighted in highly rated ESG companies relative to the benchmark. Over the last ten years the proportion of companies in High Pointe s portfolio that are rated Excellent or Good has increased from 57% to 100%.

7 Conclusion As ESG investing soars in popularity, it brings urgency to the need to know whether it is an opportunity to enhance investment returns or a constraint on maximizing returns. Our analysis shows that investing using simplistic ESG screening criteria is not likely to incur a performance penalty but, at the same time, it is not likely to add alpha by itself either. ESG factors do help capture the quality dimension of individual stocks. However, the quality dimension needs to be evaluated along with the growth and valuation dimension to identify undervalued stocks. We believe such a holistic integration of ESG factors can help an investor outperform the broad market. Our own experience managing money successfully over the years validates this belief.

REUTERS/Ognen Teofilovski. Thomson Reuters ESG Scores Date of issue: March 2017

REUTERS/Ognen Teofilovski. Thomson Reuters ESG Scores Date of issue: March 2017 REUTERS/Ognen Teofilovski Thomson Reuters ESG Scores Date of issue: March 2017 2 Contents Executive Summary...3 Data Process...4 Global Coverage...5 Scores Overview...6 Scores Structure...6 Scores Calculation