In India, corporate governance (G) is perhaps the most understood and visible aspect of the three ESG factors, which include:
- Environment: How companies make efficient use of resources and its impact (energy, water, waste management, etc.
- Social: Ripple effects on the broader community (Labour, Privacy & Data Security, Product Safety)
- Governance: Practice & policies, disclosures, corruption & instability, ethics and fraud, anti-competitive practices, etc.
In the recent past, few instances of misgovernance (PNB & YES Bank) and labour strikes (Toyota Kirloskar, Maruti Manesar) led to systemic risks in markets, embedding the importance of ESG factors in investment decisions. Today, regulatory actions are being implemented in India to ensure better ESG standards in corporates.
Benefits of ESG compliant companies
Compliance with ESG factors is part of the non-financial information released by companies. ESG compliant companies have sustainability advantage, socially responsible approach and strong governance, which ensures the longevity of business and provides a cushion from the risks of climate change, and irresponsible and unethical business practices.
From investors’ point of view, ESG companies can deliver an edge to their portfolios in the following ways.
Premium valuations
ESG values have been proven to assure sustainability of the business and offer a hedge against external shocks. Hence, ESG compliant companies offer the potential to command better valuations.
Also, ESG companies are mostly large cap in nature and are known to deliver steady compounding of returns.
Stable dividend yields
Companies with higher ESG scores also reveal a better long-term alignment with shareholders and other stakeholders.
A glance at the Nifty 100 ESG index confirms that stocks from this universe are generally dividend yielding in nature. The likes of ITC, Hindustan Unilever, Infosys, Tata Consultancy Services, among others, tend to distribute a part of their free cash flows fairly regularly.
An edge in re-rating
In addition, qualitative aspects such as goodwill/reputation with stakeholders, disclosure transparency and commitment of the management, among others, work in favour of ESG companies. Thus, these stocks tend to attract attention from investors.
In the post-Covid era, companies with good balance sheets and benefits of scale are slated to gain market share thus boosting earnings and valuations.
Potentially higher flows from foreign funds
Integration of ESG factors into the investment process has become a key criteria for decision-making in Europe, Canada, North America, Australia and New Zealand and also, to some extent, in Asia. We can therefore clearly expect that only ESG complaint companies will be prioritized for such investors’ exposure to India.
Similarly, when the weight of India in an international index (such as the MSCI EM Index) increases, ESG compliant companies will gain from the inflows.
Gaining from ESG
One of the key things to remember about ESG investing in India is that currently the pool of companies that qualify is still restricted. In terms of sectors, the NSE 100 ESG Index TRI, which is the most common benchmark for active ESG funds is overweight on banks and financial services and information technology. This implies a high concentration risk at present.
Also, alpha generation is not restricted to ESG stocks alone. There are ample opportunities in the non-ESG, mid and small cap spaces as well.
We therefore recommend determining an asset allocation that allows for the right exposure to ESG funds, bearing in mind the opportunities and risks of this theme. When ESG funds are included as part of one's portfolio, they should be a part of the 'Indian equities - Large cap' category allocation.
Investors can enter ESG funds via the SIP route to average their cost of acquisition over the long term. They can also consider deploying lumpsums on days when markets correct sharply.
Rachana Makhija is Senior Research Analyst at iFAST Financial India. The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.