ESG Scores (Environmental, Social, Governance)

Definition

• ESG scores are composite ratings provided by third-party agencies (such as MSCI, Sustainalytics, or Refinitiv) assessing a company’s performance in:

• Environmental (e.g., carbon footprint, energy use, waste management),

• Social (e.g., labor practices, diversity, community relations),

• Governance (e.g., board structure, business ethics, shareholder rights).

• Scoring systems vary by provider, but higher scores indicate stronger ESG practices and lower risk of ESG-related incidents.

Example

• Tesla (TSLA) has received both high and middling ESG scores, praised for its environmental focus but criticized for governance or social controversies.

• Unilever (UL) is often ranked highly due to sustainable sourcing and social initiatives.

Interpretation & Usage

• High ESG scores can reduce regulatory, legal, and reputational risks.

• Many institutional investors (e.g., pension funds) require minimum ESG standards.

Buy/Sell Strategy:

• Buy: Stocks with rising ESG scores or those outperforming peers, anticipating both lower risk and access to ESG-focused investment flows.

• Sell: Stocks with falling scores, controversies (e.g., pollution fines, labor scandals), or exposure to future regulation.

Real-World Impact:

ExxonMobil (XOM) and other oil majors have seen some institutional investors sell shares due to weak ESG performance, while NextEra Energy (NEE) has benefited from ESG-focused inflows.

Board Independence Ratio

Definition

The board independence ratio is the proportion of board directors who are independent—i.e., not company employees or otherwise connected. High independence is a hallmark of strong corporate governance.

Interpretation & Usage

• A high ratio suggests checks on management, reduced risk of fraud or self-dealing.

• Required minimums vary by country/exchange (often 50%+ in the US, UK, EU).

Buy/Sell Strategy:

Buy: Companies with high or improving board independence, signaling effective oversight.

Sell: Companies with low independence, especially if facing scandals or activist pressure.

Real-World Example:

In 2018, investor concerns about the lack of independent directors at Facebook (Meta) led to calls for governance reform.

Executive Compensation Ratio (CEO Pay Ratio)

Definition

The executive compensation ratio compares CEO (or top executive) pay to that of the median company employee.

Interpretation & Usage

• Lower ratios suggest a more equitable pay structure.

• Extremely high ratios may indicate weak governance, poor morale, or potential social backlash.

Buy/Sell Strategy:

• Buy: Firms with reasonable and transparent pay policies, especially where performance links are clear.

• Sell: Firms with high and unjustified ratios, especially amid poor performance.

Real-World Example:

The Business Roundtable and ESG funds have pushed for fairer pay, and companies like Costco (COST) are lauded for modest CEO pay compared to peers.

Goodwill and Intangibles

Definition

Goodwill and intangible assets represent non-physical assets (like brands, patents, customer relationships) often acquired through M&A. Goodwill arises when a company pays more for an acquisition than the book value of net assets.

Interpretation & Usage

• Moderate or growing intangibles may reflect investment in brand or IP.

• Excessive or rapidly rising goodwill (without synergies) can signal overpayment for acquisitions—risking future write-downs ("impairments") that hurt profits and share price.

Buy/Sell Strategy:

• Buy: Firms with high intangibles if they consistently translate to pricing power, margins, or market share (e.g., Coca-Cola’s brand value).

• Sell: Firms making serial, expensive acquisitions that later require write-downs (e.g., GE, HP)—often a sign of poor capital allocation.

Example:

In 2015, Kraft Heinz (KHC) wrote down $15 billion in goodwill, causing a major stock drop.

Restructuring/Extraordinary Items

Definition

Restructuring or extraordinary items are significant, non-recurring gains or losses (e.g., asset sales, layoffs, litigation settlements, disaster costs). They appear "below the line" in income statements.

Interpretation & Usage

• Occasional, well-explained items can improve efficiency (e.g., restructuring to cut costs).

• Frequent or large extraordinary items may obscure real performance or signal deeper problems.

Buy/Sell Strategy:

• Buy: If restructuring charges position the company for future growth and management is credible (e.g., temporary earnings dip but improved margins ahead).

• Sell: Firms with recurring "one-off" charges, signaling a pattern of missed targets, operational issues, or aggressive accounting.

Real-World Example:

Ford (F) and General Electric (GE) have both announced major restructurings with significant charges; sometimes share prices rebound after the initial pain if the market trusts the turnaround.

How Investors Use Quality, Governance & Sustainability Fundamentals

• Institutional & ESG investors screen out companies with poor governance or ESG records and overweight those with strong scores.

• Activist investors may buy companies with poor governance intending to push for change (and price appreciation).

• Risk-averse investors sell or avoid stocks facing ESG controversies, governance scandals, or excessive intangibles.

Portfolio Example:

A pension fund may only invest in companies with an ESG score above a certain threshold and a minimum board independence ratio, while excluding those with frequent extraordinary charges or excessive goodwill.

References

CFA Institute. (2023). CFA Level 1 Curriculum – Corporate Governance, ESG and Stewardship.

Gompers, P., Ishii, J., & Metrick, A. (2003). "Corporate Governance and Equity Prices," Quarterly Journal of Economics, 118(1), 107–155.

MSCI ESG Ratings Methodology (2024).

Investopedia. (2024). "ESG Score," "Board Independence," "CEO Pay Ratio," "Goodwill Impairment," "Extraordinary Items."

Yahoo Finance, Company Filings and ESG Data.