Incident data could aid investors

Governance, environmental and social effects

With the annual meeting season still a couple of months away and with the material for those meetings not yet published, institutional investors are in somewhat of an informational lull when it comes to governance issues.

But given the overall trend of increased attention given to environmental, social and governance factors — an attention that will only increase according to the pundits — a recently released 40-page report by Sustainalytics could provide some good reading.

The report offers “the first-ever quantitative analysis of Sustainalytics’ incident dataset,” and is based on 29,000 “incidents” that occurred in 176 countries over the period 2014 to 2016. An incident is defined as “company activities that generate undesirable social or environmental effects.”

Of the incidents analyzed, 59 per cent involved social factors; 31 per cent governance factors and 10 per cent environmental. Sustainalytics said it assesses each incident according to two criteria: its sustainability impact (the severity, the company’s accountability and the “exceptionality” of its involvement); and the reputational risk (defined as notoriety and exposure) presented.

First some of the key facts: 30 per cent of the incidents are accounted for by two factors, quality and safety (largely product recalls) and business ethics; banks account for 19 per cent of all incidents (more than twice the second-place food industry); there is a positive relationship between a firm’s size and the number of incidents; 40 per cent of the incidents occurred in the U.S. while Kenya, South Africa, Malaysia and Chile “stand out as particularly risky countries.” Germany, Japan, Mexico France and Italy are at the other end of the scale. (Canada is ranked fifteenth out of 24 countries.)

The report introduces the concept of industry incident risk coefficients, which are a “size-adjusted measure of incident risk”: over the period 2014-2016, automobiles was the riskiest industry (ahead of aerospace and defence, precious metals and banks) while real estate was the least risky. Over the period more than half the automobile companies were involved in one incident.

But incidents tend to lead to a negative effect on stock performance: High to severe incidents tend to generate, on average, a six-per-cent decline in market cap over a 10day window. For incidents with a “significant” impact the market cap decline was about one per cent.

Over the 2014-2016 period, “severe” incidents have included Samsung and the problems with its batteries, Wells Fargo and the problems caused by creating unauthorized customer accounts and Volkswagen with its emissions scandal. But “severe” impact incidents only account for about one per cent of the 29,000 incidents analyzed.

As well, only 69 per cent of companies with a severe incident suffered the six-percent decline in market cap — effects were likely to be of greater relative importance in low beta industries.

Given those results the report attempts to provide investors with a plan, of how the findings can be integrated “into portfolio strategies and engagement processes.” One way is for investors to adjust industry weights through a “tilting strategy.”

For a diversified global portfolio, such as the FTSE Global All Cap Index, the tilt would change the weights of the 10 sectors in that index by adding 0.5 per cent to the base weight of the technology sector and reducing the base weight by 0.2 per cent in the weight for consumer goods. “The negative tilt for consumer goods is driven by the high incident risk of the automobiles and household products industries,” said the report.

TEND TO LEAD TO NEGATIVE EFFECT ON STOCK PERFORMANCE.