Indexology^® Blog

March 30, 2018 marked the end of the first quarter of 2018, and so far, the regional indices for Latin America have shown strong performance. The S&P Latin America BMI, which is designed to measure the performance of 287 companies in Brazil, Chile, Colombia, Mexico, and Peru, returned 7.4% for the period. Even more impressive was the S&P Latin America 40, which seeks to represent the 40 largest, most-liquid stocks in the region, as it returned nearly 10% for the quarter—meanwhile, the S&P 500 and S&P Europe 350  were down 0.8% and 2.1%, respectively.

So what were the drivers behind this performance? When we look at each country in the region, we can clearly see that Brazil was the biggest contributor to the overall performance. According to a report published by JP Morgan,[1] Brazil’s significant decline in interest rates could potentially boost investment and consumption. Additionally, among the emerging market countries, Brazil is considered to have the largest earnings power. The report goes on to say, “Operational leverage is ongoing and the full benefit of lower rates (6.75% to 6.5%) is only now going to start to materialize. The BRL currency is seen as well anchored, especially considering the strong external position and high commodity prices.” The report mentions, “Money is flowing into EM and Brazil is a major beneficiary of that.” On the issue of the upcoming elections, “The investor consensus on the October [presidential] elections today is that whoever wins will need to implement reforms.” The country’s broad benchmark, the S&P Brazil BMI, had a strong quarter with an 11.5% return in USD. Companies like Petrobras and Banco do Brasil, among other Brazilian giants, had impressive returns for the first quarter. In fact, 8 of the top 10 performers within the S&P Latin America 40 were from Brazil. Mexico, the second-largest market in the region, did not fare as well. Plagued by the uncertainty around NAFTA and the upcoming presidential elections, the country’s flagship index, the S&P/BMV IPC, gave back nearly 7% for the quarter.

Among the other strong performers in the region were Argentina and Peru. Despite recent concerns around inflation increases in Argentina, there are great expectations for the country if it is promoted to emerging market status, which could result in greater investment in the country. At the end of the quarter, the S&P Argentina BMI returned 6.4% in ARS, with returns within the 50%-56% range for the three- and five-year periods. Despite the recent resignation of the nation’s president, Peru, the smallest market in the region, was still bullish in the first quarter, as the S&P/BVL Peru Select Index returned 4.7% in PEN; the index is designed to represent 18 of the most investable Peruvian stocks.

Chile and Colombia underperformed slightly in terms of their local currencies, but they outperformed in USD. Chile returned -0.8% in CLP and Colombia returned -3.7% in COP for the first quarter. All eyes are now turning to Colombia, which is expected to elect a new president during the upcoming elections on May 27, 2018. It will be interesting to see how the results affect the market.

In terms of sectors, energy and financials companies yielded the highest returns, as expected. The S&P Latin America Energy and the S&P Latin America Financials returned 21% and 17%, respectively.

To see more details about performance in Latin America, please see: S&P Latin America Equity Indices Quantitative Analysis Q1 2018.

[1]   JP Morgan (JPM) Emy Shayo Cherman LatAm Equity Strategy: US Roadshow Feedback: Incredible Optimism with Brazil, March 14, 2018.

Year-to-date, Facebook (FB) was down 7.13% as of April 12, 2018, compared to its 53% total return in 2017. What started as a data breach issue has expanded to encompass management structure, procedures, and safeguard concerns—issues that are all related to corporate governance. Market participants have a tendency to only care about corporate governance when things go wrong, despite empirical evidence that companies with strong governance tend to perform better than those with weak governance.

We have been exploring the “G” component of ESG, and many tech companies in general do not score favorably on the governance front. In a previous blog, we provided a breakdown of the various elements or dimensions that are part of the S&P Dow Jones Indices’ governance score. In this follow-up blog, we explore the return information contained in the governance component and how investors can manage risk by avoiding companies with low governance scores.

To test whether ESG scores, G in particular, correspond to future stock performance, we formed hypothetical, annually rebalanced quintile portfolios, and we ranked them in descending order by scores and tracked their forward 12-month performance. The underlying universe was the RobecoSAM coverage universe, which comprises 400 global companies starting from December 2000 and increasing to over 4,000 stocks in 2017. The quintile portfolios were formed on an annual basis as of December 31 of every year, and returns are in USD.

In regard to the governance score, looking at the period from inception in 2001 to present, there was little distinction in performance between companies in the top three quintiles. However, there was a clear distinction between these quintiles and the bottom quintile (see Exhibit 1). Securities with the lowest governance scores, on average, underperformed (7.84%) those that ranked higher.

The spread between the top and bottom quintile was greatest for the governance criteria, representing almost double the spread for the total ESG score (0.90%).

The asymmetrical return profile suggests that companies that rank well below average on good governance characteristics are particularly prone to mismanagement and risk the ability to capitalize on business opportunities over time. Management strategy and ability, whether superior or compromised, will manifest over time and therefore, economic dimension-scored portfolios should be viewed over longer time horizons as the time element is necessary in revealing whether the strategy is working or not.

As discussed in Part 1, the EDS is comprised of more than just traditional governance criterion and includes business strategy, risk management, and tax strategy—elements that are long term and strategic in nature. The inception data in Exhibit 2 provides a 17-year timeframe in which to gauge the performance of quintile portfolios. The bottom quintile returned 7.84% annualized compared to 9.51% for the first quintile, 10.02% for the second quintile, and 9.58% for the third quintile.

The underperformance of securities with the lowest governance scores is even more readily apparent when viewed over rolling periods. To demonstrate, we calculated annualized rolling one-year, three-year, and five-year returns, and we reported the averages. On average, across all three calculation periods, the Q5 portfolio, which comprises companies with the lowest governance scores, underperformed the Q1 portfolio by 1.8%-2.0% (see Exhibit 3). The results indicate that market participants may be economically better off avoiding securities that rank in the bottom quintile of the governance universe.

In the next blog, we will continue the discussion on ESG scores and stock performance, however with a focus on the “E” and “S” scores.

Sources:

Gompers, Ishii, and Metrick (2003) and Bebchuk, Cohen, and Ferrell (2009)

Water scarcity risk has been in the spotlight recently with Cape Town’s efforts to avert “Day Zero” and the risk of taps running dry. Although this risk appears to be receding through radical conservation measures, including wholesale elimination of abstraction rights in some cases, it underlines the common global challenge of increasing fresh water scarcity.

From a business perspective, examples such as Cape Town illustrate that water is shifting from an operational concern of securing day-to-day supplies for production sites, to a wider strategic concern for companies. For example, the 2017 CDP Water Survey found that 70% of respondent companies were now disclosing water targets to their board, and they committed to a new investment of USD 23 billion in water projects in 2017.

Nonetheless, Trucost data indicates that most companies have substantial exposure to water risk in their supply chains that is unmeasured and unreported. For a typical company, as much as two-thirds of water-related impacts occur within the supply chain. In some cases, this can be even more pronounced—Nissan Motor’s supplier engagement in 2017 uncovered supply chain water consumption 20 times that of its direct operations.[1]

Where these water risks aren’t adequately measured, they represent substantial “unpriced risk” to companies, with global-listed companies having undisclosed water risks totalling USD 555 billion.[2] When the full costs of water scarcity and pollution are accounted for, this represents a substantial share of average profit at risk across a number of sectors (see Exhibit 1).

While companies have relied upon historical data when assessing the exposure of their supply chain to water risk, this may be a poor indicator of future risk associated with climate change and rising water scarcity. Recommendations by the G20 Taskforce on Climate Related Financial Disclosure[3] emphasize the need for companies to gather forward-looking data and explore the extent to which their business model and profitability is at risk under different climate change and water scarcity scenarios. Water is a crucial element of climate risk, with current projections pointing to a 40% gap in available supply of fresh water to demand by 2030.[4]

As a response to these risks, companies should understand how their business strategy and growth depend on water. Trucost has worked with business leaders like Ecolab to create industry-leading approaches to value water risks, set context-based water targets, and measure their maturity on important factors like governance, water measurement, target setting, and water stewardship. We’ve recently supported Braskem in setting long-term, basin-level water reduction targets that account for changes in local demand in line with rising scarcity, building on 2040 projections by the World Resources Institute.[5]

To manage water risk effectively, businesses need to consider water risks from every angle—looking back into their supply chain to identify hotspots of water risk and looking ahead to ensure their overall business model is resilient in the face of rising water scarcity.

[1]   CDP (2017), A Turning Tide: Tracking corporate action on water security – CDP Global Water Report 2017.

[2]   Trucost (2018)

[3] FSB (2017) Task Force on Climate Related Financial Disclosures: Final TCFD Recommendations Report.

[4] McKinsey & Company (2009) Charting our Water Future: Economic frameworks to inform decision-making.

[5] World Resources Institute (2016) Aqueduct – Water Risk Atlas.

As oil prices continue to increase, the energy sector is rising but recently the mid and small cap stocks are outpacing the large caps.  Thus far in April (month-to-date through April 12, 2018,) the energy sector is leading all other sectors, but the S&P 500 Energy (Sector) is up just 4.8% versus the gain of 7.4% in the S&P MidCap 400 Energy (Sector) and 7.3% in the S&P SmallCap 600 Energy (Sector).

This is an interesting turnaround from the major large cap outperformance in energy over the last 1, 3, 5 and 10 years.

Generally when looking into what drives sector performance, examining the next most granular GICS (Global Industry Classification Standard) level called industry groups is a good starting point.  In the case of energy, there are no separate industry groups, but the next specific level called industries splits the sector into two parts: 1. Energy Equipment & Services, and 2. Oil, Gas & Consumable Fuels.

Immediately, the difference in performance between the two industries is apparent and can give some insight into what is driving the sector.  Annualized over the last 10 years that included the both the 2008-9 oil price decline and the 2014-16 drop, the large cap oil, gas & consumables industry held up better than the energy equipment & services, losing only 40 basis points annualized versus the 3.8% annualized loss over the period.  This shouldn’t be too surprising considering the energy equipment & services contains companies mainly in oil and gas drilling and equipment manufacturing, whereas the oil, gas & consumable industry includes many integrated companies, refining and marketing, and storage and transportation stocks.  The long-term performance split reflects how the upstream versus mid- and downstream oil companies are sensitive to oil price declines.  On the flip side, with the oil comeback, now the energy equipment & services are rebounding strong with returns more than double the oil, gas & consumable fuels in mid and small cap energy.

Overall, energy stocks may not fully capture oil price moves since companies hedge against some of the volatility, and also make other decisions for shareholder value that may not have direct influence from the oil price.  Large companies are more likely to hedge against oil price moves, and again, the upswing may help upstream more since they are the ones drilling and selling the direct oil rather than buying it to transport, refine and market.  According to the index data from 1995, using the S&P GSCI Crude Oil index as the oil price proxy, for every 1% rise in the price of oil, the large cap energy sector only gains about 37.5 basis points on average, while the mid- and small cap energy sectors gain 61.8 and 64.1 respective basis points. Also, the large cap energy equipment and services gains 54.5 basis points versus the gain of 34.9 basis points from large cap oil, gas and consumable fuels for every 1% rise in oil price.

However, the split between the two industries by weight is not equal but is according to market capitalization, so there may be adjustments market participants may make by deliberately tilting towards small caps or using the S&P Oil & Gas Equipment & Services Select Industry Index to get more exposure to the energy equipment & services industry.  This may be especially potent alongside the S&P 500 Energy sector where the weight to this industry is relatively small at only 14% of the sector.

While these weights are only recent, the allocations between industries have held relatively constant through time in large and small caps, though in mid caps, the energy equipment & services diminished from almost 1/2 to 1/3 of the weight from the under-performance in the last 3 years.  Therefore, by either using small-cap energy, or if using large-cap or mid-cap energy, to supplement with the select sector S&P Oil & Gas Equipment & Services Select Industry Index may help protect against inflation and get more upside with rising oil prices.  Remember as oil prices rise, inflation is more likely and the energy sector is potentially more attractive, so it makes sense to pay attention to the more sensitive pockets in the industries of the broad sector.

Most S&P and Dow Jones Shariah-compliant benchmarks outperformed their conventional counterparts in Q1 2018, as the information technology sector—which tends to be overweight in Islamic Indices—led the market by a wide margin, and financials—which is underrepresented in Islamic indices—matched the returns of the broad market.

The Dow Jones Islamic Market World Index and S&P Global BMI Shariah closed the quarter slightly in the red but outperformed the conventional S&P Global BMI by 0.6% and 0.9%, respectively. Shariah-compliant benchmarks tracking Asian and European equities beat their conventional counterparts by the widest margins, while the S&P 500^® Shariah eked out a small gain over the conventional S&P 500.

Global Equities Finished the Quarter in the Red in a Volatile Start to the Year

After a strong January in which the S&P Global BMI Shariah gained more than 5%, volatility set in as various risks rose to the forefront, including the potential for rising U.S. interest rates and increased global trade tensions. European and U.S. equities fared the worst among major regions, while developed markets in the Asia Pacific region and emerging markets finished the quarter in positive territory. The Dow Jones Islamic Market World Emerging Markets Index rose 1% in Q1 2018 on the heels of a gain of over 40% in 2017.

MENA Equity Markets Rebounded Following 2017 Weakness

MENA equities had a strong quarter, as the S&P Pan Arab Composite Shariah gained 6.8%, driven by strength in Saudi Arabia and Egypt. Egypt was the region’s top performer in Q1 2018. The S&P Egypt BMI jumped 17.3% in U.S. dollar terms, adding to its 21% gain in 2017, as the nation’s macroeconomic environment continued to stabilize following the IMF-supported reforms initially enacted in November 2016. The S&P Saudi Arabia BMI finished the quarter up 10.5%, as the country’s own economic and equity market reforms have, likewise, led to improved investor sentiment.

*This article was first published in Islamic Finance News, Volume 15 Issue 15, on April 11, 2018.