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The importance of company sustainability for income investors today

The importance of company sustainability for income investors today

  • 03 March 2023
  • By Fidelity International
  • 10 mins read

Risk-asset performance is being affected by a combination of surging inflation, slowing economic growth and geopolitical tension. In this uncertain environment, income investing has the potential to deliver consistency over the long term, regardless of the market cycle or global backdrop.

Simultaneously, there is a positive link between companies considering sustainability in their operations and their corporate performance or ability to pay regular and growing dividends. Environmental, social and governance (ESG) considerations are often long-term in nature, which chimes with the needs of investors seeking capital growth and a stable or growing income.

Why sustainability matters when it comes to income

Long-term market participants need confidence in the efficacy of the companies in which they invest. A compound of factors means that firms with strong governance or an ethical focus tend to outperform businesses that do not prioritise sustainability. The consideration of governance and ethical fundamentals includes effective risk management — for example, avoiding litigation threats, preserving brand value, or side-stepping stranded assets. It also involves establishing certainty around future cash flow and how these businesses engage with their stakeholders — sometimes referred to as a ‘social licence.’

Research that evaluated over 2,000 studies of sustainability performance across asset classes and regions between 1970 and 2014 found that 48 per cent showed a positive relationship between sustainability and corporate financial performance, while only 11 per cent demonstrated a negative association’.

The link between credit quality and ethical credentials

From a market-specific perspective, fixed income investors may be in a relatively stronger position in some ways, to exert pressure and promote positive change. For instance, the bond market is larger than the equity space and companies issue debt more regularly than they access stock markets. This can give fixed income participants more frequent contact with C-suite executives and potentially influence company management teams’ behaviour.

It's worth remembering that credit quality is driven by profitability, productivity, industry positioning, cost of capital and the best estimates of future value. And the characteristics that boost a company’s credit quality are often firmly intertwined with its ethical profile. A business that has superior credit quality can often access capital more cheaply than those with weaker credentials. Such firms tend to have a stronger financial footing and, crucially, a lower chance of default.

ESG factors are also vital to equity investors

That said, equity investments with a higher sustainability ranking also show superior dividend performance. Analysis of Fidelity's sustainability ratings, which grade around 5,000 companies, indicates a strong relationship between historical dividend growth and ESG quality.

On average, companies rated ‘A’ for sustainability have the highest levels of historical dividend growth, at over 5 per cent. Conversely, ‘D- and ‘E-rated stocks generate lower average dividends. This is shown below in Chart 1.

Chart 1: Median 5-year dividend per share growth by Fidelity sustainability rating

Source: Fidelity International. July 2022

Companies with solid sustainability profiles can undoubtedly add value to a portfolio and help to protect against downside risk. However, these factors are not always correctly priced by markets, which can set a potential trap for unwary investors. This highlights the importance of harnessing a blend of traditional and sustainability fundamentals in the investment research process.

Room for improvement — a positive for investors

In the Asia Pacific sphere, investors are still in an advantageous position given a relatively higher number of firms that issue debt or tap the equity market still have room to improve their ESG profiles and, in turn, their performance — something that will inevitably occur given growing sustainability awareness. For instance, this corporate evolution is already feeding through to the market with the sharp growth of green, social and sustainability (GSS) bonds across the region. As regulatory sustainability frameworks are tightened, a ‘green premium’ is also being added to the value of these types of investments.

Meanwhile, in emerging markets, steadily tightening environmental standards are also supportive of the performance of ESG-focused investments.

As such, sustainability is now an essential consideration for companies and investors, with both groups aligned in terms of long-term investment outlooks. This focus also boosts the ongoing generation of resilient and growing income returns.

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