Beware ESG ratings, strategist warns – look past them to find the best stocks to buy

Published Tue, May 18 202110:01 PM EDT

Lucy Handley @in/lucy-handley-b2b0a61a/@lucyhandley

There are bubbles in so-called ESG stocks that are continuing to grow, according to strategists at asset management firm Bernstein, who warned of the dangers of third-party ratings. In a recent note, Bernstein named stocks in the space its analysts still expect to outperform — but they're not necessarily the companies with the highest ESG scores. ESG refers to environmental, social and governance factors and has become a big area of focus for investors as they look to assess the sustainability of their portfolios. However, the huge amounts pumped into ESG funds in 2020 created a bubble in the sector, the strategists argued, and the funds have "spectacularly underperformed" in 2021. One problem is the ESG scores given to companies by third-party providers, they added, which are not necessarily related to whether or not a firm genuinely has good ESG practices. They said it had driven an "increasing wedge" between the ESG stocks considered the best and worst in their industries, which could be distorting valuations — and potentially creating investment opportunities. In a note dated May 13, Bernstein strategists led by Sarah McCarthy said that many companies get high ESG ratings simply because they release relevant information. "Stocks are likely re-rating or de-rating in part based on whether or not they disclose ESG data - and not based on whether they genuinely have good ESG practices," they wrote. A stock's re-rating or de-rating refers to investor sentiment about a stock going up or down. As such, the strategists looked at whether or not these ratings were affecting stock valuations, and argued that it had. "There is now clear evidence of a growing discount for ESG laggards and a growing premium for ESG winners within industries in Europe. Some tentative evidence in the US," the strategists wrote. Stocks expected to outperform The investment firm compiled a list of the best-scoring U.S. and global stocks when it comes to "environmental rank" — a score by ESG ratings firm Sustainalytics — which had re-rated versus the market. It also compiled a list of the worst-scoring stocks on "environmental rank" which had de-rated versus the market. There were stocks on both lists that Bernstein analysts expect to outperform. Hotels and restaurants Casino operator Las Vegas Sands makes the firm's list of "U.S. best scoring stocks on 'environmental rank' which have re-rated vs. the market," as does Hilton Worldwide . Fast-food outlets Chipotle and McDonald's are also rated "outperform," along with KFC-owner Yum Brands . Health care European firms Roche and Philips are both given an "outperform" rating on Bernstein's list of "European best scoring stocks on 'Environmental Rank' which have re-rated vs. the market," while medical device firms Medtronic and Boston Scientific Corp are on its U.S. equivalent. When it comes to the "worst scoring stocks on 'Environmental Rank' which have de-rated vs. the market" Bernstein highlighted U.S. health care company Centene Corp and Jazz Pharmaceuticals . In Europe, Germany's Fresenius made the list. These are all rated outperform by Bernstein analysts. Consumer European consumer stocks also rated outperform, but on Bernstein's list of worst-scoring stocks were stocks including Swiss watchmaker Swatch Group , and European beer brewers Carlsberg and Anheuser-Busch . Technology The analysts gave an outperform rating to Microsoft , as well as payments firms Mastercard and PayPal , all of which are on its U.S. list of best scoring environmental stocks that have re-rated versus the market.

The PayPal app shown on an iPhone.

Katja Knupper | DeFodi Images | Getty Images

There are bubbles in so-called ESG stocks that are continuing to grow, according to strategists at asset management firm Bernstein, who warned of the dangers of third-party ratings.

In a recent note, Bernstein named stocks in the space its analysts still expect to outperform — but they're not necessarily the companies with the highest ESG scores.

ESG refers to environmental, social and governance factors and has become a big area of focus for investors as they look to assess the sustainability of their portfolios. However, the huge amounts pumped into ESG funds in 2020 created a bubble in the sector, the strategists argued, and the funds have "spectacularly underperformed" in 2021.

One problem is the ESG scores given to companies by third-party providers, they added, which are not necessarily related to whether or not a firm genuinely has good ESG practices.

They said it had driven an "increasing wedge" between the ESG stocks considered the best and worst in their industries, which could be distorting valuations — and potentially creating investment opportunities.