Are green investments hurting the futureness of the stock price?

The rise of sustainable investing is changing the very language of the market, but it may cloud your financial judgment

Featured faculty: George Yang
Written by Ellis Ng

Environmental, social and governance (ESG) are the three words that have transformed the stock market over the past decade. As investors increasingly factor sustainability into their decisions, the shift is creating unexpected ripples in how stock prices reflect company performance.

By late 2024, green, social, sustainability and sustainability-linked bonds reached a staggering US$6.6 trillion globally, according to a leading European financial services group Societe Generale. The growth has been particularly significant in Asia, where companies are racing to meet international ESG standards to maintain their competitive edge and support the region’s transition to net-zero emissions.

“Firms’ performance in addressing ESG issues and ESG reporting and disclosure is more and more emphasised by corporate stakeholders and regulators, but the inherent complexity of making financial implication from ESG information means that investors will encounter severe challenges to incorporate it in their investment decisions,” says George Yang, Professor of School of Accountancy at the Chinese University of Hong Kong (CUHK) Business School. “Therefore, it should be enlightening to understand the status of the impact of such challenges in stock valuation.”

Stock price represents the company value and it reflects the company’s all future profits in investors’ expectations. However, the increasing ownership by investors with an emphasis on ESG may be shortening that “futureness.”

A new study by Professor Yang and his PhD student Zhang Yaojia, as well as Zhan Xintong of Fudan University and Zhang Weiming of IE University, uncovers a surprising consequence of this transformation. Their research paper titled Socially responsible investors and stock price informativeness discloses that the growing influence of socially responsible investing makes stock prices less reflective of companies’ future earnings.

Green waves sweep markets

When companies have many investors focused on social responsibility, the study found they experience two interesting effects. First, their stock prices don’t change as dramatically when earnings information comes out. However, when these companies face any issues related to ESG, their stock prices react more strongly.

To reach these conclusions, researchers studied the data of 22,059 American listed companies between 2004 and 2019 from S&P Compustat, the Centre for Research in Security Prices and Thomson Reuters. They identified socially responsible institutional ownership by examining how high their investment portfolios scored on ESG factors. They then analysed how much information about future earnings is reflected in the current stock price and studied whether having more socially responsible investors changes this relationship.

The researchers needed to ensure their findings weren’t skewed by investors’ selection. To do this, they looked for situations where exogenous events, rather than investor preferences, caused changes in socially responsible institutional ownership.

“An increase of the socially responsible investor ownership by one standard deviation is associated with about a reduction of 9 per cent of the stock price informativeness on future earnings.”

Professor George Yang

To see the funds’ performance, the researchers turned to the Morningstar Rating that ranks publicly traded mutual funds and exchange-traded funds. Due to random market or industry factors instead of savvy investment, the funds can earn an extra star in their rating, and this small change typically attracts additional cash flows. The researchers then compared socially responsible funds that received rating upgrades against similar traditional funds that didn’t get upgrades.

The analyses found that mutual funds that receive a higher rating from Morningstar suddenly had more socially responsible investors, likely not because of improved financial performance, business fundamentals, or overall quality, but merely for their better rankings. This result helped the researchers understand how an increase in green investors affects stock prices.

The study shows an important change in how company stocks are valued when they have many socially responsible investors. A higher level of socially responsible investors is associated with a lower level of stock price informativeness on future earnings, which implies that the green investors do not invest in firms’ long-term financial success as they promised.

“Socially responsible investor ownership has been substantially increasing in public firms around the world,” Professor Yang says. “Our evidence shows that the rise of such ownership is accompanied by reduced informativeness of stock price on firms’ future earnings.”

Socially responsible investors are found to place more weight on a company’s environmental and social impact than on its financial performance. As a result, the stock prices of these companies tend to reflect more ESG information and less earnings information, representing significant challenges investors face when processing information and allocating attention.

“An increase of the socially responsible investor ownership by one standard deviation is associated with about a reduction of 9 per cent of the stock price informativeness on future earnings,” he adds.

Feedback loop challenge

Professor Yang highlights that the above effect becomes even stronger when rating agencies like MSCI and Thomson Reuters ASSET4 give conflicting assessments of the same company. This is likely because socially responsible investors spend more time understanding these disparities and making their own judgments, meaning they have less time and resources to analyse traditional financial information.

When climate change gets more media coverage, socially responsible investors become more focused on environmental issues. They spend more time evaluating how companies are handling climate-related risks and opportunities and less time analysing financial performance.

“We observe that when socially responsible investor ownership increases, a company’s stock price is less responsive to information about future earnings, including the earnings forecasts supplied by firm management or those produced by financial analysts,” Professor Yang says.

These analysts, who typically focus on traditional financial measures, find it harder to predict earnings for these companies. They also struggle to adapt their analysis methods to include the environmental and social factors that socially responsible investors care about.

It all but leads to a feedback loop: As more socially responsible investors buy into companies, stock prices become less reflective of future earnings. It makes these companies less penetrable to investors who are familiar with the traditional valuation framework but not yet equipped with tools to dichotomise the new valuation factors (namely, ESG-related risk and performance).

Professor Yang notes that investors face significant challenges when trying to include environmental and social factors in their investment decisions because these factors aren’t purely financial. As more investors embrace socially responsible investing, there is a need to understand how the trend is affecting the sustainability of the financial system.

“Investors should spend more effort to figure out how to parse out the value-relevant portion of the ESG-related information and integrate such information with traditionally used financial information to form investment decisions,” he adds. “They need to be aware that this is not an easy task.”