How ESG Analysis Helped Avoid Volkswagen's Share Price Decline

Das auto? Das no good.

Just over a week ago, Volkswagen fessed up to rigging emissions tests in the U.S. and Europe. The company has publically admitted to installing software chips to make approximately 500,000 diesel vehicles test cleaner than they actually were. Since then, the CEO has resigned and THE STOCK has dropped 39%. For investors who own the stock directly or as part of a mutual fund, a more rigorous analysis could have prevented ownership- and helped protect against excessive loss. More and more, investment research is focusing on sustainability issues, such as those that address environmental, social, and governance (ESG). How a corporation attracts and retains employees, aligning shareholder and owner interests, as well as corporate reporting and disclosure are examples of Governance. Some argue that ESG analysis gives a more complete indication of a company's value- I am one of them. This makes sense, according to Usman Hayat, CFA. Usman is is director of Islamic Finance and ESG at the CFA Institute. Usman states "Bad governance usually drives bad outcomes." But, could ESG analysis catch the bad guys at Volkswagen in advance? Usman thinks so, and so do I. The scale of Volkswagen's deceit is large. Additional technology was installed in vehicles to alter the results of emission testing. This wasn't one C-level executive keeping hush hush. The scandal involved executive management making the decision to cheat instead of innovate. A team of engineers had to design and build the cheating chip. Last, service workers had to install the chips. It makes sense that such an operation does not take place without an internal support team, i.e. bad governance. When you look under the hood (intended pun), this wasn't the first time Volkswagen's governance appeared suspect. In Asman's most recent ARTICLE, he explains that in many "crisis", there are usually warning signs. In 2009, the Financial Times published a story titled VW Governance 'Worst' of German Blue-Chips, followed by VW's Governance Regime Irks Investors. More recently, European financial media outlet Breaking News reported that "Volkswagen's governance regime is a recipe for disaster. In the early 1990's it plunged into an existential crisis. A decade later, the company was rocked by a compliance scandal, involving prostitutes and luxury trips". Whoa! When analysts apply ESG screening criteria to stocks, a score is assigned. The better the overall score, the more likely to be included in a strategy. Stocks that receive poor scores don't receive a spot in the strategy. A perfect example of this analysis in action is the Pax MSCI International ESG Index Fund. This fund mimics it's parent index, the MSCI EAFE (a representation of international stocks) with an ESG screening overlay. In May, 2015, the ESG analysis yielded low scores of Volkswagen's Intangible Value Asset (IVA) and the backwards looking Impact Monitor (IM) screens. As such, it was removed from the index and the funds that track it. Yea investors! Volkswagen's recurring governance issues are clearly creating problems for it's stock value. These issues also pose problems for investors with values, as these types of failures cost everyone money. When ESG analysis is applied to an entire portfolio, a slew of GROWING EVIDENCE (scroll down 3/4 of the page for research reports) suggests the potential for improved returns and lower risk. ESG analysis aside, the best defense for investors against scenarios like the Volkswagen one is to broadly diversify. Try not to put more than 5% of your total investable dollars in a single stock, no matter how good you think it is. If you do decide to PURCHASE INDIVIDUAL STOCKS, be prepared for surprises!