ES Investing
Possibly the biggest trend in investing today is the shift towards ES investing. No, that’s not a typo because it is the E (Environmental) and S (Social) factors of ESG investing that are experiencing the greatest focus as humankind faces existential threat from climate change (i.e. E) and numerous social issues, whether racism, sexism, corporate culture, et al, are getting the attention they deserve because, let’s face it, there is some bad behaviour that has persisted for way too long that needs to change. We’ll come back to the G (Governance) a little later.
Right now, Investors around the world are leading the thinking and action about climate change, whilst many governments are lagging (and we Australians don’t have to look very far). Whilst governments around the world fight about what year they want to reach net zero emissions and hang onto the fossil fuel industry in order to salvage some votes for the next election (and I promise I’m not just thinking locally), investors are allocating their dollars to companies which are already positioned for the future (think Tesla) and sending strong messages making it difficult to fund potential “dirty” companies (think Adani).
Dual Objective
When we construct investment portfolios, one of the first questions we ask is around the objective. This is generally in terms of return (e.g. CPI plus x% or to exceed a benchmark) but for the ES investor, the investment objective is a dual objective which is part quantitative and, somewhat unusally, part qualitative.
The quantitative objective remains the same or similar to always, and that is to achieve optimal investment return given defined constraints (For the ES investor these constraints include redefining the investment universe based on various defined ESG requirements). However the qualitative objective is about “the greater good” where there is hope and intention of changing the behaviour of individuals, corporations, and governments. Changing global behavour for the greater good is the ultimate goal of ES investing. Please note, this article doesn’t intend to go into the detail of what these behaviours should be but they are obviously about changing the current path of climate change, increasing diversity in the workplace, improving human rights in a range of scenarios, et al.
So what are the potential consequences of this dual objective?
Changing Global Behaviour
Capital markets are particularly good at changing bad or unwanted behaviour. It does this by simply increasing the cost of capital. If a company wants to raise capital for an unpopular purpose (e.g. Adani raising capital for its Queensland operations where many believe it could be damaging to the Great Barrier reef), investors will simply refuse to invest such that the company in question will have to increase its cost of capital (whether by increasing promised interest rates if raising debt or reducing its share price on offer if raising equity), until enough investors feel the additional return is attractive enough to provide the required funding. For some ES investors, this may seem hypocritical (i.e. owning a badly behaving company) so sometimes ES-focused investors will hope to change behaviour via direct engagement with management and the board. One limitation to direct engagement is that it generally requires massive investment to be effective however this does appear to be where companies like BlackRock, PIMCO, and other large fund managers are looking to make a difference.
Expected Return Dilemma
You may have already worked out that by increasing the cost of capital of a badly behaving company, by definition, means it now has a higher return expectation compared to a well behaving company (assuming all else equal). This may also mean, and perhaps naively, that badly behaving companies have lower valuations than well behaved companies. This return expectation difference creates a dillemma as it may compromise the return objective of the ES investor and for advisers who are speaking to their clients about ESG investing this must be part of the conversation. That is, the likelihood of underperformance by investing for the greater good may be higher than investing in the alternative … so ideally, the “greater good” should be the higher priority objective.
Many may argue that higher valuations for strong ESG rated companies means they have greater growth potential, as opposed to the lower rated companies, and this is definitely a reasonable possibility. Secondly, many existing ES investors would be currently exposed to the momentum of strong capital flows and would have seen strong investment returns that are supporting their investment thesis.
Possibly the company that encapsulates this momentum and high return experience is Tesla which has provided 5-year investors an average annual return of over 75%pa. Of fundamental concern may be that Tesla is yet to generate strong or consistent profits, and currently trades on a PE ratio of around 670. To justify this valuation requires massive revenue and earnings growth in the face of increasing competition and many must be wondering how much share price growth is truly available for a company’s whose market capitalisation is already around 650billion US dollars. On the flipside to the clean energy focused Tesla, we have fossill fuel dominant companies trading on low PE Ratios. So whilst Tesla has a PE Ratio of over 600 with revenues around 35billion USD, Toyota, Honda, and the recently ESG-challenged Volkswagen trade on PE Ratios that average around 10 to 12 with combined revenues of over 600 Billion USD at ~70% of Tesla’s market capitalisation (~460 Billion USD). This momentum and return potential for Tesla may continue, but there are clearly some future share price growth risks and also relative to some fossill fuel dominant car companies.
ES Investing will be G
So looking ahead there is little doubt that ES investing will continue … because it is the right thing to do and the consequences of doing nothing may be catastrophic. It is the right thing for the planet, and equality is the right thing for all people. This will ultimately mean that governments will get on board the ES train in a much bigger way than they have so far. As Governments observe this trend towards ES investing and the movements that go with it, they will increasingly shift their policies towards favourable ES outcomes. If they don’t, over time the people currently in power will lose their jobs and they certainly won’t want that. These shifts in policies mean that governments will ultimately change laws to stop or reduce bad E and S behaviours and also adding to badly behaving companies’ cost of capital with higher taxes, tariffs, et al. It may take a few more years yet but the E and S of ESG will likely fold into law such that ESG investing may morph int G investing as bad E and S practices will disappear under law.
Summary Thoughts
ES investing is the biggest trend in investing today and will continue for many many years to come until the governments around the world are in a position or forced to make stronger laws that radically change their behaviour and those of many corporations of today. Either way, investors will continue to lead the charge by increasing the cost of capital of the badly behaving corporations but this may come at the cost of lower relative returns over the long run as expected returns for badly behaving corporations may increase from higher cost of capital. Changing the cost of capital is how real change occurs on a massive scale, and this means investors must be prepared to alter their objectives such that the “greater good” becomes the primary objective over “expected return”. Of course, this may not happen but it is an important part of understanding the risks of ESG investing.
Of course, this leads to expectations of superannuation fund performance and particularly given the new mandated performance tests … but perhaps another day.