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The Misreading of ESG

I’ve been reviewing a lot more articles about the SRI and ESG investment movements lately than I ever did before, and I think that’s a sign that more people are interested in owning shares of companies that are behaving responsibly—however one might define that.  I’m not surprised; the very first time I was exposed to the concept, I viewed the filters as a logical part of the equity research process.  They were a way to identify what many of us believe are harmful aspects of our currently barely-regulated capitalist system. 

But often the articles I’m reviewing are telling us about investment research initiatives which, I believe, are too-narrowly focused on recent stock behavior and some extrapolations of a simplistic capital markets viewpoint.  One that I have seen more and more often is the idea that, if more people prefer to buy companies with clean ESG records, they will raise the stock prices incrementally simply by the laws of supply and demand.  That (so the reasoning goes) will diminish future returns compared with the companies which have ‘dirty’ ESG records, whose prices are not bid up and therefore have more opportunity to offer higher returns.

Of course, you could apply the same reasoning to value companies whose stock prices are low for a reason; a company with clueless management or a board that provides careless oversight is trading at low multiples for a very good reason.  The opposite is true for popular growth companies; their stock price multiples are higher, but (as we’ve seen for a couple of decades now) that doesn’t necessarily mean better-managed companies will underperform going forward. 

My point is that there is nothing embedded in those rather small price differentials that would convince me that the companies with clean ESG records won’t outperform, long-term, companies that are largely ignoring those issues.  I think a high ESG rating offer some insight into the fundamental character and health of the companies, which justifies higher prices and, I would expect, promises higher long-term returns and maybe a smoother ride as they avoid scandals and revenue shocks in the future.

And part of this is a belief in the back of my mind (not sure I’ve written about it before) that eventually, every business enterprise in the U.S. is going to have to account for, and pay for, their use or abuse of our common resources.  This is already happening, to some extent.  Used to be, a company could enhance its profits by dumping the toxic waste its factories produced into the nearest river.  That was the entirely logical thing to do from a profits standpoint, until the EPA was formed, and we all recognized that the company was simply off-loading the expense of reprocessing or disposing of toxic waste onto the financial backs of the community, society, taxpayers and the environment.  The company was deriving some of its profits from the general kitty, and we were paying on the back end.  In the future, I think we will be much more sophisticated about quantifying those various costs that are offloaded on society in a broader range of areas.

How that is applied to slave labor in China, I am frankly not sure.  I know that the diversity issues, if addressed, tend to add value, and I hope we get more sophisticated about assessing the various environmental impacts of corporate behavior, and at least charging back the excess profits that come from various forms of pollution and (I actually think this is the next frontier) of paying such low salaries that the employees apply for public benefits.

If and when those new calculations are (incrementally over time) developed, I believe that some companies will have to set aside revenues to pay for these things they had gotten accustomed to taking from society at large for free, while others might not be able to sustain their business models.  A few companies with terrible ESG records, like Exxon, will see society actively trying to put their revenue model (oil extraction and sales) out of business. 

Meanwhile, I might also argue that some companies that show up in the positive screens are simply ahead of their peers in addressing long-term trends in our social awareness and necessary shifts in our still-flawed capitalist system.  The pioneers in clean energy, in bringing clean water to parched areas of the country, in sequestering atmospheric carbon and providing clean transportation alternatives will benefit as our business ecosystem demands more of their products and services.

The articles I’m reviewing mostly seem to be telling us that investors have to pay a price for investing in funds that use these ESG screens as part of their stock selection process—even though, right there in the articles I’m reviewing, they concede that much of the research has not yet confirmed this in any remotely unanimous way.  The research they cite tell us that investors should expect lower returns based on what I believe is a fairly narrow view of the capital market assumptions—that you pay a bit of a premium for these ESG-aware companies, so therefore the stocks won’t reward you quite as much going forward as the downtrodden stocks of companies that have unclean ESG records. 

If those downtrodden firms eventually have to invest heavily to clean up their acts, or change their businesses in fundamental ways, or are perhaps outmoded in a world that increasingly doesn’t tolerate their basic business model, I would argue that the shock to their returns would justify the lower “downtrodden” value they’re trading at today.  In fact, I strongly suspect that we are not undervaluing them quite enough. 

I have also read, and reported, that SRI investments account for 25%-30% of all assets under professional management in the U.S.  I think most professional asset managers may be exhibiting some passing interest in what the various ESG services have to say about certain stocks, but I don’t believe, by any stretch of the imagination, that a huge fraction of all the professionally managed money is fully dedicated to ESG investing.  I’m going to guess the real number is around 2-4 percent.  We’re still in the very early stages of this trend, and I happen to believe that the early adopters are going to outperform those who come late to the game.

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