Are you interested in making a statement with your retirement assets? Are you holding back because, in using your retirement savings to make a statement, you fear there’s a cost you might not be willing to pay?
This is a reasonable fear. In the 1980s, when activists demanded “socially responsible investing” via demands institutions divest themselves of companies participating in economies of targeted countries, academic studies at that time suggested mixing portfolio management with political advocacy generally produced less than optimal returns.
But, is it different this time? Certainly, you should remind yourself that “past performance does not guarantee future results.” This time, however, it might go beyond this standard SEC disclosure.
“There is certainly an argument to be made that the world population will eventually have to face climate change and a host of other environmental/social issues,” says Derek Horstmeyer, an Assistant Professor of Finance at George Mason University's School of Business in Biloxi, Washington, D.C. “To this degree that facing these problems has to happen, divesting from fossil fuel companies makes long term financial sense. Many consider fossil fuel firms stranded assets since they will be worthless once we go to renewables.”
This type of industry scrutiny is not new. Long ago, securities analysts determined the coming age of the automobile would make buggy whips obsolete. In a sense (and despite the irony), what’s called “ESG-based” investing follows a similar theme. It may be merely following consumer demand trends.
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Only today, unlike in the past, these trends emphasize policies, not products. You can put your hands on a product. You can measure its monetary value and collect hard financial data regarding its use. It’s a greater challenge to quantify and measure the true impact of a policy. Still, this may be the direction you’ll see securities analysis heading in.
“Intangible assets such as brand value, intellectual capital, and customer loyalty are increasing components of corporate value reflected in a company’s stock price—assuming efficient market theory works,” says Robert ‘Bob’ Smith, CIO and President of Sage Advisory Services in Austin, Texas. “Every day we find examples in business where investors are exposed to a myriad of risks from relatively infrequent but high impact ESG-related events. These include safety incidents, ethics scandals, natural resource shortages, product liability claims, etc. Think of Wells Fargo
“ESG” is short-hand for “environmental, social and governance.” There’s no clear consensus on what these terms actually mean in a practical sense. That doesn’t mean there won’t eventually be a standard agreement.
For now, it’s often easier to identify negative ESG factors as opposed to positive ESG factors. This isn’t just a testament to the effectiveness of the “cancel culture.” Long before the current phenomenon became socially acceptable, investors would regularly punish stock infected by bad news. That we couch this traditional behavior in modernized terms doesn’t really change much.
“Each ESG circ*mstance must be analyzed on a case by case basis,” says Frank Lee, Managing Director for the Institutional Division of Miracle Mile Advisors in Los Angeles. “An example of a company’s ESG issues being aligned with the financial performance of the stock is Wells Fargo. Due to poor corporate ‘Governance’ (the ‘G’ in ESG) with fraudulent accounts and overcharging, Wells Fargo stock has suffered and underperformed versus its peers and the broad market.”
Here’s the important takeaway from this for you and your investments: the negative ESG factors often come about unexpectedly. When WorldCom revealed it had manipulated its financial statements, no one knew. Certainly, those public filings contained no hint of this (which is the objective of any such fraud). Such negative surprises will cause a precipice drop in the stock price.
“These incidents occurred because of what could not be detected in the financial statements or 10Ks issued by these entities,” says Smith. “There was significant impact on stock values—both near and long term—because of ESG related risks that were not well understood or overlooked through reliance solely upon conventional financial analysis, which might have been strengthened by blending in ESG risk analysis applications. ESG factor analysis can give forward-looking insight into performance and risk.”
While you may understand fraud and its consequences, how do you discover positive ESG factors?
“A cutting-edge company such as a tech company may have developed a good reputation of being a good corporate citizen and get that boost with good performance of their stock price,” says Kathleen Owens, of Aurora Financial Planning & Investment Management LLC, in the San Francisco Bay Area. “ESG is an integral part of that company’s culture.”
More importantly, when it comes to investing for higher returns, how do you discover these factors before they’re already reflected in the stock’s price? To take full advantage of ESG-based investing, you’ll need to be ahead of the curve. You’ll have to identify a solvable problem, then find the company capable of and interested in solving that problem. Here’s one simple hypothetical example:
“Let’s say a community has rusty water,” says Stephen Akin of Akin Investments, LLC in Biloxi, Mississippi. “A company comes in and overhauls the waterworks. People pay their bills. The company pays out a portion as a dividend and retains the remainder of the earnings. The stock goes up. Everyone is happy.”
Again, this isn’t a new way to invest. It’s merely the same process of finding something consumers desire and matching a company to this need. For the time being, when it comes to ESG-based investing, it’s easier to find a company to punish, but even that by no means guarantees future results.
“If a company in the ESG portfolio is a polluter, it may have an environmental liability problem, which is a financial problem,” says Michael Edesess, Adjunct Associate Professor, Division of Environment and Sustainability at Hong Kong University of Science and Technology. “If an ESG portfolio excludes such companies, it may possibly—though by no means necessarily—enhance its financial prospects. Why do I say ‘by no means necessarily’? Because a company with an environmental liability is likely to have an accordingly depressed stock price, which could mean its prospective returns are higher than they might otherwise be, given the risk.”
Well, that was unexpected, wasn’t it? Maybe you should use ESG-based investing as a buy signal, but only after a company is punished for violating ESG-rules.
We need look no further than Wells Fargo for an example of this. By the time the Consumer Financial Protection Bureau fined Wells Fargo $100 million on September 8, 2016, the company’s stock price had already dropped 15% from its July 2015 high. It would drop another 12% before hitting its low in October 2016.
Sounds like using the negative ESG warning factor might have worked with Wells Fargo, right?
Well, here’s the twist. In the 16 months following this post CFPB fine low, Wells Fargo rose 51% before topping off at a new all-time high in January 2018 (which was 12% above its previous all-time high). Sure, Wells Fargo has since hit new lows (thanks in part both to missing earnings expectations and the recent market swoon for bank stocks in general), but, as you can see, an astute contrarian investor could have made a tidy sum rather quickly despite Wells Fargo getting an “F” grade in the “G” of ESG.
Oh, and in case you’re wondering, while Wells Fargo shot up 51%, the S&P 500 only managed a 33% gain. And that includes reinvested dividends, something the Wells Fargo number omits.
Granted, these numbers represent short-term results, too short to make meaningful generalizations, but the lesson remains.
Be careful. ESG issues can often align with stock performance, just not in the way you think.
Then again, past performance can never guarantee future results.
