The topic of ESG is a fairly expansive one that covers many different ideas and concepts. We were able to hit on many of those in great detail in the first blog post on this topic a few weeks back, titled "The New Kids on the Block: what should be made of ESG," however a few ideas still need to be addressed. To round out this subject, we are joined by Ben Nye, Narwhal's Chief Investment Officer, for his thoughts on investing through an ESG lens.
- What do you make of Larry Fink's comments on ESG? Do you view them as significant?
Ben: "I think it's significant because it's getting people thinking about investing in these products that wouldn't normally think to. I think it's a good move because if you look at who's buying these, a lot of times it's RIAs like us, buying them for younger clients. Those RIAs need a product that can be presented to clients as positioning them in ESG friendly ETFs that are low cost and endorsed by BlackRock (the largest asset manager in the world). It's a selling point for RIAs, a selling point for BlackRock, and it's translating into higher and more stable inflows. If you look at the inflows into iShares ETFs that are labeled ESG by BlackRock, during the first 3 quarters of 2020, you saw really consistent growth of those inflows, Q1 $10 billion, Q2 $12 billion, Q3 $8 billion, roughly $30 billion of net inflows into those ESG products. For context, all inflows into iShares ETFs through the first 3 quarters of 2020 were $106 billion net, so almost 1/3 of that coming from ESG. And where it really gets interesting is the stability of the inflows of ESG versus everything else. Over the same time period that you saw the inflows of ESG go from 10 to 12 to 8, you saw all other iShare ETF inflows fluctuate from 14 to 51 to 41, so those traditional inflows seem to be much more volatile. This is part of the reason Larry Fink is so high on ESG because of the consistency of those investments, so from a pure investing and marketing standpoint, I think those numbers are significant."
- Do you think that he's right to say that there will be a massive reallocation of capital, and if so, what will this look like?
Ben: "I think it will start off with an allocation of capital, and over time it will become a reallocation of capital. Although, what I would say is, if you think 10-15 years down the line, you're not going to have many firms that won't be ESG. Let me see if I can think of a good analogy. It's kind of like looking at advertising on food labels; one product might say that it's "all-natural," and currently that might be a differentiator for a product, but at some point, that becomes the norm, and that is expected by consumers instead of being a unique selling point. I think that could end up being a similar story with ESG. So, I see it starting out with capital allocation with more and more inflow from new money and younger investors pouring into those products. In regard to Larry Fink's comments, I would tweak them a little bit and say that it won't be a true reallocation of capital, but again, I certainly see it as standard operating procedure down the road."
- Do you agree that climate risk is a form of investment risk that should be considered with the same rigor that is used when analyzing other forms of investment risk?
Ben: "First, I think it's important to differentiate companies that are exposed to climate risk from those that promote climate risk. Companies exposed
to climate risk can be significantly impacted by natural disaster factors prevalent in the areas where the company operates. For example, something like a drilling company that has a bunch of offshore rigs in the gulf, or a real estate company in San Francisco, those are companies that are exposed to climate risks, a storm or an earthquake can significantly disrupt their business. You want to be very mindful of those factors while considering them for investments by diversifying to mitigate that risk. On the flip side, you have companies that promote climate risk, like companies with large fossil fuel emissions, utility companies burning coal; those are promoters of climate risk. If you look at these promoters of climate risk within their industry, you can compare them to similar companies that operate the same core business but do so in an environmentally friendly way. These companies operating with environmentally conscious mandates are called detractors of climate risk. Renewable energy companies, those centered around green tech, are examples of detractors of climate risk. If you compare the promotors to the detractors, you begin to see that a few things will happen over time. First, those greener companies have a big opportunity to see costs decrease, creating a significant cost advantage in the future. This will be a secular trend in my opinion that favors detractors of climate risk, compared to the promoters of climate risk (i.e., fossil fuel dependent companies) that won't see a reduction in input costs going forward and, in actuality, have seen commodities inputs increase in price over time. The second piece that hurts the promoters of climate risk is that many will be subject to carbon emissions taxes, which becomes a form of business risk that you have to be cognizant of as these taxes become more common. These secular trends should also be considered when analyzing potential investments."
- Is there a way that you could envision sustainability as an operational/competitive advantage lever that companies could pull to outperform others in their segment?
Ben: "I think it will take a long time, but I do think it will happen. Like I said earlier, a lot of "greener" technologies have a higher cost of goods right now, but over time those costs will come down eventually leading to the point of parity. Beyond that, you'll have a point where the green tech is actually cheaper to produce, leading to a competitive advantage. You can see that companies are recognizing this already and investing in green tech, knowing the cost advantage that can be achieved down the road. Beyond just cost savings, you have companies that can charge more for a product because of the perception of superiority. Some companies can capitalize on this already. Take Beyond Meat, for example; they can charge much more for a pound of their product than a company can charge for a pound of ground beef because of the differentiation Beyond Meat offers. However, like I mentioned earlier, I expect that differentiation to fade over time, but it certainly bolsters revenues in the short term. The term for what a company like Beyond Meat is experiencing right now is what we call a "blue ocean strategy," where they can actually charge more for a product that is cheaper to produce. It's cheaper to grow a pound of beans than to raise a pound of beef, but they can still charge more for it. Again, I expect that to change over time, but for now, it's certainly created a competitive advantage."
- When valuing a company's long-term viability and their ability to be capital generators going forward, do you consider ESG factors? Does Narwhal as a whole consider any of these factors in its current due diligence process?
Ben: "We especially look at the "G" of ESG, which is the governance side, and it's actually explicitly called out in our analysis. We also look at the Macro side, which considers many social and environmental impacts, but more through the lens of what is happening on a big picture scale and how those trends are affecting a particular business. For example, cigarettes, one of the reasons we don't hold cigarette companies as a large portion of the portfolio is because its product actually harms its customer base resulting in a secular decline for the industry. You can see that in dropping cigarette volumes year over year. So that's an example of us looking a little more at the "E" and "S" portion of the formula through the lens of macroeconomic trends. I think if you ask, "does Narwhal look at ESG" I would say yes, it might not be to the extent of making sure every company checks every one of the ESG boxes, but I'm not sure how practical that actually is, and companies that claim to view investments explicitly through that lens are probably cutting corners."
- Do you think that ESG investments will outperform traditional investment segments long term?
Ben: "That's a good question. So, I think the "G" of ESG has always outperformed. If you have good governance, then you have good management, you'll be making smart decisions on how you deploy capital; that's the definition of the "G," or at least how I define it. Some define it more in terms of a quota for diversification standards on a board and having to meet particular parameters; I don't look at it that way. I'm looking at how the board addresses issues; if it's comprised of good people, do those people manage the business well, and are they heavily involved. That's how I define corporate governance, but not everyone defines it that way. As far as the "E" and the "S" relate to performance, I don't think there are a ton of companies that have been successful for a long time and should continue to be successful into the future that consistently fail at the "E" and "S". That being said, it can be hard to invest based on the "E" and the "S" in the short to medium term. There are companies that have not done well in those facets but have still been successful as a company, making it hard to determine how performance in the environmental and social areas will be perceived and how that affects a business. I think companies that consistently fail in those areas won't be around forever, but again it's just a hard thing to judge and a hard thing to invest in when considering the short to medium term."
- Do you see a Biden presidency playing a role in the acceleration of adoption/overall success of ESG strategies?
Ben: "I think carbon taxes are coming. I think that regulation will increase. From a market perspective, you won't see companies necessarily parading around talking about how ESG they are to investors, but I do think you will see companies doing that to the government. I talked to a lobbyist a few weeks back, and he was explaining that under the Trump administration, companies wanted to show the government how they created jobs and how they helped veterans. Whereas, under the Biden administration, those companies are going to want to paint the picture that they can help reduce carbon emissions. I think that will be a big shift within companies and how they want to be perceived. This is less related to a Biden presidency, but I think the concept of ESG and what falls into that category will continue to change. Specifically, on the social side. I think that things that are deemed socially responsible now might not be, and things that were not seen as socially responsible before will go through a perception change. Take sports gambling, for example. People have fought its adoption but now see it as a way to fund education by imposing taxes on it. That's an example of an industry with a historically negative perception being changed into a positive one. On the flip side, you see companies like pharmaceuticals walking a tight line of whether or not they are good or bad. That's a tough part of the "S" component of ESG. Things that were once perceived as good can switch and be perceived as bad, and vice versa, and that swing can happen quickly. So, if you are an organization leaning on the "S" in ESG, you have to control the messaging and stay out in front of it."
- If Larry Fink's comments are correct, how will Narwhal position itself to capitalize on this market shift?
Ben: "In terms of the businesses we emphasize, we just pitched a company called Stoneridge. We like this company for a few reasons. Firstly, they promote safer driving for large trucks, and secondly, they make those large trucks 2-3% more fuel-efficient. We aren't investing in it on an ESG basis, but we think it fits many bigger ESG secular trends. It's a cyclical stock that has a secular undertone driven by ESG factors. We have a lot of companies that we are looking at that have a similar story. Another example could be NextEra. It's a utility company with some favorable ESG components. We are definitely mindful of those overarching ESG themes when we evaluate different companies."
- Any closing remarks?
Ben: "I think I sounded fairly favorable to ESG investing throughout this interview, but it's not something that I would say is a mandate, and I certainly wouldn't back it as strongly as Larry Fink has, but that being said, it's happening, and it needs to be considered in investing no matter what."