The New Kids on the Block: What should be made of ESG

You may have heard the phrase "ESG investing" and not known what it meant, or you may know what the phrase means and think that it's a great idea but not going to truly impact the world of investing, or you may disagree with the idea altogether and think that it has no place in the world of investing. If you fall into any of the above categories, I think you've come to the right place. This article isn't going to try and persuade anyone to change their opinion on whether or not ESG investing is virtuous or valid. This article is simply aimed at informing the reader of what ESG investing is and its effect on the world of finance. Back by popular demand is everybody's favorite analyst duo, Jason Seeb and Vincent Qiao, to discuss the idea of ESG investing, significant comments made by the CEO of the world's largest money manager, and what this whole trend means going forward.

What is ESG investing?

Jason: "ESG Investing is investing in companies that do positive things in the world in terms of environmental, social, and corporate governance issues."

Vincent: "I view ESG investing to be investing through a lens that considers those 3 factors."

For a while, it seemed like ESG investing was a nice idea but not a true strategy, was that the perception of ESG, and what is the perception of ESG today?

Jason: "I definitely think it started as something that was more of a side piece or the gravy on top, but a couple big organization have endorsed it as a realistic strategy for them, and since then, you've seen a lot of funds and advisors pop up that have ESG as their main focus. A side note, ESG is definitely more popular with the younger generation of investors."

Vincent: "So, if you break the three down, environment and social have never been traditionally thought of as core foundational investing principles, but governance has always been a crucial piece of any long-term investing strategy. I don't really know when the term "ESG" was originated, but at first, all serious investors disregarded it as an investment principle by itself. But now, with mutual funds and asset allocators actually allocating capital to funds with these mandates and ESG related strategies, it doesn't really matter what the active managers think anymore. They have to adopt an ESG mandate, or else they will lose market share, see reduced funds flow, etc."

How are ESG investments measured in the markets today, what qualifies an investment to be ESG, and is there a so-called "standard" that makes an investment ESG?

Vincent: "No, there isn't a true standard, and rather than qualifications, it's more along the lines of a scale to see how a company is doing environmentally, socially, and from a governance perspective. It's not scientific at all. I should say that there are "common standards" provided by various market data/index providers. Still, their analysis of ESG is not very good, and that has been a central criticism against ESG is that these valuation methods are very bad."

Jason: "I agree that there's not a single definition. Companies that could fall into the ESG category could be an electric vehicle company, someone that makes sustainable farming equipment, a company that commits to paying all their workers above minimum wage, or a company that makes handbags produced in Africa and donates half the proceeds back to the town that the product is produced in. It's really more of a "you know it when you see it" kind of situation."

My first thought about ESG goes right to alternative/renewable energy investments. What other areas in ESG are getting attention from investors?

Vincent: "It's really vague in general and kind of hard to peg down what companies even fall in the category, as I mentioned a second ago. There are 3 criteria, companies can exemplify all or one of them, it's just really vague, which makes this idea all the more difficult."

Jason: Your question certainly points out a big portion of ESG by mentioning the environmental side with renewables and environmentally focused products, that's a big piece, but I would add that ESG involves more than just the end product that a company produces. A company with environmentally focused supply chains or manufacturing processes could fall into the ESG category even if the product they produce has nothing to do with any of those issues. On the social side, how they treat their employees, what they do with their profits, that could lead to ESG consideration. An aspect of ESG that has been in the news this past week, on the corporate governance side, is that the Nasdaq has announced that they are considering implementing diversity standards for the boards of all companies listed on that exchange. So, a company could be classified as ESG if the company's board meets that standard. It's a trend that's been happening for a while but definitely has picked up steam over the summer."

Vincent: "Goldman Sachs actually said that they won't work with any company if the company's board doesn't have any women or minorities."

How significant were the comments made by Larry Fink regarding BlackRock's stance on investing in companies with an ESG focus, and do you see that as a major turning point for the course of ESG investing?

Vincent: "No."

Interviewer (John): "Care to elaborate?"

Vincent: "No." (long pause followed by laughter)

Vincent: "I mean BlackRock is a giant organization, and not to take credit away from Larry Fink, but I think the movement is broader. I think a lot more capital allocators are looking at this trend that may not be in the spotlight like Larry Fink is, so that's the reason for my initial response, its not a major turning point because of Larry Fink's comments alone."

John: "So you are just trying to make the claim that Larry Fink isn't the only one seeing and acting on this trend?"

Vincent: "Essentially, yes."

Jason: "I think that his comments did have an impact. An organization as big as BlackRock making it a focal point gave other smaller funds and organizations the go-ahead and set a precedent for them to act more boldly moving forward."

In his letter, Larry Fink claims that the view on the importance of ESG investing is changing, and we are on the verge of a "fundamental reshaping of finance," and we will see "a significant reallocation of capital in the near future." Do you agree with those ideas?

Vincent: "In principle, I don't like the idea of ESG, but practically speaking, there's a real chance of widespread capital reallocation happening. I base that off of, as Jason mentioned, a demographic shift from older investors to younger investors as holders of capital and institutional capital allocators adopting this."

Jason: "I agree with Vincent. I think it's a little bit of an overstatement, but I do think there is pressure on companies to follow these trends."

What does it mean for major corporations when a company as powerful as Blackrock makes this kind of statement? Does Blackrock have the ability to directly affect companies through its own resources if they don't feel that a company is meeting ESG standards?

Jason: "Obviously the amount of money that BlackRock has gives them some level of voting influence, and all the other funds and companies that followed in BlackRock's footsteps investing in ESG further adds to that, but I would say that overall societal pressures, which we've discussed with the Nasdaq implementing diversity requirements on company boards and other things like that, is a much larger influence on corporations than the influence from investors. This idea that society can impose its views on corporations and how they should be run is pretty remarkable but also very powerful."

Vincent: "I agree with Jason, but I think there is an additional factor at play. If you think about how big BlackRock is and how many ESG analysts they have hired, all of these analysts are talking to companies' management and their investor relations teams. It's hard to imagine their presence alone not having at least some effect on companies. They are likely to be more powerful in the board room. And yes, if it's an ESG focused fund, then obviously they could vote against certain deals, reallocate capital and all that."

Some people claim that companies like BlackRock are using this idea of socially responsible investing as a marketing ploy that these critics call "greenwashing." Do you think this is true? Would companies try and take advantage of this trend by labeling themselves as socially responsible to entice investors or garner more favorable rates on borrowed capital?

Jason: "I think that, just because these companies might be taking action with ulterior motives, it doesn't negate the positive externalities that would come about and benefit the environment or the company's employees. The economics major in me says that, how do I phrase this, there are lots of examples of how people get incentivized to do things that they wouldn't do otherwise, but the results often turn out for the greater good. I think this is just that idea on a bigger scale. Also, it's not unreasonable to think that companies left to their own accord usually don't do the best things for the world, which is why we have government regulation. This societal push for ESG compliance is just a form of social regulation on companies. So even if they are only doing it for PR, not out of the goodness of their heart, the level of carbon in the atmosphere doesn't care about the motives, the result is still positive, and that's what matters."

Vincent: "I agree; it doesn't matter why or what the motives are behind this movement. This movement is real, it's happening, it has the potential to drive the cost of capital for certain companies down, and therefore it matters. Incentives work, and those incentives are paying off."

How will investors differentiate between true social responsibility and this so-called “greenwashing,” and does it even matter if the outcomes are net positive like you mentioned in your last answer?

Jason: "I don't think it matters, actually maybe it matters a little. If the company's intentions are good, they are probably more likely to be effective with their ESG initiatives. But regarding trying to figure out if the intentions are genuine, I think there are two ways to look at it. The first way would be to look back to what management said in the past, look back 10-15 years ago; if they were mentioning these things before ESG was a trend, I would say it's more likely to be a true priority, not just for show. The second way and this is true for so many things in life, is to follow the money. Is management just saying it and putting up content on their website, or are they actually putting their money where their mouth is and investing and giving to these causes."

Vincent: "Investors won't be able to differentiate between the two purely because the criteria is so unclear. I think there is a problem looking at what has been said by management historically to try and understand their stance today. Say 20 years ago, people would get fired in the board room for bringing up environmental factors because those societal pressures worked in reverse back then to discourage that kind of talk. So again, incentives matter."

**Couldn't make out all the banter that followed about whether or not Beyond Meat should be considered ESG, Tom walked in and fired up the coffee maker, which is pretty loud. Ben swung by to argue that Beyond Meat is not socially responsible because it is so expensive. Tom said it's not ESG because it's terrible for the Orangutans because they destroy rainforests to harvest palm oil for it. No real consensus from the others, the debate continues.**

As virtuous an effort as ESG investing may be, virtue alone doesn't move the needle for investors. What will truly drive the adoption of ESG strategies and make them the new normal in investing?

Vincent: "I think virtue does move the needle because if people invest according to their virtues, then by default, ESG will be adopted. Again, I think it's just a generational shift in attitudes. 30 years ago, people invested because they wanted to make money, nowadays, people want to make money, but they are also conscious of how their capital is being directed."

Jason: "I would argue it's pretty normalized already, especially among the younger generation."

Vincent: "Apparently, I'm not the younger generation."

Jason: "I would also argue that it's more popular among people that invest very infrequently, or they spend very little time thinking about it. They have some money sitting around; they think it might be cool to invest it, so they might as well invest it into a cool electric vehicle company or a company that is pioneering renewables, things like that. And we probably won't ever get to a place where 100% of companies are focused on ESG, but it's certainly got a lot of traction now."

Historically speaking, how have ESG products performed compared to traditional products, and do you think that trend will continue? Do you think Larry Fink is correct that ESG companies and investment products comprised of those companies will outperform going forward?

Jason: "So I saw a presentation the other day that said ESG is outperforming by 3-6% depending on how you define ESG."

Vincent: "Fake news."

Jason: "I haven't looked up the math behind that, but I would think a lot of that is coming from electric vehicle companies which have significantly outperformed this year. If it can outperform, that will drive a ton of capital there because you are making money and feeling good about yourself. And I know that the international monetary fund did a research study that shows that ESG has outperformed over the longer term."

Vincent: "Fake news."

Vincent: "So traditionally, from the studies I've seen, ESG has either performed equally to or outperformed slightly compared to traditional investments, which suggests outperformance, but I don't think ESG was the causation factor. I think it is more correlation. But again, it doesn't really matter; it's being adopted, it has worked, and it will continue to work.

Jason: "I forget where I heard it exactly, but someone was saying that this might be an ESG bubble. They claimed it was a fad, and a lot of these companies that are just popular because they are ESG and don't have strong underlying fundamentals will eventually get hurt."

Vincent: "Yeah, people say things are fads, and typically they are correct to say that the current levels won't be sustained going forward, but what is actually more typical is a sort of wave phenomenon. Each wave that follows the previous waves will get higher and higher as the waves continue. Obviously, this electric vehicle craze won't last forever, it could crash in a year or two, and ESG could crash in a year or two, but in 5-10 years, I think ESG will be a meaningfully higher percentage of the index than it is. The wave will keep riding higher after each crash."

Jason: "I'm just waiting for you to say buy tesla."

Vincent: "Ill never say that."

Are there areas within ESG that you guys find attractive / areas that you think are danger zones that you would avoid?

Vincent: "Don't have one."

Jason: "I'm partial to beyond meat, as a former shareholder myself. But no, I think you can definitely find niches and find companies that make sense for you. The danger comes when you get enamored with the company and the story because it's great for the environment and great for social causes. You decide to invest without looking into the financials or without understanding the fundamentals, and a year down the road, you find out that everything wasn't what it seemed. You're stuck with major losses because you invested purely based on the fact that it was ESG and not on the quality of the underlying company."

Interviewer (John): "You mean like Nikola? (we did a blog post on Nikola a few weeks back, check it out)"

Jason: "Yep, exactly like Nikola."