It is unbelievable – but probably fair to say – that six years ago, the ESG space was thought of by some in the City as a little outré, a bit tie dye and crystals. But as the imperative to save the planet has moved to the forefront of everyone’s minds, ESG is most definitively not a trend. It’s the direction of travel.
There is now a level of complexity and nuance that has proved challenging for some investors. A few might have felt let down by the performance of their strategy, for example, whereas others have felt that their individual sustainability objectives have either not been met or were too loosely defined.
A lot of investors have also been hoodwinked by greenwashing, which was prolific until the Financial Conduct Authority in the UK stepped in to introduce rules to crack down on unsubstantiated sustainability claims.
So, with the evolution of the ESG space, what are the key lessons we have learned?
There is a difference between good companies that are good at sustainability and good companies that are good companies because of sustainability.
If this distinction seems pedantic, it isn’t. Take a tech device company that makes money from selling laptops, phones and headphones. While it’s useful for both the company and the planet if they do this with a lower carbon footprint, in the absence of a carbon tax, the firm lives or dies by selling laptops, phones and headphones.
But does the world need more ‘stuff’? Phones and headphones don’t help the world decarbonise. Solar panels do. This doesn’t mean a mobile company should never be owned in a sustainable fund and the company is not short of investors keen to own its stock. But the best fund managers we have found in this space have been able to allocate to companies where strong sustainability characteristics give the company a measurable advantage over their competitors.
Choosing not to invest in a company is not the same as choosing not to buy from a company.
A lot of investors miss this distinction, but it does matter. If I choose not to smoke, that is one less customer for a tobacco company. If I choose to sell my shares in a tobacco company, I have to sell them to someone else. Selling my shares does not mean the company sells fewer cigarettes.
Hypothetically, it would be socially useful for investors to buy enough stock to take over a company making cigarettes and change it into a company that makes solar panels. But that’s not feasible and we don’t have fund managers who have based strategies on changing tobacco companies into solar panel manufacturers.
The better fund managers are good at engaging with the companies they own stock in and encouraging sustainable behaviour at those companies. They can’t change what they do necessarily, but they can help them do what they do in a more sustainable way.
Not every good story is a good investment.
Humans have always been influenced by storytelling. And because of this, it can be very easy to convince yourself anecdotal evidence is indicative of an investment trend. All of us quite frequently meet family, friends and colleagues who are consciously trying to eat less meat. Given the huge percentage of emissions coming from the food sector, we find the idea of companies involved in meat alternatives an intriguing story.
But unfortunately, the anecdotal evidence is not supported by financial metrics like sales growth and profits. The percentage of vegans in the UK is not significantly more than it was five years ago. The plant-based meat market has not significantly grown market share over the past five years.
The more unpalatable truth is that not enough meat eaters have been convinced to switch. This does not mean the world doesn’t need to eat less meat. But it does mean fund managers investing in plant-based meat products do not necessarily have an investment thesis that matches the reality of sustainability in the area.
But sometimes it is.
Electric vehicles (EVs) are helping the world move towards a lower emission form of transport. Batteries have become much cheaper and more powerful over the past 15 years, so the electric car is becoming a product that is more viable as an alternative to the internal combustion engine.
Car companies are finding new car sales are being driven by these products and battery companies are seeing increased revenues and better profits. This transformation is happening at different speeds, depending where you are in the world, but ultimately we see the anecdotal evidence (your neighbour deciding to buy an EV) being supported by hard data.
Fund managers investing in the future of electric transport therefore have options in areas like car companies, battery manufacturers and charging infrastructure.
Diversification requires more thoughtful portfolio construction.
If you have a reductive view of sustainability and expressed it via buying a lot of technology companies and excluding the traditional ‘sin sectors’, the past 18 months have been tough. There are times where the only game in town is energy and other times where technology is the market darling.
But plenty of sustainable themes have very different sectoral exposures. The EV value chain involves technology and industrials, with geographical focus in Japan and China. The clean water value chain involves utilities, with more of a focus on Europe. They behave very differently. Intelligent combinations of sustainable themes can add a lot of diversification benefits to a portfolio.
Open minded fund selection is a superpower.
The best managers we have found in this area have generally been smaller and specialist. While there are lots of US value managers, there are not that many managers investing in electric mobility or waste management. A focus on these markets tends to suit a more specialist skillset that requires both industry expertise and stock-picking ability.
While these managers are rarer, they tend to have strong track records and tend to not be household names. On the basis you need to be different to the market to have a chance of out-performing it, this can be a good space to unearth hidden talent.
The whole ESG investment space is in in the early stages of development and this is why you have seen managers make mistakes. The next phase will involve more specialist managers targeting the intersection of the transformative companies that are great because they are sustainable, rather than sustainability being an add-on.