The TL;DR on the ESG Investing MegaTrend
- We are at an inflection point in investing trends.
Tesla semi-truck loads of money are flowing into ESG stocks and funds. Reported amounts invested in ESG are all over the map, with recent articles pumping out figures ranging from $250 billion to $1 trillion—the important point being that this is way more than at any point in the past. Investors are demanding environmental and social responsibility. It is unlikely that this pendulum will swing back the other way any time soon as 95% of millennials are keen on sustainable investing. - Buyer Beware
As of yet there is no standard for what qualifies as an official ESG investment. I’ve seen Amazon and Nike named as top ESG stocks to invest in, which is surprising given Nike’s sweatshops in China and how Amazon treats its employees. I also just saw McDonald’s on such a list—lol wut??? Responsible investors must still conduct their own due diligence to avoid this financial asset marketing ploy.
- ESG In The Microcap Space
Focus on companies delivering ESG products and/or services. This will often mean focusing on the Environmental aspect. A small company that is working to make the world a better place will stand out far more in the ESG sector than one that is simply included due to S/G practices.
More and more people are investing in companies producing the changes they want to see in the world. Just have a glance at the recent performance of a few good companies under this umbrella.
Exro Technologies: Making electric motors more efficient.
Very Good Food Company: Plant based food pioneer.
Greenlane Renewables: Technology powering renewable natural gas.
Tesla: Electric car company, duh!
Sector Overview—ESG Investments
The year 2020 seems poised to go down in the annals of history as the Year of the Pandemic. Though in the investing world 2020 will likely prove to be the year that ESG investing became a mainstream megatrend. This should end its long-held status as a fringe concept based on whatever investor social activism might be popular at the time.
ESG in today’s investment climate is all encompassing and its emergence into the mainstream is evidenced by inflows of more than $70 billion into ESG funds the first six months of this year. That’s some serious coin when you consider that only about $20 billion was invested into ESG funds in all of 2019 and that such funds only attracted about $5.5 billion in 2018. According to some analysts, there are now almost 600 ESG-focused exchange-traded funds (ETFs) listed on the indexes with more than $165 billion in assets under management. [Other analysts claim that ESG-focused ETFs and related investments now represent more than $1 trillion under management worldwide.]
If you are now wondering what the heck an ESG fund is and trying to guess what the ESG acronym might stand for, you’re probably a Baby Boomer or older member of Generation X. Most Millennial investors know exactly what ESG stands for because they are in large part responsible for bringing the ESG investing trend into the mainstream. So, let’s catch up with the times, ya geezer, and learn exactly what ESG is all about.
ESG Equals Environment, Social, and Governance
The acronym ESG stands for Environmental, Social & Governance (that is, “corporate” governance) and specifically refers to accounting for ethical concerns in the context of investing. The concept—which has also been referred to in whole or in part as “values-based investing,” “sustainable investing,” and “socially responsible investing,” among other terms—has actually been in play in the investing world for centuries.
American Quakers became early adopters of the concept in the mid1750s when the religious group prohibited its members from investing in companies supporting the slave trade. More recently, activist investors launched the Pax Sustainable Allocation (MUTF: PAXWX) fund in 1971 to specifically curtail investment dollars from flowing into companies that were supporting the Vietnam War effort. ESG-related activist efforts were also made to curtail investments in fossil fuel companies following the Exxon Valdez oil tanker spill and to companies with business interests in Apartheid-era South Africa.
The primary difference between the concept today and on an historic basis is that most earlier ESG-style investing focused on investment exclusion rather than inclusion. Today, it’s much more about investing in companies with the best ESG standards and practices rather than specifically avoiding companies lacking such. So, let’s look closer at exactly what ESG means:
Environmental—This broadly refers to evaluating exactly what impact a company might be having on the environment. Companies that specifically work on improving the world’s environment and/or develop environmentally friendly products score the highest in this metric. But companies can also score points by how eco-friendly and sustainable they run their operations. As with all components of ESG, there is no one-size-fits all definition. Eco-friendly on any number of parameters might warrant inclusion as an ESG-worthy investment, while lack of attention to environmental concerns on an operations basis, or development of non-sustainable/eco-unfriendly products, warrants exclusion.
Social—Treat your customers, workers, and the general public right and a company scores social points. This category covers a range of issues including human rights, labor practices, diversity, product safety, working conditions, non-discriminatory pay, and anything related to social justice. Companies gain cachet in this category by ensuring they follow social justice dictates in their operations, and by actively supporting social justice causes.
Governance—This involves an examination of a company’s corporate structure, transparency, and business ethics. ESG points in this parameter are largely based on corporate board racial and gender-based composition, executive compensation, and the presence or absence of any potential ethical concerns that may be inherent in the company’s history, practices, and/or products.
ESG Investment Paradigm Largely Driven by Millennials
Interest in ESG investing over the past few years has been primarily driven by the Millennial Generation, which is also the primary driver of activism involving environmental issues such as climate change, as well as the full slate of social justice issues from racism to income inequality. Not only are members of this large generation now in the workforce and starting to take an active role in investing but are also stand to be the recipients of a massive $30 trillion transfer of generational wealth from their aging Baby Boomer parents. While this wealth transfer will not happen overnight, the generation will slowly but surely accrue more economic power in the years ahead. In short, the generation represents a force to be reckoned with as it will increasingly become the decision makers in all aspects of life.
The surge of interest in ESG has come to a head this year due to the current climate of social and economic distress. Just consider how much attention is being paid to climate change concerns, the rise of Black Lives Matter, political strife between right- and left-wing ideologies, and COVID-19 pandemic-induced economic disruption that has put enhanced focus on the extreme divide between rich and poor.
The bellwether for this recent surge in ESG interest was marked earlier this year by a shareholder letter penned by the CEO of one of the world’s most influential fund companies, BlackRock (NYSE: BLK). In his letter, BLK CEO Larry Fink called sustainability the company’s “new standard for investing” and announced plans to make “sustainable investing more accessible to all investors.” Not only does his company plan to double the number of ESG ETFs within the next few years but will significantly expand consideration of ESG factors in all aspects of its investment strategizing.
What of ESG’s Impact on the Bottom Line?
Wait a minute! Isn’t investing supposed to revolve around finding companies with exciting growth prospects and sustainable earnings generation and expansion? Wouldn’t a focus on environmental and social justice issues prove costly and negatively impact a company’s bottom line?
Yes. Initiatives designed to drive sustainability, limit carbon footprints, provide fair compensation, enhance working conditions, etc. do come with a cost. But they can also lead to cost savings and in some cases improved sales. For example, efforts to limit a company’s environmental impact can lead to money saving reductions in energy consumption and waste generation fees. Initiatives to provide better pay and enhance the work environment can stimulate productivity, employee retention, and attract higher calibre workers. Products deemed safe and environmentally friendly can lead to greater sales.
And many such initiatives are supported by government funding in the form of grants, interest-free loans, tax breaks, and other incentives. North American governments tend to be fond of offering feel-good largesse and the incoming Biden administration may prove especially favorable in promoting corporate, environmental and social justice initiatives.
All this to say that while there is a cost for implementing ESG practices, they can offer a variety of offsetting returns.
Are ESG Investors Just Virtue Signalling?
If you’re still concerned that ESG investing might just be the latest fad, consider the ESG investor. Sure, making money from the investment is a primary concern, but many ESG investors also target their investments in support of a cause. Not just as a means of virtue signaling, but usually because they truly support the cause. Such support tends to be fervent, which can make ESG investors strong holders of the companies they love.
Evidence for this can be seen by looking at the trading action in some of the most popular ESG stocks, such as Beyond Meat (NASDAQ: BYND), Tesla (NASDAQ: TSLA), and First Solar (NASDAQ: FSLR), to name a few. Sustained positive investor sentiment tends to be strong in such companies and in the sector as a whole. Sentiment can also be gauged by considering fund flow. We already pointed out how flows into ESG funds have surged this year. Juxtapose this with the fact that fund flows into the oil and gas sector have been essentially flat for the past two years.
Will the ESG Investing Surge Prove Sustained?
The focus on ESG in company operations and its emergence as a distinct investment sector has legs. And they are running a marathon, not a sprint. A recent Morgan Stanley survey of Millennials revealed that 95 percent of those surveyed are interested in sustainable investing. The survey also found that 88 percent believe that financial gains can be balanced with ESG considerations.
Stock analysts and ratings firms now almost all include ESG as another metric that needs to be examined and weighted for inclusion in company reports. And publicly traded companies are responding by reviewing their own ESG practices to find out where they need to make improvements.
How to Consider ESG in Your Investment Research
Stock analysts now tend to include ESG as a metric to assess in company research, yet there is no clear standard for how ESG parameters are to be rated. This typically means that a company’s ESG profile may vary depending upon the analyst and ESG scoring methodology. Interestingly, the CEO of BlackRock released a letter to CEOs in conjunction with the shareholder letter calling for the adoption of standardized ESG reporting by companies and analysts.
Until a standardized framework for evaluating a company’s ESG grade is put into place, investors are going to have to rely on company self-reporting and what various analysts think. Whatever the case, evaluation of ESG criteria should not trump fundamental financial analysis.
ESG considerations with Microcap Investing
With regard to investing in ESG-friendly microcap companies, go beyond ‘SG’ considerations in company operations and look to companies that produce ‘E’-related products and/or services. With the current focus on ESG, a small company that is working on making the world a better place will likely stand out far more in the ESG sector than one that is only included in the sector due to best ESG practices. This means focusing on the “environmental” component of ESG. Products and services related to social justice and corporate governance are limited.
Such environmentally oriented companies are at the forefront of a revolution. The world desperately seeks solutions to climate change, environmental degradation, waste management, and the scourge of plastics. The companies that successfully come up with cost-effective solutions will inevitably rise in the hierarchy of ESG investments. This will undoubtedly occur in conjunction with a noticeable rise in revenues and stock price. And by getting in on the ground floor, early investors have the potential to reap the greatest rewards.
