As the global ESG “industry” grows, evidenced by a staggering $40.5 trillion in dedicated global assets (as of 2020), there is a rush to categorize, rank and measure companies’ ESG (environmental, social and governance) characteristics. A number of indices have sprung up to quantify ESG with Dow Jones, Morningstar, FTSE, Stoxx, MSCI and ISS joining the fray, each with their own objectives, definitions, methodologies and data. As is often the case, these rankings can be a blunt instrument, based on a simplistic exclusionary or “box-checking” approach; no two indices produce consistent results. For example, The Wall Street Journal in a September 2018 article entitled, “Is Tesla or Exxon More Sustainable? It Depends Whom You Ask” found that Tesla was considered among the best global car companies by MSCI, but the worst by FTSE on ESG issues.
ESG indices often rate companies on factors not pertinent to their industry. The impact of a bank’s carbon footprint is immaterial to global carbon emissions; yet some banks are directly involved in money laundering or lending to companies that have poor environmental, societal or governance records. ESG credited banks for the former and missed the latter, in part because the voluntary and reputation-focused nature of sustainability reports tends to leave out bad news.
Entry to ESG indices is seemingly subjective. Companies are bypassed, categorized in a “sin-bin” slot for mining, liquor, gambling or the like without consideration of their efforts to push their respective industries forward, and giving back to the communities in which they operate. Yet others, like British American Tobacco and Coca-Cola, are ranked in the top five environmentally and socially responsible companies on the FTSE 100.
And we witnessed ESG manipulated by crowd behavior, driven by the repurposed “S” in ESG: “social media” investing. This is not investing at all, and drives stock valuations to extreme levels. Case in point: as fellow portfolio manager Jason Crawshaw observed, the largest stock in the Russell 2000 is Plug Power, a hydrogen fuel cell story, with $25 billion market cap, 30 years in the industry, never made money, but is up 15x over the last year. There is massive speculation in “green” areas of the market, particularly smaller names where social media groups can “pump and dump”.
Companies like Plug Power actively position to become ESG entrants by changing their business model to fit the trend of the day with nary a thought to business sustainability five, 10, or 20 years down the road. We observe that once the stock meets predefined ESG thresholds, indices willingly slap on the ESG nomenclature, buzz is generated and investors’ cash starts flowing in.
Many of these stocks are now trading at elevated price-to-earnings multiples that are increasingly hard to justify. Those ESG ratings don’t take into account a company’s financial strength, how ESG fits into its competitive strategies or if ESG efforts deliver better shareholder returns. In fact, there is no conclusive evidence that socially responsible screens or company positions on lists such as the Dow Jones Sustainability Index deliver alpha for investors.
It may behoove investors (and indices) to steer away from narrowly-focused ESG rankings, and instead look at companies for their “shared value” properties. A theory propositioned by Porter et. al in a 2019 Institutional Investor article, “shared value” looks at the causal link between a company’s social impact and its competitive advantage. The thesis stands that tying the two together offers greater benefit to the public, and more often than not, shareholders as well. We support this notion, with slightly different rhetoric. At Polaris, we believe that sound companies with best practices and ethical underpinnings would prove sustainable over the long term – regardless of a label.
We do not rely on the blanket standards to inform our investment decisions. Instead, Polaris continues to conduct its own analysis to see if a company holds true to our high ESG principles. Dedicated personnel oversee this analysis, with Alexis Horn-Snyder, senior investment analyst and operations coordinator, continuing to spearhead weekly reviews.
As part of the process, we gauge ESG risks as they relate to company fundamentals; analyze market forces and companies’ ESG reporting; speak with management about relevant ESG topics; monitor ESG-related headlines on an ongoing basis; and engage on proxy proposals, such as remuneration standards tied to ESG and Board diversity. We are also keenly aware of who presents at corporate ESG presentations – is an ESG team showcased? We also look at a company’s history of ESG transgressions and how they were remediated while the future financial liabilities of repeat offenders are incorporated in our financial models. Our team asks the right questions; keying in on how ESG is sustainably intertwined with corporate strategy.
Principles of transparency, good corporate governance, shareholder interest and positive community impact are generally associated with good management, employment practices, employee satisfaction, productivity and positive cash flow. These are qualities intrinsic to a company that may not “check the boxes” under the various industry ESG rating standards, but is a sustainable company by Polaris’ standards. In short, ESG and sustainability = good business = good return for shareholders.
This blog was penned by Bernard Horn Jr., President & Portfolio Manager, in April 2021. Mr. Horn founded Polaris in April 1995 to expand his existing client base dating to the early 1980s. Mr. Horn’s pure global value philosophy combines investment technology with traditional fundamental research. His 40+ year track record exceeds most current competitors in length and has produced admirable risk-adjusted returns since inception.
IMPORTANT INFORMATION: The views in this article were those of Bernard Horn as of the article’s publication date (April 23, 2021) and may be subject to change. Information, particularly facts and figures, are dated and in many cases outdated. Views and opinions of Bernard Horn expressed herein do not necessarily state or reflect those of Polaris Capital Management, and are not nor shall be used for advertising or product endorsement purposes.
Polaris Capital is an investment adviser registered with the Securities and Exchange Commission. For more information about Polaris, please contact us at (617) 951-1365 or at clientservice@polariscapital.com.
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