Many financial professionals still recite a pat response when clients ask about socially responsible investments: Beware! They will likely underperform the broad market.
A decade ago, that answer was fairly accurate as a generalization. Take, for example, the so-called “sin” stocks, such as alcohol, tobacco and gaming. A 2007 Journal of Financial Economics paper called “The Price of Sin: The Effects of Social Norms on Markets,” found that these stocks outperformed peers (returning about 3% more per year). Since most socially responsible investing at the time purposely excluded these stocks, they could be expected to underperform.
Today, the underperformance argument sounds fairly uninformed. Socially responsible investors at the time were largely foundations and endowments. Their aim wasn’t to earn a higher rate of return; it was to avoid supporting undesirable activities, arguably even to punish the enterprises that participated in them. And by appearances, it worked.
A key principle of investing is that as the price of a stock goes down, the expected return goes up. This is governed by a simple equation known as the “dividend discount model.” Simply put, the stock price is equal to the future dividends (or cash flows) it pays, divided by the required rate of return. (A growth rate is also subtracted from return.)
Stock price = Dividends / Expected return
The return the investor expects to earn is, in fact, the equity cost of capital for that stock. By pushing the prices of these stocks down, institutional investors drove their expected return up. The expected return to investors is the cost those firms have to pay to access capital from the market. Mission accomplished.
Now let’s take environmental, social and governance (ESG) investing today. A variety of themes spring from these three buckets, and they’re much broader and more far-reaching than the original premise for socially responsible investing. Environmental investments, for example, may look to underweight or eliminate polluting companies or high carbon emitters, while socially directed investments might rank firms on working conditions and employee relations or human rights records. The governance approach considers issues such as the diversity of a company’s board, corruption and accounting aggressiveness.
Many ESG investors feel that it’s good enough just to support companies working toward a better shared future. Indeed, how much money can we all make in the long run if we let the world go to pot? As Mark Carney, a former governor of the Bank of England and a strong ESG proponent, noted recently on Twitter, “We’ve been trading off the planet against profit for too long. This has depleted our natural capital, had devastating effects on Earth’s biodiversity and is causing unprecedented changes to our climate.”
The large companies that essentially own everything have long understood how systemic problems are investment problems. But how do these problems affect an individual investor’s returns?
Though ESG has evolved from its origins in socially responsible investing, in one sense the story is the same. Just as investors avoid tobacco and drive its price down and return up, investors could conceivably drive up the price of renewable energy firms or companies that invest in their workers, and the expected returns for these “good” companies would then possibly decrease, right?
That’s true by itself, but ESG also offers something else: an “alpha thesis.” There are good reasons to believe that investor preferences for these stocks will be validated by better actual corporate performance that leads to higher cash flows. Thus, the numerator in the dividend discount model would go up, offsetting the denominator increase that reflects increased investor interest.
Why might ESG-aware firms outperform? There are a variety of specific reasons that have been given—that these companies avoid fines and can respond better to physical threats and cost efficiencies. But an even better answer is that these companies are the ones prepared to operate in a changing landscape. Climate change can irreversibly alter productive operations as we know them. And clients, regulators and business partners are increasingly demanding that the private sector incorporate ESG concerns into their businesses. As with any paradigm shift, there will be winners and losers, and investors are looking at ways to make sure they are investing in the winners.
Thus, for many people, ESG investing is not just about incorporating their values in their investments, but also about adding value—reducing risk, adding return or both.