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 pretty broad-strokes accurate. Today, that same answer is pretty uninformed. Several studies, published years ago, showed that so-called “sin” stocks, such as alcohol, tobacco and gaming, outperformed. For example, in their 2007 Journal of Financial Economics paper, “The Price of Sin: The Effects of Social Norms on Markets,” Hong and Kaperczyk found sin stocks returned around 3% more per year than comparable stocks (Source: Hong and Kacperczyk , “The Price of Sin: The Effects of Social Norms on Markets,” The Journal of Financial Economics, 2007).
Since most socially responsible investing at the time bluntly excluded these stocks, they could be expected to underperform.
Interestingly, one might argue that this was not a negative finding for socially responsible investors, who at the time were largely comprised of foundations and endowments. After all, the point wasn’t to earn a higher rate of return, it was to avoid supporting undesirable activities, arguably even to punish these enterprises. 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.
So, what has changed today? Enter environmental, social and governance (ESG) investing. A variety of themes can reside under these three buckets, much broader and far-reaching than the original socially responsible investing premise. 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. Governance considers issues such as board diversity, corruption and accounting aggressiveness.
For many, supporting companies that are working toward a better-shared future is reason enough to invest in ESG. 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 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.”
Universal owners, large institutions who essentially own everything, have long understood that systemic problems are investment problems. But what about individual investor returns?
While the themes may differ from socially responsible investing, in one sense, the same story still applies. Just as investors avoid tobacco and drive its price down and return up, so too they will drive up the price of renewable energy firms or companies that invest in their workers, and expected returns for these “good” companies will decrease, right?
True, but ESG comes with 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, leading to higher cash flows. Thus, the numerator in the dividend discount model goes up, offsetting the denominator increase coming from increased interest.
Why might ESG-aware firms outperform? There are a variety of specific reasons, from avoidance of fines and responsiveness to physical threats and cost efficiencies, but they largely center around the expectation of a landscape that is fundamentally transitioning. This transition is coming about both because climate change has the potential to irreversibly alter productive operations as we know them and because 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, ESG investing is not just about incorporating their values in their investments, but also about adding value—reducing risk, adding return or both.
The impact of climate change in particular is a risk that many in our industry are sounding alarms about. BlackRock CEO Larry Fink took an unmistakable stance in his 2021 letter to CEOs: “There is no company whose business model won’t be profoundly affected by the transition to a net zero economy – one that emits no more carbon dioxide than it removes from the atmosphere by 2050, the scientifically-established threshold necessary to keep global warming well below 2ºC … companies that are not quickly preparing themselves will see their businesses and valuations suffer, as these same stakeholders lose confidence that those companies can adapt their business models to the dramatic changes that are coming.”