According to a recent Bank of America estimate, $20 trillion will flow into ESG funds over the next two decades. That will add to the $11.5 trillion in the U.S. and the more than $30 trillion globally that is already held in sustainable or green investments (see WILTW June 13, 2019). To our mind, this “tsunami of assets” is likely to prove the best investing opportunity for active managers since the dawn of the passive era.
Selectivity is key as the ESG revolution is deeply flawed. ESG funds are concentrating capital in a handful of behemoth companies—Microsoft, for one, accounts for roughly 3% of all assets invested in ESG stock funds. Corporate “greenwashing” is endemic, with many companies exaggerating their social and environmental progress. The SEC is now investigating several ESG funds for misadvertising their products. And ESG ratings remain untrustworthy—MIT recently studied the ESG ratings of five firms on 823 companies and found a correlation of just 0.61, which compares to 0.99 for credit ratings.
We believe effective active management can exploit these weaknesses to an advantage. Throughout 2020, we will focus our attention on identifying these opportunities. To begin, we view the following three strategies as worthy of attention:
- To beat the index, bet on the indexers and data providers: According to MSCI projections, large investor use of ESG ratings will expand from 30% to 50% between 2018 and 2021. Indexers and data providers are positioning to seize this explosive growth. Morningstar holds a 40% stake in Sustainalytics, a private company and the second-biggest provider of ESG ratings behind MSCI. Meanwhile, in April, Moody’s purchased ESG data company Vigeo Eiris. And in November, S&P Global acquired the ESG ratings arm of Robecosam.
Indexers and data providers are already realizing impressive growth and outperforming the broader market (chart below). In 3Q19, S&P Global reported a 9% increase in revenue, growth driven by its index and ratings divisions. Its stock ended 2019 up 60%. Meanwhile, MSCI reported a 10% revenue increase for its index segment in October. Its stock jumped 74% for 2019.
Indexing is increasingly profitable as it scales. MSCI’s operating margin has improved from 37.5% for 2015 to 47.9% for 2018. And it is a business with strong network effects. ESG investing will inevitably become dominated by artificial intelligence. The dominant data providers and indexers will be better equipped to develop or acquire AI technologies and feed them the richest data sets. Bet on further dominance from the already dominant.
- Target the “double-play” beneficiaries: Consumers concerned about climate change won’t just invest sustainably, they’ll spend on sustainable products. This will prove especially true for the millennial generation, which is set to inherit roughly $30 trillion over the next three decades. According to a recent Morgan Stanley survey, 95% of millennials view sustainability as an investing priority.
Consider the company Trex. Its business is sustainability—Trex manufacturers composite decks out of recycled plastic bags and reclaimed wood fiber. According to the company, it now diverts 500 million pounds of recycled plastic out of landfills each year. It also scores well for governance—its CEO to median pay ratio is 39x, which compares to typical ratios between 200x and 300x for most public companies.
Here’s the “double-play”: The company’s stock stands to benefit as ESG funds overweight its stock given its high ESG rating. Second, the company’s fundamentals will benefit as millennials buy homes and look to build decks as sustainably as possible.
More “double-play” opportunities are apparent across sectors. In WILTW November 14, 2019, we highlighted several companies on the forefront of revolutionizing the cement industry. The Ball Corporation is also worth attention. The company is the largest manufacturer and distributor of aluminum cans, which can be recycled again and again, therefore more sustainable than plastic and glass bottles. Solar is another clear double-play opportunity, though valuation consciousness is key. As solar emerged an early focal point of ESG enthusiasm, the Invesco Solar ETF became the best-forming, non-leveraged ETF of 2019, rising 66.5%.
- Scrutinize the top and bottom quintiles: JUST Capital—which ranks companies based on ESG factors—has found companies in its top quintile have 18% to 22% lower volatility, 6% lower beta, 5% shallower drawdowns, and 4.5% higher ROIC than companies ranked in its bottom quintile. This is not a unique finding—Deutsche Bank evaluated 56 academic ESG studies and found 89% show that companies with high ESG ratings outperform the market in the medium- and long-term. This is for obvious reasons: better-managed, more forward-thinking companies inevitably perform better.
ESG data is no doubt circumspect for many companies, with “greenwashing” an endemic problem. That said, the top-ranked companies are likely those most-able to prove their ESG credentials. Ratings and valuation scrutiny is still required, but the top-quintile will benefit most from ESG fund inflows while having the most-resilient case they are socially responsible.
The bottom quintile is also a compelling place to look for medium-term value opportunities. According to a Bank of America report released last month, 24 ESG controversies resulted in peak to trough market value losses of $534 billion over 12 months for the companies involved. “It can take a year for a stock to reach a trough following an ESG controversy…[and] ESG funds that owned companies which have become involved in a controversy can exclude these stocks for five years or more,” said Savita Subramanian, head of US equity and quantitative strategy at Bank of America.
An ESG controversy is often evidence of poor governance and intractable, systemic problems at companies. According to Bloomberg, roughly 90% of bankruptcies in the S&P 500 between 2005 and 2015 were by companies with poor environmental and social scores. That said, an ESG controversy can also be a wakeup call, driving an overhaul in executive leadership and a reevaluation of business priorities. Given ESG funds are slow to react to such a turnaround, active managers have an opportunity to buy at the trough.