Wednesday, January 5, 2022

The Great Societal Promise – and Risk – of This Booming Investment Trend

By Berna Barshay

It's one of the biggest trends in the market right now...

I'm talking about environmental, social, and governance ("ESG") investing.

I explained what ESG is in the August 23 Empire Financial Daily, which covered last summer's extremely alarming UN report on climate change...

ESG investing takes into account the financial risks and opportunities presented by environmental, social, and governance factors. These factors are more qualitative than the financial metrics that analysts typically look at... but ignoring them could prove detrimental to future stock returns.

Any company that ignores its role as a citizen of the planet and the countries and communities it inhabits is increasingly at risk of regulation as well as seeing revenue drop as consumers and other businesses shun it. Investors are increasingly factoring in the effect that a company's response to climate change and other collective social concerns will have on its future financial performance.

ESG investing isn't just about virtue signaling... it's about making sure revenues and profits don't go into secular decline in the future.

ESG started as a big trend in Europe. Consider these amazing stats from the German investing blog Klement on Investing...

In Europe and the U.K., ESG investing is the fastest-growing investment trend ever. Assets under management of dedicated ESG funds grew by c.75% per year between 2019 and Q3 2021 and the fund flows into equity ESG funds are larger than all other equity fund flows put together. Not even index funds when they were such a small part of the market as ESG funds are today, experienced growth rates similar to that.

But ESG is no longer just a "Europe thing"... it has now gone global.

According to Bloomberg, by 2025, one-third of global assets under management are expected to be in funds following ESG mandates.

A niche of investing no longer, funds dedicated to ESG investing compliance are one of the fastest-growing areas of the market. And what started as an institutional trend is quickly morphing into a trend with retail investors as well.

Again, looking to Europe – since it's the first mover in this area – check out recent retail fund flows into U.K. mutual funds...

Source: The Investment Association

These British retail investors are smart... they are following the money.

It doesn't matter whether you personally believe climate change is one of the most serious issues facing our world. What matters is that the investing powers that be – big institutions like banks, mutual funds, pension funds, and insurance companies – believe it is... and are therefore investing accordingly.

If one-third (and growing!) of the world's assets are going to be dedicated to companies that are actively seeking to reduce their carbon footprint, reduce waste, treat workers fairly and equitably, and root out corruption and malfeasance... then that is a tailwind for their stocks. It's also a headwind for the stocks of companies that opt out of ESG (or in businesses that can never hope to comply).

Being one of the hottest things in the markets these days, ESG has predictably attracted its share of haters...

It doesn't help that the traditional energy sector – old-school, polluting, fossil fuel companies – was the best-performing sector in the market last year at the very moment that the hype around ESG investing was reaching a fever pitch.

With so many economists and market watchers worried about the effect that inflation will have on growth, markets, and interest rates, the rapid rise in the price of energy and commodities (which also tend to be mined in ways that aren't particularly "green" or socially conscious) poses risks to sustained good times in both the markets and the real economy.

Many market watchers worry that all the money going into ESG is starving energy and commodity companies of capital investment for production expansion, which is traditionally the market mechanism that keeps inflation in check.

The argument against the ESG investing trend tends to be loudest out of traditional deep value investors – they tend to naturally gravitate towards ESG-unfriendly sectors like energy, commodities, heavy industrial cyclicals, and tobacco, in the pursuit of high free cash flows on the cheap. These value investors also tend to eschew cash-burning, unprofitable companies with big valuations and market caps... common characteristics in green industries like clean energy and electric vehicles ("EVs").

Some of this crew – who tend to be big bulls on traditional energy stocks – are predicting a coming energy crisis brought on by ESG investing sucking up all the fund flows, starving incumbent energy companies of money to build new capacity in a world that increasingly uses more and more energy.

Harris Kupperman – aka Kuppy – whose excellent "Ponzis Go Boom!!!" post I wrote about last April – articulated this worldview in a post last June called "ESG = Energy Stops Growing"...

For most of my career, oil demand has grown each year and supply has roughly kept up. Sure, it's overshot in both directions. We've seen shortages and we've seen gluts. We've even seen oil go negative. Throughout this time, we've always intuitively known that the cure for high prices is high prices. Last week may have forever changed this prudent logic. I'm starting to wonder if ESG really means Energy Stops Growing.

The event he was referring to was small, activist ESG hedge fund Engine No. 1's successful takeover of two board seats at energy giant ExxonMobil (XOM), with a stated intention to push the company to address the long-term business risk that comes with being wholly tied to fossil fuels. Engine No. 1 didn't make a moral argument... it made a business one. But in doing so, the fund clearly intends to push Exxon to redirect capital investment from traditional drilling and exploration to more green and clean technologies.

In a September follow-up post – provocatively titled "Will ESG Create The Next Lehman Moment...???" – Kuppy points out that in starving the fossil fuel industry of investment capital, the financial markets are starting to shut down the "carbon economy" before the infrastructure for the new "green economy" is even in place, and possibly before the technology for it is even proven.

Kuppy thinks this will end up causing a global energy crisis. As he writes...

Almost every day, we hear of a different policy plan to reduce energy production. We learn of new mandates, new taxes, more cancelled pipelines, more cancelled permits, and more penalties. What we don't hear about is where the replacement energy comes from. The wind doesn't always blow and sometimes it is cloudy. My car won't drive on unicorn farts and billions of people in developing economies want a Western standard of life – complete with a Western level of energy consumption.

These people refuse to pay for "green energy," especially when the "carbon economy" is so affordable. Or maybe, they have the pragmatism not to build "green energy" while the technology isn't fully proved-out. Maybe they're looking at spiking gas prices in the U.K., spiking electricity prices in Europe, factory shutdowns in China, rolling blackouts in California and asking if the "green economy" is right for them.

Developing nations intend to consume more. Western nations intend to consume more. China intends to consume more. At some point, declining production will slam into rapidly increasing demand. It will only be solved by higher energy prices. The clearing price will stun people.

Obviously, a global energy crisis – if one were to unfold – would have a dramatic effect on corporate profitability and all sectors of the market. Turning back to his thesis that the days of profitless prosperity for money-losing story stocks (the "Ponzis") are numbered, Kuppy continues...

I have been a bit early in calling for the end of the Ponzi Sector, but I have never wavered one bit in what would do it in. Inflation is coming. It will be driven by energy inflation. It will shred the Ponzi Sector. In the not-too-distant future, we will have a moment where oil goes parabolic, and the Nasdaq detonates. This isn't a tomorrow thing, but it may not be far off, unless there is a dramatic course change.

I'm not as bearish as Kuppy on inflation and an inflation-driven growth stock meltdown, but I do think energy prices are likely to stay at elevated levels...

He's right that the ESG movement is directing funds away from needed capital investment at fossil fuel companies, basic materials companies, and other heavy polluters. So... does this make ESG investing a bad thing?

I would definitively say no.

The climate crisis is real. And fires, floods, extreme heat, and other natural disasters aren't good for most businesses either – whether the business is farming and agriculture, owning coastal real estate, tourism-related, or many other pursuits. If we don't address environmental issues, more and more businesses will be exposed to more and more risk (as will we as individuals who want our bodies and homes to stay safe, healthy, and protected).

Just like it's never a convenient time to go on a diet or start exercising more or begin saving more money every month, it's never a convenient time to invest in a future less dependent on carbon. But all these things are good for you in the long term...

The ESG movement will persist because companies, governments, investors, and individuals have decided it is important and necessary. ESG investing isn't going anywhere... and will be a huge tailwind for companies that meet ESG investment criteria.

But as we look to the future, the critics are right that we can't forget about the present. We need to get from where we are to where we need to be without creating chaos and suffering along the way. In societal terms, that means maintaining the fossil fuel infrastructure until we have had the time to replace it.

As for investment strategy, it means that both energy stocks and ESG investments make sense as allocations within your portfolio. There may be some ethical hypocrisy there, but it will likely be the best way to maximize your returns.

Right now, I'm extremely bullish on ESG investing...

I've identified three tiny stocks that are in a great position to benefit massively from the coming wave of investment into ESG.

If you want to learn more about this megatrend, what's driving it, and who's going to emerge victorious, be sure to watch my brand-new video presentation.

For a limited time, you can watch it – no e-mail address or credit card required – by clicking here.

In the mailbag, I'm sharing some of the comments you made in response to my 2021 climate change poll...

Do you think it is hypocritical or pragmatic – or maybe both – to consider investing in ESG and fossil fuels at the same time? Do ESG factors play into your investment decisions... for financial reasons or ethical ones? Share your thoughts on these questions or ESG and/or energy investing in general in an e-mail by clicking here.

"I've been concerned since the 60's [about climate change] – Humanity should have been investing in ESG since the 70's – I hope it's not too late now!"

"I think it's too late for low-lying, sea-level, flood-plain property. My #1 investment decision is how prepared for change is each business."

"Economics run the world. Make something financially rewarding and people/institutions will want to be part of it. That carrot is essential to success."

Berna comment: I agree, and it's why institutions are forcing change through these ESG mandates. If the corporate executives want their stock options and restricted stock units to appreciate, they need to get their companies on board with ESG goals.

"The climate is going to change no matter what man does. Climate has been changing since Earth was formed. The Sun and entire solar system have more to do with it than man. Man is but a speck in the universe. Change happens."

"Too much confusing, directionless, regulation. if something has to give (climate or GDP) it will be climate. It's a giant prisoner's dilemma."

"Unless modern nuclear power is discussed as part of our power grid, then you are a climate poser and not serious about real solutions."

Berna comment: I agree entirely and am long-term bullish on uranium (no idea about the short term).

"The climate scientists have been warning for thirty years that we have to act NOW, or else. Ever heard of the boy who cried wolf? Climate Change is happening slowly, and we will adapt just fine as humans always have. Sounding a five-alarm fire is just hysteria, and not a practical response."

"A lot of what's out there, unfortunately, is sort of "green washing" and hugely inadequate. Much more investment in climate tech and sustainable infrastructure is URGENT."

Berna comment: I agree – there's a lot of "green washing" out there, and it doesn't help that ESG investment standards are so inconsistent and unspecific.

"I work at NASA on a satellite that monitors the polar ice caps, so I've been following climate change for decades. I've never believed that folks don't believe in it – they just don't want to take responsibility for it. Individuals can only do so much. It's the systems in place that have to change."

Berna comment: Thanks for writing in with your informed perspective... and I agree that it is up to systems, not individuals, to address these problems.

"It was warmer during ancient Rome, the medieval period, and other moments in history before the industrial revolution. China is the largest polluter on the planet and electric cars aren't green. Most electricity is generated via fossil fuels, and mining for lithium is quite dirty."

Berna comment: It's true there have been warmer periods in history, but that doesn't mean we don't have a problem now. I agree with you about China and the problematic aspects of EVs.

Happy New Year!

Berna Barshay
January 5, 2022

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Berna Barshay

Berna Barshay is editor of Empire Financial Daily and a contributing editor to the Empire Stock Investor and Empire Investment Report newsletters. She graduated cum laude from Princeton University and earned her MBA from Harvard Business School in 1997. Following her graduation, Barshay spent 20 years on Wall Street. She began her career in equity derivatives at Goldman Sachs and later worked as a buy-side equity analyst at Sanford Bernstein, where she covered global consumer cyclicals and conglomerates. Later, Barshay spent five years working as a portfolio manager of the Ingleside Select Fund, a long/short fund with a focus on value and event-driven stocks. She later was a portfolio manager at Swiss Re, where she managed the Consumer long/short book on the equity proprietary trading desk. She has additional experience as a buy-side analyst at several long/short hedge funds – including Sky Zone Capital, Metropolitan Capital, Buckingham Capital, and LaGrange Capital – where she primarily covered consumer and technology, media, and Internet stocks in the U.S. and Europe, with some additional work in financials and energy. Barshay is a fashion enthusiast, a pop culture addict, obsessive indoor cycler, and prolific social media user. She currently lives in New York with her husband, daughter, and three dogs.

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