From time to time, investors become irrationally enthusiastic. The important thing to note about these manic moments is that the investment theme underpinning them makes perfect sense. The narratives are rational; it is the market excess surrounding them that is not.
In the early 1970s investors became transfixed by a group of seemingly bullet-proof stocks, collectively known as the Nifty 50, that came to be viewed as ‘one decision’ stocks. The likes of Kodak, IBM and Xerox were ‘buy and hold’ shares for which no price was deemed too high. History subsequently showed that it could be.
There aren’t many investors who remember that period. There are plenty, however, who experienced the late 1990s moment of over-exuberance. Twenty years ago, as we know, it was all about the emerging internet, with sky-high and ultimately unrealistic growth expectations for which investors were prepared to pay an irrational price. Investors who were lured into tech stocks ended up as disappointed as followers of the Nifty mantra had been 30 years before.
Today’s hot investment story is sustainability. As with the largely consumer story of the Nifty 50 and the digital revolution of the 1990s, the story underlying today’s ESG narrative is completely plausible. The environmental strand reflects the most important challenge facing the world today, climate change. Neither the social nor governance themes are fads either. They mirror unstoppable changes in what is considered acceptable corporate behaviour.
That ESG should have started to be talked about as a potential stock market bubble is disappointing. I report it through gritted teeth because I defer to no-one in my desire for a world in which companies manage themselves honestly and prudently, are concerned for the health of the planet, and look out for the well-being of their employees, suppliers and customers. I think that what we do with our money matters.
But as with the two previous episodes, the underlying narrative is only part of the story from an investor’s perspective. There are plenty of good reasons to consider environmental, social and governance factors when we decide where to invest our money. But unless you place yourself firmly at the philanthropic end of the investment spectrum, none of them are reasons to disregard the fundamental factors that drive returns. The stories that underpinned the Nifty 50 and the tech bubble were not wrong, although they were maybe exaggerated or premature. Today’s enthusiasm for ESG is likewise wholly reasonable. But none of them were enough by themselves to overcome the stock market’s law of gravity.
A share price is ultimately a reflection of a handful of measurable factors. It is determined firstly by expectations about future earnings growth and secondly by the price that investors are prepared to pay to participate in that growth. That sounds simple. It is complicated, however, both by the fact that the future is inherently uncertain, so we are always guessing what that future growth will be and when it will arrive, and by the ever-shifting calculus about what constitutes a reasonable valuation.
Those two variables multiplied together would be enough by themselves to make financial markets volatile and prone to bouts of over-exuberance. Add in a third key factor – the sheer weight of investment money, which in the short run can disguise the fundamentals – and it is hardly surprising that prices spend almost no time at the ‘right’ price but move widely either side of it.
Of these three drivers, growth is where the ESG story is on firmest foundations. Even before the pandemic, the need to combat global heating, even out the inequalities highlighted by the financial crisis and its aftermath, and align corporate governance with changing social mores, was creating an abundance of investment opportunities. Covid has merely accelerated the desire to build back better.
The problem then is not a lack of potential growth. It is rather that many investments are being wrongly identified as growth opportunities. Just as adding dotcom to the name of a company did not make it a good investment in 1999, labelling a business as sustainable will not change anything of substance in 2021. As I said last week, there is a burning need to rationalise how we describe these investments. Looking at ESG factors may help us identify better, faster-growing, more sustainable companies but we better get it right.
The second driver, price, is where ESG is on shakier ground. One of the key arguments for investing in sustainable companies is that directing capital towards them makes the world a better place. It does this by lowering the cost of capital for well-behaved businesses. More good things happen because companies find it more profitable to engage in green or socially responsible activities. And bad companies are effectively priced out of existence. On one level that’s clearly a good thing, but the flip side of a low cost of capital for good companies is a low expected return for the investors who provide it. The more you pay for a given cash return the lower its effective yield to you.
The third driver, the weight of money chasing returns in this area, is perhaps the most dangerous of all. This is because the wall of cash going into ESG investments disguises what is really going on with the other two drivers, growth and price. It drives prices higher in the short term thanks to the simple arithmetic of supply and demand. ESG-focused assets have now reached US$40trn and the pace of accumulation has accelerated during the pandemic. Inflows of US$46bn to ESG funds in the first quarter of this year compared with outflows of US$385bn in the broader fund universe, according to Morningstar. The performance is self-fulfilling for now.
This matters because ESG matters. When the Nifty 50 blew up it was not the end of the world. Even the bursting of the tech bubble merely set things back a few years. The ESG stakes are higher. A little less exuberance now might not be a bad thing in the longer run.
