A thoughtful dissent from the ruling investing orthodoxy…..

Aswath Damodaran’s recent Musing on Markets blogpost (from Sept 21) offers a thoughtful dissent from the ruling orthodoxy on ESG investing. He highlights how the current “hype” (his word) leaves critical analytical questions “unanswered or answered sloppily.” For example, he asks,  “Do companies perform better because they are socially conscious (good) companies, or do companies that are doing well find it easier to do good?” If the latter, “researchers will find that ESG and performance move together, but it is not ESG that is causing good performance, but good performance which is allowing companies to be socially good.”

He points out the ESG positive bias toward small, niche, and private companies that are able to score well. That’s not much solace for investors in large public companies. And he highlights the fundamental challenge still to be worked out: Is ESG investing a way to generate higher returns or is ESG investing a moral justification for accepting lower returns. You can’t have it both ways.

From my perspective as an investment manager, it is relatively early days as to how the data on ESG investing will play out. We’ll know in a decade or so. In the meantime, I can attest to the daily deluge of in-bound emails that I receive from sell-side brokers, data vendors, and consultants peddling their wares and promising an investment edge through their “proprietary” take on the matter.  The sheer volume of new products and commentary invites a natural degree of skepticism.

But there is a way to salvage utility from this movement. And elements of it are represented in Damodaran’s own post.  Particularly relevant for dividend managers, Damodaran’s observes that a factor should be judged on whether “it” (whatever it may be) affects cashflows or risks to those cashflows. That is how I have come to view the panoply of ESG material presented to me. It is an extra arrow in the quiver of the dividend-focused investor to help assess the long-term cashflows of an enterprise that can be distributed to company owners.  For now, we have to wait to determine how effective the arrow is; the data is early and very inconclusive. But it is not the sole arrow in the quiver. We have many of them, developed over a century of dividend-focused investing.  And that is an important caveat. If one invests narrowly as an ESG-focused investor, you had better be confident that ESG-focused investing “works.” But if you are using it as part of a broad and deep toolkit, then certain shortcomings of that particular tool can be mitigated. Use it where it may be helpful, as with any other tool.

As to where it may be helpful, Damodaran has identified two areas in which I am in agreement. They include not “investing mechanically in companies … already identified as good (or bad),” but [investing] through strategies focused on corporate social responsibility “that are not easily measured and captured in scores, or from getting ahead of the market in recognizing aspects of corporate behavior that will hurt the company in the long term.”

The first of those two can be understood as corporate engagement. He does not call it such, but refers to it as Transition Period Payoff where getting companies to move towards a more “sustainable” future–the definition of that term remains highly subjective and problematic–is helpful to companies and to investors in them.  This engagement process has struck me as perhaps the most important part of ESG investing, and only some investment house ESG efforts feature it. Fortunately, my employer is one of them.

In the second, the latest ESG tools can be seen less as a direct investment tool and more as a risk management tool, specifically as a way to reduce exposure to what Damodaran calls “disaster risk.”  As in many other ventures in life, it is not necessarily about getting more things very right than it is about getting fewer things very wrong. ESG tools and the ESG engagement process do seem to me to offer that latter potential.

Please read the entire Damodaran piece. My précis does not do it full justice.



A thoughtful forward-looking response sent to me by a market participant:

I enjoyed the Damodaran article. Although it takes a familiar angle at evaluating ESG’s historical performance, and probably doesn’t spend enough time evaluating why ESG could become a bigger contributor to investment results in the next decade. The reason ESG could work going forward has more to do with engaging the investor rather than the issuer.

The first stop on that journey will be to engage issuers who are also investors (they are most susceptible to “engagement”). Many big institutional investors – European banks, insurers, pensions and endowments – are in the early innings here. But in order to establish real financial incentives, the majority of the investment community needs to become more willing to punish bad actors with higher costs of debt and equity (and reward “good” companies with better valuations on their funding vehicles). Ultimately, the extent to which the less-engageable element of the investment community adopts ESG as a major decision-making input will determine how far issuers will be willing to go in order to improve their ESG profiles.

If only a fraction of investment managers are placing a high degree of importance on ESG issues, the still-large “ESG-denier” community can benefit from what they perceive to be mispricing. The ESG-alpha argument will be a difficult one to make over the next decade if only a handful of large, highly-visible institutional investors (that are susceptible to public shaming) will be placing high values on “good” companies. And if the pro-ESG approach were to produce negative alpha in the next decade, then there’s a backlash coming. Good companies (and investment managers) that don’t produce competitive results are still in trouble. In that scenario, the pragmatists that have moved more slowly/deliberately on ESG evolution would look pretty smart, and the ESG crusaders will have a lot of explaining to do.

Lots of different theories around how this plays out, without a lot of visibility. That’s why I think ESG is one of the biggest investment “bets” we’ve seen in our lifetime. TBD whether it looks like the Tech bet from the late ‘90s or the Tech bet of the late 2010’s.

Investment results aside, ESG evangelism is going to ramp HEAVILY in this decade. Because investment managers would need to be fully on board in order to form the Circular Economy of Virtue that (I believe) is required for ESG to produce meaningful alpha. You have to convert the nonbelievers on our side of the business just as quickly as you convert the issuers. It’s a chicken-and-egg problem.