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With the presidential election results delayed into Wednesday and possible litigation extending into the later part of the week, we all eagerly wait on who will ultimately win the U.S. 2020 Presidential Election.
This aside, some market trends have a minimal reaction to the presidential election’s outcome. Some trends are the increased investor appetite for ESG, technology, and intangible assets. Intangible asset investment and intellectual property value have derived from our societal shift and dependence on technology. This societal shift has caused companies to invest in intangible assets commonly (inaccurately) booked on a company’s balance sheet as an expense. On the contrary, intangibles resemble an important asset that aligns with both the current and future trajectory towards an advanced planet (should be booked as an asset). Though not as financially misaligned as intangible assets themselves (though ESG companies can have intangible assets), environmental, social, and governance (ESG) initiatives have currently emerged alongside technology as one of the most desired categories in both equity and fixed income markets.
ESG initiatives run very close to our societal dependence on technology. As technological advancements increased, so did ESG advancements. Yet, ESG initiatives have been on a much slower course than technology. As technology and intangible investments disrupted the status quo starting in late 1990 (“tech boom”), ESG initiatives could do the same. Societal behaviors and consumer sentiment on sustainability skyrocketed within the past 5 years, but at its fastest pace within the past 18 months. Governments across the world, more specifically the U.S., increased their investments and subsidies for “green” industries. Amid policy shifts toward “green” accommodations, technological improvements lowered the cost of complex green technologies (i.e., hydrogen-powered equipment and cars) and environmental projects (i.e., reduced emissions, slower deforestation, etc.). An example of this close relationship between technology and sustainability resides in the Electric Vehicle (EV) Industry. Companies like Tesla and NIO show the increased behavioral spending and investor curiosity of sustainability and its’ integration with technology. This resulted in companies like General Motors, a traditional vehicle company, to develop and release brand name electric vehicles (i.e., the long-awaited Hummer EV) expectantly met with great consumer reception.
However, investors’ exposure to ESG investments do not come cheap. HEC Paris Business School professor Augustin Landier and MIT Sloan professors Parinitha Sastry and David Thesmar published a study illustrating investors’ willingness to pay $0.7 more for a firm giving one more dollar per share to charity. Meanwhile, companies with a weak ESG agenda were valued by investors at approximately $0.9 less per share than their neutral counterparts. This is an interesting dynamic. In some ways, investors psychologically deem that their investment in ESG companies provide attractive growth metrics and aid our environments and society collectively. This collaborative trend fundamentally drives the demand for sustainability. This could lead to a situation where some of these ESG companies could compete with some of the world’s most valuable companies as the relationship between supply and demand becomes muddled.
With this said, many companies have shifted, added, or pioneered their own green initiatives. Apple and Coeur Mining Inc are among companies in different sectors with initiatives that abide closely to environmental, social, and governance projects. Apple regularly issues bonds with the proceeds used to fund green projects (i.e., solar panels) while also revamping its supply chain to utilize renewable energy to support other environmental solutions. With that said, Coeur Mining Inc, a gold and silver mining company domiciled in North America, has an industry-leading position on ESG programs by winning awards for governance, sustainability, and climate change. Coeur Mining Inc regularly incorporates diversity and inclusion, reduces emissions, waste minimization, water stewardship, etc. This is just a small sample that illustrates how ESG overlays and business ideas have transcended and remained impartial towards sectors and industry norms.
Besides companies specifically, many investment managers added sustainable overlays to their analysis of potential holdings, with many retail investors increasing their appetite for funds with an ESG conscience. According to PwC, “as much as 57% of mutual fund assets in Europe will be held in funds that consider environmental, social and governance factors by 2025, or 7.6 trillion euros ($8.9 trillion), up from 15.1% at the end of last year.” The U.S. will likely follow this trend relatively closely.
What comes next?
As previously explained, one of the causalities of the technology boom remains the inaccuracy of “booking” these assets on the balance sheet. As mentioned in my previous blog, “New Thought to Financial Metrics,” this occurrence is more than likely a direct result of the quick appreciation and value of intangible assets (and deeply rooted integration to our society) amid the lack of accounting evolution pinned to strict and inflexible accounting regulations. “Green company” investors should be aware that this same financial ambiguity plaguing technology’s intangible assets could happen to ESG companies. There are two instances where this could be the case. First, the fast growth of green technologies and their heavy dependence on intellectual property could yield a vague representation on their financial statements (i.e., Tesla). Second, financial and accounting metrics’ inability to properly value the true impact of ESG advancements and initiatives. For example, board diversity promotes collaboration and improves decision making. In a 2018 study by the Boston Consulting Group, “companies that employ diverse management teams showed revenues increase by 19% driven by innovation.” Additionally, companies like Apple and Coeur’s ESG initiatives and renewable solutions will likely save these companies’ money in the long run. Apple’s investments in renewable energy for its supply chain and Coeur’s investments in lower emissions, waste management, etc. will all have a delayed financial benefit that is not immediately reflected in financial statements. The company’s sustainable investments also have an indirect financial impact on investors (arbitrage opportunities from policy, societal shifts, new industries) and societal norms (i.e., cleaner planet, health, etc.).
In other words, the most “archaic” accounting principles may not completely depict the true intrinsic value of ESG initiatives as perceived by the public and its link to societal norms, behavioral spending, and subconscious psychological cues. This makes the true valuation of ESG companies and initiatives very difficult to pinpoint.
Therefore, the same growth trend that drove tech companies will likely drive ESG companies. ESG investors should take these companies’ financial statements and accounting metrics with a grain of salt. Investors should focus on fundamental metrics such as customer growth, sales growth, policy renewals, test results, etc. to indicate true baseline investment quality. Additionally, investors need to weigh in each companies’ relative operating strategic assets to decipher strategic and tactical competitive advantages. Customer franchises, product pipelines, brand strengths, unique talent, patents, and a degree of intellectual property collectively can partially determine future organic growth (as it did for many tech companies). Therefore, when it comes to sustainable investing, similar to technology investing, understanding the financial metrics, accounting ratios, and statistical data remains important, but looking through each company’s deployment and effectiveness of its strategic assets is the key to finding outperformers. Historically, market-disrupting industries rely on their forward-looking growth largely supported by each company’s implementation, deployment, and effectiveness of operating strategic assets.
COVID-19 disruptions and the new wave of technology dependence aside, the chart below illustrates that, over a 5 years span, the Dow Jones Sustainability Index and the Dow Jones Technology Index have similar upward growth patterns using Price/Earnings Ratios and Enterprise Value (EV)/ Trailing 12M Sales. Obviously, coronavirus disruptions have unfairly depressed many sectors, including ESG stocks. On the other hand, COVID dislocations presented a unique opportunity for technology stocks amid economic uncertainty, national/regional quarantining, and work from home orders. Even though technology’s interdependence trend will likely linger, ESG stocks’ current growth metrics seem unfairly underrepresented relative to forward looking trends rooted in increasing demand, policy accommodations, and their overall expected long-term growth pathway.
Source: Bloomberg, 11/04/2020
Footnotes:
*Green line= EV to Trailing 12M Sales
*Blue line= Price to Earnings Ratio (Annualized)
W1SGI = DOW JONES WORLD SUSTAINABILITY INDEX
W1TEC = DOW JONES WORLD TECHNOLOGY INDEX
We seem to be in the same situation regarding ESG integration as during the technology craze. This comparison can yield similar results giving investors opportunities to capitalize on arbitrage situations caused by supply and demand disruptions. Investors should understand that most disrupting industries favor growth analytics over value analytics. Therefore, understanding its objectives, competitive advantages, and strategic assets while understanding accounting’s limitations will likely deliver the opportunity to achieve attractive risk-adjusted returns. This does not mean to abandon financial statements and quantitative analysis as it does remain vital to determine overall quality. Rather, I am proposing to combine the two thought processes to optimize a complete fundamental understanding. While ESG investing demand increases, understanding how to capitalize on forward-looking growth companies with ESG agendas remains the real opportunity to exploit during the sustainability trend that will likely continue.
