Investment

Is ESG going from a voting machine to a weighing one as too much money chases a return?

Warren Buffett’s mentor Ben Graham once said: “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”

Buffett said Graham made the remark after the Wall Street Crash of 1929, when US investors lost their savings after voting on overpriced stocks in the preceding boom. 

When the dust settled, prices settled as analysts dug out their weighing machines to assess long term prospects.  The results weren’t pretty, but the wisdom of crowds provided a platform for recovery.  You can see elements of this in the wake of the 2000 dotcom bubble and the 2008 credit crisis.

ETFs containing baskets of ESGs have performed really well over the twelve months but they often back companies that can be loss-making; require equity funding, or rely on trading links with China amid tension with the West. 

Voters are currently piling into opportunities in ESG, aka Environmental, Social and Governance. Their enthusiasm is even putting bitcoin to shame.

Sums under ESG management have tripled over eight years to $40 trillion. Smaller solar and fuel cell stocks have often tripled in a year. Clean energy ETFs have doubled, or better.

Plug Power, the fuel cell specialist, recently rose 11-fold in a year, despite its losses. But it has attracted backing from SK Group of Korea and signed a deal with Renault. So that’s all right. Its market value is now $30 billion. 

The surge in ESG stocks is extraordinary. Bill Gates and his billionaire supporters are emboldened. They have added a second $1 billion to their Breakthrough Energy venture fund. On 5 November 2020, Family Capital identified 45 family offices putting money behind sustainable initiatives.  There are many more. 

They have profited mightily. Quantumscape battery company, backed by Breakthrough and Volkswagen, has tripled since listing in December.  The Climate Change Crisis Real Impact SPAC jumped 43% in a single day in January on plans to merge with EVgo, a vehicle charging business. 

What’s going on? 

* Governments across the world are providing fiscal incentives worth trillions for infrastructure to put ESG to work. Net-zero emissions by 2050 have become a key target.

* Central banks, institutions and corporates are backing ESG to prevent a runaway climate crisis. They are providing finance to buy or back, sustainable projects. Institutions are reluctant to even look at a fund that lacks ESG.

* Retail investors have become increasingly worried over a number of green issues. This has fuelled their purchase of ESG stocks, as well as consumer products.

* Sustainable products, such as clean energy and meat-free meat, have resulted from technological innovation, currently seen as the answer to most corporate problems.

* Monetary authorities are stimulating the global economy with excess liquidity and low-interest rates in the wake of the pandemic.

Once you put these factors together, you realise it isn’t too surprising that irrational exuberance is out and about.

Ambienta, a $2 billion ESG specialist, is worried. It believes prices for renewables are massively over-cooked, arguing investors fail to assess the limitations of science and economics.

Analysts at Motley Fool are cautious on hydrogen fuel cells: “These companies have consistently reported net losses and been unable to generate positive cash flow.” 

Dan Higgins, investment chief at Marylebone Partners, says ESG is important. But he argues stocks in sectors like solar energy and electric vehicles are distorted. 

And they are being packaged in ways that attract the votes of investors through their presentation, rather than transparency. 

And no one should doubt it isn’t always easy, being green. In 2008, the Wilderhill New Energy index fell 68% in six months, as renewable stocks were snagged by a global disappearance of credit.

ETFs containing baskets of ESGs have performed really well over the twelve months but they often back companies that can be loss-making; require equity funding, or rely on trading links with China amid tension with the West. 

In a surge, companies can attract sufficient votes to achieve a decent ETF weighting because their market value outstrips their capacity to make money. Their shares greet news of new backers with delight but few bother working out the difference the funding actually makes. 

Few think of the way new equity finance can dilute the interests of existing shareholders. Few stop to think of the way a narrowly-focused ETF can benefit from inflows that lift the market value of its index constituents, forcing other ETFs to follow suit. 

SPACs are a great way to raise finance for successful companies. But corporate uncertainties are often masked by the ballyhoo which surrounds the launch. 

Nikola Motor had an army of supporters at the outset, but saw its shares shrivel as it lost key contracts, along with the services of a charismatic, but controversial, chief executive.

The capital supplied during the VC and SPAC process is also capable of fuelling manufacturing overcapacity, as we may see with electric vehicles, where traditional carmakers are keen to get involved.

Uncertainty over the very purpose of ESG is rife. For many, it means sorting out climate change. For others, it is an environmental measure. It can be an issue of social good.  The protest group Extinction Rebellion would see it as a universal truth.

Even now, there are no accepted standards for the way ESG is used by companies and investors. No prioritisation is attempted for E, S, or G.

ESG ETFs will include big tech stocks like Facebook because they are perceived to be energy efficient despite evidence that online products are addictive. Questions have been asked about the differing quality of green bonds. ETFs which try to rank the ESG-ness of sovereign bonds struggle with complexity. 

The quant analysts at data provider Scientific Beta say average ESG scores fail to provide an accurate guide to corporate success in hitting environmental and social targets.  But they certainly benefit from marketing initiatives. Just as we once saw with credit default swaps, diversified growth strategies and 130/30 hedge funds.

Not before time, the IFRS Foundation, which oversees the International Accounting Standards Board, is creating a Sustainability Standards Board. 

This will enable investors to judge sustainability reporting, taking account of financial issues and executive pay. It will be a big step on the road towards the use of sustainable finance. 

Given the current state of exuberance, sober analysis can’t happen soon enough.

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