Why values-based investing is about to get easier

A new regulation set to shake-up the fastest-growing portion of the global funds universe will come into effect in the next few months. In addition to helping stamp out “green-washing” as funds seek to jump on the environmental, social and governance (ESG) investing bandwagon, there are several reasons why investors should care about the European Union’s Sustainable Finance Disclosure Regulation (SFDR).

This regulation, which begins to roll-out from June 2021, is arguably the biggest fundamental change to the way asset management is conducted since the UK’s “Big Bang” de-regulation reforms in the mid-1980s.

Under SFDR, fund managers are required to make firm and product level disclosures that clearly outline and measure how sustainability risks are taken into account in their investment process.

A key feature of this framework is that it provides a definition of sustainable investment and lays down the criteria fund managers must meet to qualify. For our part, we welcome the efforts to bring greater clarity and transparency to an area of investment that has been wide open to highly subjective interpretation.

With a new generation of savers looking to invest in funds, which can adhere to a set of principles they can identify with, this regulation should provide much-needed transparency.

Graph 1: Cumulative flows into ESG Funds (US$ Bn)

ESG themes underpin only about 6% of the total active global equity funds universe, but it’s the only segment to see significant growth in assets-under-management fund flows over the past five years. And ESG is about to take over.

Although active management has been in a 20-year structural retreat, equity funds classified as having an ESG or SRI focus have been growing rapidly in recent years.

The change appears revolutionary and sudden, but has been in the making for some time.

COVID-19 is once again the accelerator, and this isn’t just about the finance industry. Everywhere customers are more discerning and are migrating to companies that ‘do’ the right thing; employee loyalty is greater for those who support and retain workers through challenging times.

As investors, we have witnessed this in real time in our portfolio stocks over the past 12 months. Shifting attitudes of what represents value, a need for greater resilience in our communities – supported by policy and regulation – means what was once an ESG breeze is now a full gale-force storm.

Perfection isn’t the answer

Globally, there are already 60,000 (and growing) ESG-based indices and ETFs to choose from—all offering an ESG solution and a home for the growing ESG fund flow.

Commonly discussed factors, such as Value or Growth, are easy to measure. They are based on historically reported data, which is standardised then audited. Such standardisation doesn’t exist in the ESG world, because ESG itself focuses on externalities. These are often not measured by companies themselves and are rarely, if ever, disclosed to the public.

The result is a market wanting exact answers in an uncertain world. It is all too easy to see the headline ESG rating and immediately assume a company is good or bad. There appears to be no middle ground.

Ratings agencies and asset owners alike cannot afford to have a problem child on their books. Only the best ESG score will do. You may remember that the German duo, automotive giant Volkswagen and electronic payments company Wirecard, were part of ESG indices before their issues became all too real.

Work carried out by Bernstein suggests the highest ESG scoring companies are already heavily crowded. This indicates that greater potential returns could be found investing in companies with low ESG scores and then enjoying the fruits from improving trends as ratings agencies and the market catch up with reality.

Graph 2: High ESG scores appear crowded, whereas rising ESG scores are ignored

This matches our own experience, where rising ESG scores have tended to outperform, whereas those with falling scores underperformed. This could be coincidental, and isn’t statistically material, but it is in line with the outcome we would expect from our Future Quality investing.

The embryonic nature of the ESG industry provides an opportunity for active investors to take the lead. To invest ahead of the flows and to engage with management teams about these long-term issues and identify where the market underappreciates value.

The long-term nature of the problems being addressed, and the difficulty of measuring success, suggest this is a natural home for the active investor. A perfect ESG score today may not be the only indicator for tomorrow’s winners.

Case study: Palomar

We first invested in Palomar (PLMR), a Nasdaq-listed company that provides earthquake insurance to individuals and businesses in the US, in 2020. Its mission is to leverage technology and data to provide a range of insurance solutions to Americans who have been historically underserved by the industry. These include families and small businesses who turn to Palomar for insurance against a range of natural disasters; from fire to flood to earthquake. Many of these customers are underserved or priced out of the market due to the inefficiencies of the incumbent market participants.

Despite a low ESG rating by MSCI (‘B’ rated), our assessment of Palomar against ESG factors has been very positive, and for a few key reasons:

• The company provides affordable insurance products and services to millions of people living in vulnerable parts of the country.
• Its largest and original product is earthquake insurance and it leverages technology and data to provide more granular and efficient pricing than peers.
  
• It has used this IT advantage to enter other general insurance markets, such as select wind and flood, again being able to analyse and underwrite risk more accurately than peers and then price accordingly.
  

Formed in 2014, Palomar is a young company with an employee base of about 100. When compared to some of its behemoth incumbent competitors, it is not surprising for the company to have a low ESG rating. But lack of disclosure is common for young companies and easily rectified.

We’re confident our ongoing dialogue and long-term support will lead to greater transparency and eventually a more accurate appreciation of the company’s ESG credentials. There are many aspects of this company currently underappreciated by the market.

Why should investors care?

Equity investors have been “balls to the wall” – to borrow a term from the aviation industry ¬– since last March. The term refers to a pilot aggressively and without restraint pulling back on a ball-shaped throttle, causing an acceleration skywards – something like a squeezed GameStop share price (on the way up, that is).

For stock investors today, increased asset allocation, savings and raised liquidity are driving increased speculation, some of which is undoubtedly bubble-like in nature. Stretched valuations in some “green” ETFs suggest that investors’ expectations are already elevated. Examples include the iShares Global Clean Energy ETF (ICLN) – currently trading at about 70-times earnings, along with a large number of green special purpose acquisition companies (SPACs). Red flags are waving in the wind.

There is a limited valuation premium for ESG stocks once the fundamental qualities of the stocks are taken into account, according to a study of US stocks completed by Empirical Research Partners. But they have discovered that there is a skew of “agreed” ESG winners within the ESG universe, and at the extreme there is an argument that an ESG premium exists.

Graph 3 shows that the skew is heavily weighted to the tech sector where some caution may be warranted; though perhaps only a mirror reflection of leadership in the market in general.

Graph 3: Top 20 stocks by ESG funds – sector weights

Conclusion

The investment industry has reached a tipping point. Today’s market participants think of ESG as a separate category to active investing, but soon they will be synonymous with each other. Perhaps the prevailing wind isn’t set to change but in fact it is set to strengthen as the shift of capital towards solving our long-term environmental and societal issues combines with further technological advances to create an ESG storm that is only now starting. It is a sign that things are changing and in the long run we will all be better for it.

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