Does Sustainable Growth Drive You Crazy?

“Being right means being non-consensus at the time of investment. In sort of practical terms, non-consensus translates to crazy”  Alex Danco – Scarcity, Abundance and Bubbles [Invest like the Best, Episode 121]

Show the average investor the chart above, and there’s a good chance they’d roll their eyes. We’re taught to be cynical of such outlandish forecasts.  We’re constantly reminded of past bubbles and the naïve market behaviour that they imbue.  The pithy wisdom of legendary investors like Warren Buffet is usually translated to the mantra: invest in established quality companies and sectors at a discount, anything else is …. Crazy!

Dynamic power (getting there) is completely different from static power (being there), but the two are often conflatedThe key to strategy is identifying emerging scarcity. Scarcity is where innovation can create power”  -Hamilton Helmer, 7 Powers: The Foundations of Business Strategy

Helmer is a highly successful investor and strategist. Here he’s saying that identifying emerging competitive advantages requires a different approach to identifying established competitive advantages. A lot of investment value can be captured when evidence of advantage is just beginning to emerge.  This often arises around new innovation (technology and / or business models) which addresses an emerging scarcity.

In short, we should not measure the rebel on the same metrics we measure the Emperor.  The rebel won’t have a castle, but might have a new flying machine and a novel strategy for sacking the Emperor’s. The table below shows that some of the biggest rebel winners of the last 10 years looked very expensive on traditional metrics in 2008.

Best and worst performing stocks 2008-2018


Source: Factset. 8 Best performing and 8 worst performing stocks (continuously listed) within the MSCI AC World Index between the end of 2008 and the end of 2018.

So what’s my point? My point is that I believe investing in higher multiple growth stocks can be counter-intuitively contrarian.  It is psychologically challenging for the following reasons:

  1. It requires volatility tolerance: By definition, more of the value of a fast growing business will be in the long-term future. Thus, in the short-term share prices can be very sensitive (i.e. volatile) to seemingly slight changes in long-term growth expectations and / or the assumed cost of capital.
  2. It requires a thick skin: Being ‘crazy’ can draw a crowd of not so friendly onlookers. Sometimes they throw stuff.
  3. It requires being wrong… often: You strike out more often if you always swing for the fences, but this approach increases your chances of hitting home runs. This is called the “Babe Ruth Effect”.

Focusing on the last point, according to Kahneman and Tversky, the pain of loss is about 2.5 times as potent as the pleasure of an equivalent gain. As a result, people are a lot happier when they are frequently right. But being right more often does not necessarily determine investment fund performance. Weird I know, but more often a few stocks going up or down dramatically will have a greater impact. In equity markets, the distribution of returns is skewed positively towards a small number of stocks that deliver extreme upside.

Hendrik (Hank) Bessembinder, Do Stocks Outperform Treasury Bills? (May 2018)

Great.. but what does all this have to do with sustainability? Well nothing… unless……. Unless, sustainability trends are a form of disruptive change?

In the early 1900’s humans were encumbered with very high transport costs and a terrible horse manure problem. These frictions were resolved by relatively cheap oil, the combustion engine and Henry Ford.  It took a while to become clear (not as long as some like to pretend), but these solutions created clear frictions of their own…..

In my view, investors who have a sustainability mind-set combined with a disruptive growth mind-set will increase their chances of gaining exposure to the extreme positive returns of the future. The trade-off is that we will strike out more often, which will make us feel bad in the short-term.

Warren Buffet is a legend but we deliberately take a different approach. He backs the Emperors to stay in power, while we invest in the rebels that try to profit from their emerging weaknesses.  I’m not saying Mr Buffet is wrong….. he’s just a different kind of crazy.

“Our approach is very much profiting from lack of change rather than from change.” Warren Buffet

 

 

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for co-managing global equities portfolios. He joined us in 2014 from SWIP, where he was investment director in global equities. In addition Craig also had analysis responsibilities for the tech, energy and utility sectors. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors, a member of the global environmental equity team. Craig has a 1st Class honours degree in Building Surveying, an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 17 years’ industry experience*. *As at 30 November 2018

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The power of perception: The sustainability survey results

“So much advantage in life comes from being willing to look like an idiot over the short-term” [a guy I follow on twitter]

I’ve got a confession to make.. well two actually.

Firstly, I’m biased. I have a vested interest in the Kames Global Sustainable Equity strategy being a success. Being a sustainable strategy, I also have bias towards wanting sustainable companies and investment funds to do well. Having reached the three year anniversary of our strategy, I’m more strongly motivated than ever to convince people of this. I always try to be wary of biases (especially my own) and one thing I have noticed over the three years co-managing and marketing our strategy is that sustainability is an emotional subject. And emotion increases the likelihood of bias.

Hypothesis
When focused on long-term or absolute returns, I have noticed that investors find the merits of sustainable investing intuitive. However, when focussed on short-term risks (less than 3yrs) relative to the market, the fear of missing out (FOMO) becomes the focus.  This focus on short-term relative risks is wrong. I believe that this bias means that any period of short-term relative underperformance is often viewed as proof that ethical & sustainable strategies have a performance cost. Meanwhile, there is increasing empirical evidence to the contrary.

Objective
I wanted to undertake a sustainable investing perception survey to test this theory. Do biases exist in the way ethical & sustainable investing is perceived?  This leads me to my second confession. We tricked you. I’m sorry… It was a wee white trick. We devised a series of positively framed questions and a series of negatively framed questions. Essentially the same 4 questions, except we split the respondents into two groups, one group received the positive questions and the other received the negative ones (this is called an A/B test).  The intention was to see if how the question was framed, affected how people responded. The 5th question was a neutral one, the same for all.

Scope
I’d like to thank the 590 wonderful people who took the time to complete the survey.  Many respondents also made qualitative comments which is great.  In terms of statistical significance, I think this number of responses puts us somewhere between a spurious “firmer skin in two weeks” beauty product claim and the certitude that climate change has been induced by humans. I’ll let you decide which it is closer to. It’s probably worth pointing out that I’m not a statistician or psychologist, and I’m not claiming a significant breakthrough here but I do think we can learn something from the results.

For those of you wanting to cut straight to the point, I’m going to go rogue and get straight to the juicy bit of every report – the conclusion. [For those with the time and curiosity to get into the detail, the question-by-question analysis is appended below along with some intuitive charts. Please contact me if you want to dig even deeper.]

Conclusion
It is clear that both groups believe companies benefit from acting ethically or sustainably (and that there are risks if they don’t). I had expected negative framing to effect the results but it did not. However, when considering the implications on fund manager performance, the results from each group was significantly different. A positive framing led to strong agreement of a performance benefit, whilst negative framing led to a meaningfully different skew. In fact, a negative framing led to more respondents suggesting it would hurt fund manager performance than help it. To me, this seems like a contradiction. On one hand, companies and their share prices will benefit from being ethical & sustainable, but on the other hand fund managers who invest in such companies will suffer a performance cost. It certainly confirms my prior bias anyway.

Finally we gave both groups a free option. Would you want to help the planet and society if there is no downside? Unsurprisingly, the response was overwhelmingly positive. I would suggest the fact that a small minority were willing to give up this free option, is indicative of an extreme bias against ethical & sustainable investing. A kind of protest vote against the whole notion of it.

Where to from here?

I believe the inclination to negatively frame ethical & sustainable investing (including tentative or apologetic language) cultivates the bias that there is a performance cost. Despite increasing evidence that ethical & sustainable investors can generate investment alpha and despite market support for this view, the short-term relative risk of underperformance still casts a long psychological shadow. This is still a barrier to adoption of ethical & sustainable investment strategies today, but I believe there are three ways we can collectively lower these barriers.

  1. Long-term performance: We need to aim for better than the market over a longer time frame. We will do this by investing in good ethical & sustainable companies, not managing short term factors. In short – as the quote at the outset suggests – if we want to gain an advantage (investment alpha) we should be willing to risk looking like idiots (underperform) in the short term.
  2. Education: Misinformation and historic biases exist. The weight of evidence is in our favour. Continually promoting the empirical and intuitive evidence of why it works should be a priority. This is why our sustainability soapbox exists
  3. Absolutely positive: Investors broadly appreciate that companies benefit from acting sustainably. When discussing sustainable investing, focus on these long-term absolute benefits rather than negative language which encourages short-term thinking and historic biases. See How to talk to sustainable investing sceptics

One last thing. We started our global sustainable journey three years ago. Our BHAG (Big Hairy Audacious Goal) was to be the best performing global equity fund in the world. We can’t claim to have achieved that (yet J) but we’ve done well over this relatively short time frame. It is our continued aim that our investments, our performance and this blog to have a positive impact on the planet, society and client returns.

Results in more detail

Sample bias is likely in the results with more sustainably minded investors (our blog readers etc.) being over-represented. Responses came from a variety of backgrounds including professional financial advisors, buy-side and sell side investment professionals, general financial professionals and a small number of interested retail investors.

Questions 1, 2 and 3 were designed to see if investors expected sustainable actions by companies to result in benefits or costs. I wanted to consider both fundamental economic impacts (i.e. revenue and profits) and market perception (i.e. valuation and risk). NB – Because of the A/B test, strong agreement to the positive questions = strong disagreement in the negative questions. The charts below show that respondents from both groups were in strong agreement that companies acting ethically & sustainably will see positive market / economic benefits. There is no significant difference.

Question 4 was designed to ask the all-important question (well to us fund managers anyway) of whether a fund manager’s performance is effected by investing ethically & sustainably. The charts below show that when framed positively, 67.4% of respondents agreed or strongly agreed that there could be a direct performance benefit to investing sustainably. When framed negatively, the equivalent response was only 41.9%. A 25.5% divergence. 43.2% of responses to the negatively framed question agreed or strongly agreed that performance could be impaired by excluding companies that have negative impacts. To put it statistically, there is a clear skew in the distribution of responses which suggests that the framing of the question has influenced the results.

Question 5 was the same for everyone (no tricks here). A simple hypothetical question.  Would you invest in an ethical or sustainable fund rather than “traditional” fund if the risk / reward was the same? An overwhelmingly positive response shows that 92.2% of respondents either agreed or strongly agreed that they would rather invest in a sustainable or ethical fund vs a “traditional” fund, all else equal.

 

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for co-managing global equities portfolios. He joined us in 2014 from SWIP, where he was investment director in global equities. In addition Craig also had analysis responsibilities for the tech, energy and utility sectors. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors, a member of the global environmental equity team. Craig has a 1st Class honours degree in Building Surveying, an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 17 years’ industry experience*. *As at 30 November 2018.

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How to talk sustainable investing to sceptics

A November 2018 Monmouth poll found that 78% of Americans now believe climate change is real, up from 70% three years ago. For the first time, a majority of Republicans (64%) accept it vs 49% in 2015. Moving in the right direction but still low percentages. Climate change deniers have long had more traction than they should and this is in part due to the dry way climate scientists communicate (i.e. via boring old boring old scientific journals and balanced debate). The scientific communication machine is simply not set up to counter a co-ordinated misinformation campaigns and social media memes.

I see some similarities in the ESG / sustainable investment debate. To be clear, I’m not saying alpha from sustainability analysis will magically make your fund manager a great stock picker, but it helps. There is a growing body of evidence of this and it is even stronger than many traditionally accepted “alpha factors”. Regular readers may remember my blog of June 2018, which supports this view and jests that 60% of the time it, works every time.

Some ardent ESG deniers will never shift their position, but too many swing voters are still in the wrong camp. The “performance cost” meme is strong and as mentioned in the blog above, researchers have noted that “clients want incontrovertible evidence that sustainability adds alpha before considering it”. This is not the case for any other alpha factors and is convenient for the denier because unlike climate change, incontrovertible evidence can never be found.

Which brings me to our communication problem. Like climate change scientists, I sense timidity (and frankly dullness) in how some of the ESG community communicate.  It’s the same problem. Dry and balanced debate meets cynical and often conflicted incumbents.

Dry / meek statements Positive / conviction alternatives
ESG is really just a risk management tool which reduces the chance investor exposure to controversies and disasters

My experience suggests sustainability analysis is useful for identifying sources of competitive advantage

ESG is less important to some companies than others

All companies are different and their material sustainability issues are different as a result, but that doesn’t mean they are less important. Facebook and Vale are two recent examples of this. We think it is self-evident that identifying those material issues and tracking them over time will add value
Alpha from ESG really just comes from the assessment of governance

Evidence suggests that E & S factors are equally as valuable sources of investment alpha*  Intuitively, environmental and social issues can be very material to many businesses

ESG is very difficult to do in emerging markets

This creates opportunity. Evidence suggest that the emerging markets are actually where ESG is most valuable* More bottom up hard work may be required though

We don’t believe there is value in judging a company on the sustainability of its products. Who are we to decide?

The sustainability of a company’s products is vital to its long-term strategic success. In this respect, strategic positioning and vision can be a long-term tailwind or headwind. An unsustainable product (i.e. coal) is a huge strategic headache for any management team, just as a sustainable one will create a tailwind of opportunities.

The risk adjusted returns of an ESG fund are only slightly better/worse than a traditional fund Many ESG studies show improved risk adjusted returns vs. traditional funds, lower volatility and higher returns. However, risk is a backward looking measure and the cohort of sustainable/ESG funds is historically small. We see no reason why a well-managed sustainable investment portfolio won’t achieve equal risk adjusted returns over the short-term and have the potential to achieve higher risk-adjusted returns over the long-term (it all depends on the quality of the stock picking)

There is a culture and history that goes some way to explaining the lack of ESG conviction. ESG research departments have historically operating like a risk management department. They were advisors who only stepped into an investment decision in extreme (typically bad) circumstances. N.B – With our global sustainable equity strategies, we deliberately counter-positioned ourselves from this approach, which I discussed in ESG Collaboration – A Third way?

Lately however, ESG integration has become a core requirement in everyone’s investment process and credible sustainable and ethical investment strategies are seeing strong demand. The average ESG Researcher or manager now has a vital communication role.  Whilst I’m always wary of hype and marketing in our industry (and the number of sustainable funds launched in the last year may be an indicator of such), I believe that we should now be bolder and more confident in the sustainable investment message we are sending. Hopefully my quick reference guide will help you do that.

* Friede, Busch, Bassen (ESG & Corporate Financial Performance: Mapping the global landscape). September 2016

 

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for co-managing global equities portfolios. He joined us in 2014 from SWIP, where he was investment director in global equities. In addition Craig also had analysis responsibilities for the tech, energy and utility sectors. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors, a member of the global environmental equity team. Craig has a 1st Class honours degree in Building Surveying, an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 17 years’ industry experience*. *As at 30 November 2018.

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Don’t put the ESG cart before the Sustainable horse

Have you read any studies in to ESG investing recently? If you have, then you’ll know that across the board, academic studies continue to stress the positive alpha-generating potential of ESG factors. Research demonstrates that there are positive links across all three environmental, social and governance factors. So, with this in mind, the solution is clear. Screen your investment universe based on ESG scores at the outset of your investment process…right? Wrong.

ESG screening tools provide us with big data sets that are useful for doing academic research and making generic assessments, but we have to be careful how we deploy them in practice. Far from perfect, the broad scope of the screens provides bottom up sustainable investors like ourselves with problems if we don’t use our initiative as well.

We discussed these issues in previous soapboxes (here and here). But just to recap, the problems of using ESG screens in isolation include:

  1. What impact does it have? – The screen provides limited or no assessment of product impact
  2. Where is the data from? – ESG data quality can be poor – inconsistent and self-reported
  3. One size fits all? – The screens follow a cookie cutter approach (every company is different but is treated the same)
  4. Large cap bias – Small or mid-sized companies are not covered or are harshly treated
  5. Geographic bias –  Emerging market companies are not covered or are harshly treated
  6. A leopard never changes its spots – They are point-in-time measures and inherently backward looking

Don’t get me wrong, ESG screens are useful for flagging potential risks. The scores produced are fairly likely to align with our bottom up assessment when considering an established, large cap, developed market company. But an ESG screen NEVER makes our decision for us. We use them, but we don’t abuse them.

So there you have it. That’s why we choose not to pre-screen our opportunity set using ESG scores. For us, it’s important to do bottom-up analysis first. And our own sustainability analysis focuses on two other key components- materiality and intentionality. So what is important for this business and does the management have ambitions to improve things? And with this open-minded approach, what do you get? Insights that you wouldn’t have without the human, active management, analysis. Typically our most valuable insights are missed by the ESG screens due to the factors above.

We always find it exciting to identify companies that have embedded a sustainable mind-set in their strategic vision… not just to reduce risks, but to create revenue opportunities as well as creating competitive advantages. Interestingly, recent research indicates that ESG is actually more powerful when combined with traditional fundamental factors (rather than in isolation) and this effect is amplified in ‘risker’ areas of the market. So what’s the inference here? That small cap, mid cap and emerging markets are the best suited to leveraging detailed sustainability analysis while complementing traditional analysis.

Our representative sustainable investment portfolios go where most other sustainable strategies don’t, and this can mean our sustainable portfolios score poorly on ESG screens- but that isn’t our primary concern.

So whilst we’re on our horse analogy, perhaps I could extend it a little and suggest that we are the Lone Ranger of sustainable strategies.  We clearly don’t gallop with the herd and like any Hollywood Lone Ranger, sometimes, to be a good guy you need to split from the herd.

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for co-managing global equities portfolios. He joined us in 2014 from SWIP, where he was investment director in global equities. In addition Craig also had analysis responsibilities for the tech, energy and utility sectors. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors, a member of the global environmental equity team. Craig has a 1st Class honours degree in Building Surveying, an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 17 years’ industry experience*. *As at 30 November 2018.

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Less pain more gain

The source of my pain? An interview I read a while ago with a particularly impassioned ESG advocate (although I don’t think he was a fund manager). The topic of conversation was a controversial company that has experienced a substantial share price drop as a result of material sustainability issues. My bugbear was with the response of the ESG advocate though. I’ll paraphrase for convenience but when asked whether the stock might now represent a great buying opportunity the advocate replied:

“The whole point of ESG investing is to take pain. We should be willing to underperform if this means avoiding companies that do harm”

Ouch… that hurts. There’s the pain.

Who knew sustainable investing was a masochistic pursuit (not me)!

For me this is the clever work of a cynical journalist cherry picking sentiment, and it totally misses the point. For me, sustainability analysis involves assessing the sustainability of products and practices and the rate at which these factors improve (or regress). For me, it’s a meaningful alpha generating tool.

So back to “taking the pain”…do we think that’s a factor of sustainable investing. No. I see it this way. The point is to:

  1. a) Avoid the pain
  2. b) Identify disruptive sustainable growth opportunities before the market does

You may have to suffer through the short-term underperformance and watch companies and subsectors that we deem to be unsustainable outperform. BUT that’s very different from deliberately underperforming as the above quote implies.

If our analysis is correct (and before we get ahead of ourselves – no analysis is always correct), outperformance of an unsustainable company will be brief and its unsustainable products and/or business practices will be found out in the end, unless it takes steps to address these shortcomings. By definition, something which is unsustainable, will not sustain. And if it is not going to sustain, it is never going to be a good investment. So there you have it – in an unsustainable company you may get a short term speculative trade (perhaps), but never a good investment, in my opinion.

If nothing else, the original quote does teach us one thing – that as a group, sustainable investors need to do better at communicating the multiple advantages of sustainability. Yes we are intentionally trying to have positive impact with our clients’ capital, but it is not simply an ideological venture with a performance cost attached. So what would my response have been to such a question? Hopefully something like this:

 “Is the product that the company sells getting more sustainable? Is the company demonstrably improving its practices to address its material sustainability risks? If not, I will never think it is cheap enough to be a great investment opportunity.”

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for co-managing global equities portfolios. He joined us in 2014 from SWIP, where he was investment director in global equities. In addition Craig also had analysis responsibilities for the tech, energy and utility sectors. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors, a member of the global environmental equity team. Craig has a 1st Class honours degree in Building Surveying, an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 17 years’ industry experience*. *As at 30 November 2018.

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