Cynicism is a good trait to have when investing your hard-earned money; getting carried away with the latest fad is for suckers, as those with memories stretching back to the dotcom bubble recall. Much of the fluffy marketing around environmental, social and governance (ESG) has probably caused serious investors to tut and roll their eyes, but there is substance behind the strategies that it would be foolish to ignore on the way out of the coronavirus crisis.
Before the global pandemic turned everything on its head, ESG was the hot investment topic. Asset owners such as sovereign wealth funds, large pension funds and endowment funds, have started to demand that their money is invested to not exacerbate problems such as climate change – and hopefully to help solve them. Aiming to meet these requirements and having an eye on the next generation of retail investors (ESG-conscious millennials will soon benefit from an enormous generational wealth transfer from their Baby Boomer parents), asset managers have developed ESG scores to decide how they choose and weight investments in shares and bonds.
Companies that score badly against the criteria could suffer the threat of divestment by major investors, which would have the effect of decreasing their share price and increasing the yield they would have to pay bondholders. Basically, companies that don’t clean up their act will see their cost of capital increasing, making it harder to do business. The ESG trend was already presenting enormous challenges for the largest UK-listed companies and the coronavirus crisis is helping compress the timeframe within which they must adapt.
BlackRock, the world’s largest asset manager, says that because flows into ESG investment have so far been in their early stages, “full consequences of a shift to sustainable investing are not yet in market prices – and a return advantage can be gained during this transition”.
Mainstays of 20th century portfolios such as banks and oil companies now look weak at best and investors need to decide which are the industries and companies of the future. Several leading asset managers tout ESG as the investing framework to identify these companies and position for most upside after coronavirus. There is not only a growth aspect to sustainable investing; these opportunities are undervalued, raising the tantalising prospect of ‘Magic Formula’ growth-value shares (à la hedge fund legend Joel Greenblatt) for when the world economy recovers.
Ex-growth FTSE 100 will leave your portfolio struggling as dividend cull spreads
If you started investing in the year 2000, holding UK shares had been an ex-growth pastime even before the coronavirus caused the market to sell off so spectacularly in March. Up until the end of 2019, UK share prices had lost on average 0.9 per cent a year after inflation (Credit Suisse Global Returns Yearbook, Dimson, Marsh and Staunton) so far this millennium. The positive real total return of 2.7 per cent a year relied on dividends being received and reinvested.
Coronavirus and lockdowns are sending the world crashing into recession. The break on the economy, coupled with ramifications of stimulus packages by governments and central banks, is a disaster for dividends. Broker Peel Hunt reported that more than £15.5bn of UK dividends (from FTSE 350 and Aim 100 companies) had been axed already at the start of April, and insurance companies have just joined the list in scrapping their payout. Clearly that calls for serious questioning of the investment case for shares.
This is especially true when it comes to blue chips included in the FTSE 100, a highly concentrated index, which gives massive exposure to companies that have only been worth holding for income. Some of the biggest, notably Royal Dutch Shell (RDSB), have gone to great lengths to protect dividends in the past, but even this dividend aristocrat has had to submit to phenomenal headwinds.
Shell made a strong statement in support of its dividend, before succumbing to make a first cut in decades. Central banks slashing interest rates reduces the cost of short-term credit facilities, which had enabled Shell to secure $12bn (£9.7bn) of funding to bolster its cash liquidity to $40bn. It also suspended its programme of buying back shares and shelved investment in some projects. In the end, it still felt compelled to reduce the payout, and perhaps the coronavirus crisis foreshadows further challenges.
For instance, costs of longer-term debt finance have spiked considerably. The spread in yields that investors require to purchase corporate bonds over government debt, such as US Treasuries or UK gilts, has widened due to the market reappraising risk. This is portentous for oil companies’ costs in raising term finance, especially as investors will increasingly add an ESG premium for polluters.
Falling oil prices are the obvious impediment to operating cash flow. Even without a pandemic crisis, with the cost of renewable energy tumbling and advances in battery technology, in future there will still be slack demand to meet supply gluts when producer nations quarrel. Given that borrowing to boost cash flows will become more expensive, it is time to question whether oil companies will always have enough dry powder to safeguard dividends the next time revenues are hit (remember it was only in 2016 that the oil price last nosedived).
Banks have already seen their dividends axed as a direct consequence of the Prudential Regulation Authority (PRA) demanding they retain earnings to remain as well capitalised as possible. This makes sense for the financial system, which is stretched to breaking point maintaining liquidity and fulfilling the government’s support packages for the UK economy. For investors, however, there is now little reason to hold bank shares.
Net interest margins, the difference between what a bank charges for loans and what it pays depositors and other funding sources, were already wafer thin. The Bank of England cutting interest rates to 0.1 per cent will make it very difficult for lenders to make a profit and, with restrictions on using leverage, banks may find it impossible to grow.
Furthermore, banks are in something of a Catch 22 situation, due to ESG scores that have punished them for lending to polluters, as well as past scandals involving product mis-selling and some governance issues. On the one hand, they want profitable business, but on the other, if they ever tap equity markets for funding, a lower share price (because ESG scores dent demand) increases the cost of capital funding. If the cost of equity is rising and the return on equity is falling, the investment outlook is truly bleak.
Competition from nimble fintech providers, which have a lower ratio of operating costs to income, is a significant disruptive threat and the likes of N26, Monzo, Starling and Revolut are seeing usage of their slick apps spike during lockdown. These upstarts, free of legacy image problems, are attractive to retail customers, and so hoover up deposits – a crucial source of cheap funding.
ESG shows defensive qualities and could offer a way forward
Oil & gas and banking are two hugely represented industries in the FTSE 100, yet both are ex-growth and banks are not paying dividends now. More profitable investments are to be had elsewhere and research by Bank of America (BoA) suggests the recent performance of companies with strong ESG credentials shows the way.
In the US, by 25 March amid fierce selling, the top fifth of S&P 500 companies by ESG score outperformed by over 5 per cent on average. In Europe, the BoA study found the 50 shares held by ESG funds in the most overweight proportion, compared with their size in benchmark indices, beat the most underweighted shares by 10 per cent. It would seem from this that ESG is not a bull market luxury but instead adds resilience to portfolios.
Asian markets are the exception when looking at how much share prices have fallen, but lower-ranked ESG companies have seen larger downward earnings revisions in the US, Europe and Asia. The BoA study noted that this was particularly evident in consumer discretionary, technology, utilities and real-estate investment trusts (Reit) shares.
UK-listed shares out of top 50 European stocks most overweight in ESG portfolios
|Company||Price 7.04.20 (p)||ESG score (out of 100)* as of Feb 2020||Average overweight (%) as of feb-2020||% change LTM||% change YTD|
|Severn Trent (SVT)||2158||60||0.6||10.6||-14.2|
|United Utilities (UU.)||841||55||0.5||3.4||-10.8|
|Smurfit Kappa (SKG)||2331||57||0.3||-1.4||-20.4|
|Johnson Matthey (JMAT)||1804||59||0.2||-45.2||-39.8|
*Bank of America derived Refinitiv score. Table source: Bank of America Global Research, Refinitiv
Of the top 50 European shares from the BoA analysis, 10 are UK-listed. Utilities companies are prominent, as are materials and industrial sectors. Since 31 December 2019, the share prices have fallen roughly 22 per cent, on average, compared with an almost 26 per cent fall for the FTSE 100 index. On a 12-month basis, the 10 shares highlighted have averaged a 10 per cent fall versus 24 per cent for the index, but that can be attributed to the preponderance of utility stocks, which enjoyed a rally after Jeremy Corbyn lost the December 2019 general election.
When building a sustainable portfolio, would 30 per cent allocated to utilities stocks be appropriate? It was identified recently by Peel Hunt as the sector that had moved least towards cutting dividends, and in a world where government bond yields are offering nothing, their so-called bond proxy status could be attractive. That said, these are companies with debt obligations and high maintenance capital expenditure requirements, both of which take a chunk out of free cash flow.
The hidden risk is pension fund deficits, and it is possible those bond proxy cash flows will be needed to meet shortfalls in defined-benefit pension schemes. Finally, the very reason utility stocks were cheap last year was fears of nationalisation. It won’t be for ideological reasons but, with the government potentially helping consumers with energy and water bills as the economy is shut down, it’s more than credible that investors could be asked to take a haircut on dividends at some point.
Of the other companies in this list, some have clearly suffered more than others due to the coronavirus lockdown. Contract caterer Compass (CPG) is down 35 per cent in the year to date and catalytic converter systems provider Johnson Matthey (JMAT) has shed 40 per cent of its value. The nature of the crisis will hurt these businesses operationally, but it is also worth noting that neither boasted especially fat operating profit margins going into the downturn.
Balancing risk with UK quality and US mega caps
Reliable quality such as chemicals business Croda (CRDA) and Halma (HLMA), a specialist in life-saving industrial technologies, are also flagged. The risks in the case of shares in these companies is mostly to do with their expensiveness. Croda is 17 per cent cheaper than a year ago, possibly easing concerns that it is a ‘quality trap’ (see Phil Oakley’s article, August 2019), but Halma is up 8.5 per cent.
Like any portfolio, an ESG strategy is about balancing risk, so perhaps blending the factor risks of companies made cheap by coronavirus, those that have traditional defensive properties and pricier bastions of quality, is a good way to diversify. More can be achieved by going international, with some hints offered by the companies that appear most prominently in ESG funds, including some large-cap growth juggernauts.
US companies most held by ESG funds
|Company||Price 7.04.20 ($)||% of ESG funds held by||% change LTM||% change YTD|
|Texas Instruments (US:TXN)||106.26||34||-7.8||-17.2|
Source: Bank of America Global Research
The top five US companies ESG funds have a position in is headed by Ecolab (US:ECL), a $46bn market cap provider of water, hygiene and energy services. The target share price for the business has been subject to several downgrades by US investment houses in the past week. Also noteworthy is that it issued $250m of 4.8 per cent bonds expiring in 2030 – that’s a spread of 4.05 per cent above US Treasuries.
While investors will have reservations over some companies, others in the US top five can be counted among the world’s most consistently successful companies, with strong market positions and loyal customers. These include Microsoft (US:MSFT), Google’s parent Alphabet (US:GOOGL), Visa (US:V.) and semi-conductor and circuit manufacturer Texas Instruments (US:TXN). The S&P 500 has oscillated wildly, but is pausing for breath after a spectacular rally at the time of writing, although it would be no surprise to see opportunities to buy companies on further dips in the weeks ahead.
But can you rely on ESG ratings?
Other US and European companies highlighted in the BoA study make it possible to build a diverse international portfolio across different sectors. Because of withholding tax issues when repatriating gains from continental Europe, it may be better for a UK investor to use a collective investment scheme. Whether questioning a fund manager’s picks or individual companies such as Adidas, Danone, L'Oréal or Siemens to name a few, the rather fundamental questions for an ESG investment need to be asked: is it ethical and is it working to improve?
Answering these questions is made more difficult by the lack of standard ESG measurement – the main index providers such as FTSE, MSCI, Refinitiv and Sustainalytics all have their own methodology. In the case of MSCI, environmental factors are broken down by a company's carbon footprint (both industrial processes and the impact their products have); stress on natural resources; polluting by-products; and they positively look at moves towards green technology. Governance factors consider business ethics, tax transparency, board structure and accounting practices. Index providers are most aligned on environment, but there is great disparity on measuring social impact and, perhaps most surprisingly, on governance.
There are also bespoke ESG indices created internally by the likes of Legal & General Investment Management (LGIM). Indices such as LGIM’s, which tilts portfolio weightings based on companies’ responsiveness to ESG issues, have won praise from groups such as charity Share Action. The methodology rewards companies that are trying, but have more to do – but it also has teeth, being backed up by the threat of divestment for companies that are unresponsive.
Yet not all ESG benchmarks are created equal, and Priya Taneja, senior associate, and Nathan Menon, associate, at law firm Reed Smith, also flag inconsistent data, a lack of industry-wide definitions (especially relating to social ‘S’ issues) as barriers to standardisation. That said, the proprietary nature of some ESG rating methodologies might prove to be the biggest hurdle in sharing information.
For investors, the absence of a codified ESG structure can mean substantial variations in the performance of different benchmarks. Much of this stems from classification. The Reed Smith associates identify that: “A key shortcoming of the ESG taxonomy is that it cannot offer investors a consensus-based end-point to work towards, as multiple trade-offs exist between environmental, social and governance factors.”
Addressing this issue may become a priority as investors require more guidance creating portfolios for the post-coronavirus world. Reed Smith says: “We could also see an increase in private-public partnerships for ESG. This will increase the need for a robust ESG taxonomy.”
For now, investors – whether focused on morality or just returns – should probably treat the ESG scores like any other stock screen metric: as a starting point for further research. The companies from the BoA research aren’t necessarily screaming buys – the usual work must be done to make good estimates of whether the businesses are going to grow and generate cash, how vulnerable they will be in recessions and to check their current state of solvency and financial position.
Timing divestment for when the golden geese stop laying
Similar efforts must be made in assessing shares that going forward may not warrant the role they once did in portfolios. Timing divestment is difficult, however, especially when businesses still offer the immediate inducement of a tasty dividend.
ESG indices don’t necessarily exclude large companies that don’t score well. Instead they tilt the weighting of companies to below that of their market capitalisation. This means that in theory, an investor could follow the ESG weightings to maintain exposure to big dividend-paying stocks such as the oil super-majors, but in a way that provided guidance on the rate to divest.
Morally, if you’re not a total clean energy evangelist, you might be comfortable holding shares in big oil companies if they are making progress on pledges such as BP (BP.) chief executive Bernard Looney’s vision of being a net zero carbon company by 2050. If seen to be living up to promises, firms like these will not be punished by sustainability ratings and the case to remain invested will be reflected in ESG indices.
Crises like the coronavirus throw this into doubt, however. The oil price crash compromises oil companies’ own divestment strategies (by making it harder to sell assets) and causes delays to important investment in future clean energy. Protecting dividends may be a priority but taking on debt to do so just increases the structural burden on companies.
More generally, seismic disruption like that caused by the coronavirus pandemic, should encourage reflection in portfolio management. If such an enormous co-ordinated effort can be made by governments, central banks and populations in the face of an immediate crisis, hopefully they might do the same to avert a climate catastrophe.
Assuming humanity can rise to the challenge, optimistic investors will be thinking about the companies that will thrive in the next era. Current ESG strategies may not have all the answers, but they are a good place to start looking.