ESG = Environmental, Social,…Guns(?)
Does Covid show that ESG is here to stay? Er…Maybe?
This post was coauthored with my colleague Joe Brunk
A little late to this, but interesting nonetheless…the Wall Street Journal ran an article discussing Environmental, Social, and Governance (ESG) investing in light of the recent coronavirus crisis. The article highlights an argument that the coronavirus crisis shows that investments in funds that prioritize firms that score “well” on factors relating to environmental impact, social responsibility, and strong corporate governance are not a fad and are in fact outperforming the general market. As the article points out, there was doubt as to how those funds would perform in a down market and whether investors would stick with “doing good” if they were no longer “doing well”. Proponents of ESG point out that ESG funds are performing better than average in the crisis, seemingly validating the theory that investors can have their cake and eat it too because the things that make a firm score well on an ESG metric also make them better investments.
Of course, it is unclear how much of this is crisis specific. As the article notes, ESG funds tend to be heavily invested in big tech companies, which tend to be socially progressive, have strong governance, and have a low pollution profile (though it is unclear whether the power used to run their server farms is counted in the equation), while they also tend to avoid energy businesses, especially those involved in fossil fuels. The coronavirus crisis has resulted in a mandatory cessation of economic activity, which in turn has led to a dramatic reduction in energy use as factories are idled, stores are abandoned, and people are restricted to their homes. Meanwhile, those who can work from home rely on big tech products to do so. In short, it would be hard to come up with a situation that better matches the ESG investing strategy.
Well, almost…because in another article the WSJ does point out that one group of firms that tend to be disfavored by ESG funds is doing quite well, firearms. Concerns about personal safety driven by recent events have caused a significant spike in firearms sales, leading some of the larger manufacturers to dramatically over-perform the market.
So, is the lesson that the winning investment strategy is ESG+G? Let’s slow down. If you could go back to December 2019, it would have made sense to invest in ESG plus firearms (or maybe a private island) but that doesn’t mean it will make sense in December 2020.
Firearm stocks are notoriously volatile. Which makes sense when you realize that firearms are durable goods. While some of the people who purchased guns for protection will buy more, buy ammo, and become active consumers of firearms products, others will sell their guns as quickly as they feel they can, flooding the secondary market with like-new guns and depriving gun makers of new sales. Many of those that keep their gun will put a box or two of ammo through it a year, but never buy more firearms.
Ok, so current performance is no guarantee of future performance with regards to firearms, but ESG is proven to be rock solid, right? Well, maybe not. The success of ESG during the pandemic may be context specific. One potential effect of coronavirus is a migration away from cities to suburbs. If that happens people who currently do not own a car are more likely to get and use one. This coupled (hopefully) with a resumption of economic activity will increase energy consumption, improving the performance of energy stocks shunned by ESG funds. It is also possible that some combination of regulatory changes and changing preferences may also take some of the premium off of tech stocks in the future. Further, while this crisis was uniquely well suited to play to ESG’s strengths, if there is another crisis (and the way 2020 is going I wouldn’t bet against it) that one could cut a different way. No mutual fund is entirely crisis-proof, and depending on how the next crisis hits, ESG funds could be the ones underperforming. After all, the world of Mad Max was heavy energy* and firearms and light Zoom meetings. (Of course, there also wasn’t a functional stock market, except maybe in Bartertown?)
Is any of this investment advice? NO! It is simply an observation on the perils of predicting what investment strategies are “here to stay” based on (hopefully) idiosyncratic events. ESG was well suited for this crisis (except for the shunning firearms part) but it may not be well suited for the next one. God willing, we will get to a better place soon, though depending on how that Murder Hornet thing pans out maybe the chemical industry deserves a second look?
*Is anyone else confused that everyone in Mad Max drives a big V8 when the crisis that precipitated the collapse of civilization was a massive reduction in the amount of oil available?