A Contrarian View of ESG Ratings

The idea of investing with a social conscience is nothing new. In 1928, Pioneer Investments launched a fund that excluded all alcohol, tobacco and gaming investments. Later on in the 1970s, college campus activism (centered around university endowments) expanded the divestiture list to defense companies and South African gold mining establishments (which took part in apartheid).

The modern ESG movement originated with The United Nations, which began developing a rating system just over 20 years ago, then went public with a 2004 report called Who Cares Wins. The first ESG funds came in the years that followed, catching on in both the U.S. and Europe. In the early days, ESG was seen as a research tool that could help identify stocks with growth potential that might not be as obvious with traditional fundamental research techniques.

More recently, it has taken on a life of its own. The "E" in ESG stands for Environmental, with corporations scored mainly on their current contribution to CO2 emissions and their efforts to reduce that number over time. The "S" stands for Social, with scores usually set based on a firm’s compensation practices, adherence to labor laws, workplace safety, promotion of women and minorities, and how it chooses and manages its suppliers. "G" is for governance: corporate structure, management decision-making, risk management, selection criteria for board members, compensation of board members, anticorruption practices, monitoring and avoidance of conflict materials, lobbying and other factors.

While there is relatively little debate about the "E" part of ESG, the "S" and "G" have political ramifications. For example, some ESG raters downgrade non-union firms, as well as those with too few independent board members or not enough women and minorities on their boards, or firms who resist shareholder proposals from activists. Or worse, they downgrade companies that fight frivolous lawsuits while upgrading those who generously settle any lawsuit that comes their way.

As such, it’s not too surprising to see Democrats lining up in favor of encouraging A Contrarian View of ESG Ratings Linde Chemicals Prologis Real Estate Accenture Software American Tower Cell Towers Elevance Health Health Insurance Danaher Pharmaceuticals Lowes Retailing Cisco Network Equip. Home Depot Retailing Applied Materials Semiconductor Equip. Salesforce Software Oracle Software NVIDIA Semiconductors ADP Payroll Processing Thermo Fisher Pharmaceuticals or imposing ESG criteria on investment firms, with Republicans now taking a stand against such efforts. But the more important issue is the ramifications of ESG scoring and its likely effects.

Much like bond ratings, favorable ESG scores serve to boost a firm’s market value and reduce its cost of capital. The assumption is that companies will have an incentive to do well by doing good, which in turn will speed the rate at which the world can shrink its carbon footprint, improve its workplace conditions, and treat its shareholders with respect. But what if the environmental premise is largely false?

Consider the inherent industry bias in today’s ESG ratings. If you’re a software company, all you have to do is embrace consumer privacy, and you’re home free. But if you produce fossil fuels or equipment that uses fossil fuels (or anything else that uses a lot of energy), there’s really no hope. Even Tesla, which is arguably doing more than any other single firm to move the world off carbon fuels, lands in the bottom 15% of ESG ratings for the 100 largest S&P 500 stocks.

Now consider the path forward for moving the world off carbon: the companies with the lowest ESG scores are the ones that must raise (by far) the most capital to make it happen. Oil and gas companies must build e-fuel refineries that produce carbon-neutral fuels. Aerospace firms must build new engines that run on this kind of fuel, along with battery-powered short-range planes. Makers of heavy equipment (and automakers) must invest heavily in new factories that can produce battery-powered or e-fuel-powered equipment and transportation. Even Amazon, which has built its own delivery firm, must now find a way to electrify its ground transportation and fuel its jets with carbon-neutral e-fuels (Amazon’s ESG score is even lower than Tesla’s).

All of this takes an enormous amount of capital – capital that is being steered away from the firms that need it most by the ESG rating system. Taken to extremes, the ESG path to sustainability can only occur through disruption, where startups get capital but established players get none. Does this really speed up the transition to a carbon-neutral world? I can think of only one example where it might: Boom Supersonic’s plan to disrupt Boeing with faster jets that run on e-fuel.

In all other industries that use or produce a lot of energy, the established players are the ones in the best position to drive change (Tesla is one obvious exception, but it doesn’t need to raise capital). And depriving them of capital via ESG ratings can only slow progress.

Which brings me to the main point of this message. There are no ESG funds in our portfolios, as our objective is simple: maximize returns for the amount of risk incurred.

There’s an old adage that professionals should never "mix business with pleasure" because it creates a situation where the goals may be at odds with each other. In my mind, the same is true with ESG. To have a positive impact on the world, I would suggest a two-step process: (1) invest only for the purpose of maximizing returns, and (2) use profits from your investments to facilitate the kind of change you consider most important (for example, making charity donations, replacing a gas furnace with a heat pump, or retiring early to do volunteer work).

First Quarter Review
With inflation moderating, investors began the year on a hopeful note, with bargain-hunters scooping up beaten-down tech shares in hopes that the Fed was nearly finished with its string of interest-rate increases. But strong employment numbers prompted the Fed to pour cold water on that theory, which caused stocks and bonds to pull back in February.

Then the Fed and the markets were both surprised by an event no one saw coming: classic bank runs brought on by fearful depositors moving their money elsewhere. Silicon Valley Bank was the first to fail due to its heavy losses in long-dated Treasuries and large base of business depositors whose accounts exceeded the normal FDIC limit of $250k. But others followed, prompting the Fed, the FDIC, and a group of large banks to take extraordinary measures to address the lack of confidence in regional banks. Those measures, along with depositors moving large amounts of cash to bigger banks and money market funds, allowed the financial system to stabilize relatively quickly.

An uneven market recovery followed in late March, with the S&P 500 finishing the quarter up 7.5%. However, lingering concerns over the potential for a credit crunch (and a more pronounced economic slowdown) weighed on smaller stocks, with the Russell 2000 gaining just 2.7% for the three-month period. Those same concerns gave a lift to investment-grade bonds, allowing the Bloomberg Barclay’s U.S. Aggregate to post a gain of 3.1% for the quarter.

Performance-wise, accounts that had exposure to our sector picks managed to outperform the S&P 500 on the stock side, but non-sector portfolios generally finished shy of the index due to our heavy emphasis on mid-cap stocks. On the bond side, we tracked close to the U.S. Aggregate return as a result of our large bet on that index. But with heightened recession fears benefiting intermediate- and long-term bonds more than short-term bonds, and also holding back the highyield group, the bond side of our portfolios finished shy of the U.S. bond market.

Outlook
Corporations were big buyers of their own stocks in 2022, and despite a 1% tax on buybacks for 2023, the trend is continuing this year as well, which could help support stocks if earnings forecasts weaken. Despite higher borrowing costs, ongoing labor shortages, and recession risks, most firms outside of the financial services group see their stock prices trading at attractive levels and are continuing to repurchase shares. That means existing shareholders end up owning a slightly bigger share of the company with each passing quarter (19.2% of S&P 500 firms boosted yearover-year earnings per share by more than 4% by repurchasing stock in 2022). The S&P 500’s dividend plus buyback yield ended last year at 4.63%, very close to its 10-year average of 4.68%.

The success of ChatGPT, an Artificial Intelligence (AI) bot that was incorporated into Microsoft’s Bing search engine, suggests that AI has a bright future as a productivity tool for writing, software development, and many other tasks. Not since cell phones made their debut has the business stage been set for such a major boost in productivity. It’s possible that AI will become the "next big thing," spurring investment in more sophisticated data centers with specialized processors that require a much greater amount of memory. This comes at the right time for the semiconductor industry, where some players have been going through a period of severe contraction. It also bodes well for the technology industry in general.

The regional banking crisis could end up negatively impacting the economy and smaller stocks. We are reconsidering our mid-cap stock exposure, and we may shift our portfolios more in the direction of large cap growth, which is more globally diversified and may benefit from a weaker dollar. On the fixed-income side, high-quality bonds with intermediate and longer maturities may now represent the best opportunity. We already have a large position in that segment with U.S. Bond Index, but we may add to it going forward.

Sincerely,

Jack Bowers
President & Chief Investment Officer