Housekeeping
Like always, it goes without saying that what I write in these posts is not financial advice. Also, the opinions here are solely my own and they don’t represent the views of any company I might be affiliated with at the time of writing.
It’s been a while since my last post, but sometimes life gets in the way, and sometimes I just don’t feel like writing. Anyway, a couple of months ago I was in New York, where I took advantage of the chance to experience the comedy club scene at the Black Fat Pussycat (not a strip club - I swear). One of the comedians, who was a bit too weird for my taste, zeroed in on a couple in the audience that happened to work for Facebook. The running joke was basically that the couple worked for the most evil company in the world, and that they were insiders in Mark Zuckerberg’s scheme to sell all of our data to fascists, or something along those lines. Just a typical conversation that one would have in Brooklyn on a Tuesday.
While I did not think about it at the time, as a shareholder of Facebook (now Meta Platforms) it was interesting to hear the common person’s perception of the societal value of a company I’m invested in and, by definition, rooting for to succeed. In the months since, I’ve made some new investments in tobacco and alcohol companies that have led me to more deeply consider the moral aspect of investing. Specifically, how do we evaluate the goodness of a company, and how to establish the line beyond which we will not cross to earn a profit?
It really does feel a bit like this👇🏽
ESG
It would be impossible to talk about investing and virtue signaling goodness without mentioning ESG. The rise of ESG/Responsible Investing/Sustainable Investing, or whatever new marketing gimmick they’ve come up with, has been very real.
The premise is that executives, investors, and regulators, should push companies to be good not only because it’s a net positive for society, but also because it results in higher risk-adjusted returns. There are a number of problems with ESG, however.
First, what is “good” is highly subjective, especially in the Social and Governance categories. And while Environmental metrics might be a bit more objective, not everyone agrees on the scope of what needs to change, nor by how much. There’s a naive (I’m being nice here) group of people that are adamant we should stop all use of fossil fuels… like… yesterday. Not only is this not doable without a massive global crisis, I would argue it is not even desirable given the need to have a well-balanced energy mix that is both resilient and cost-efficient.
Let’s take Governance, the forgotten letter in the famous acronym, as an example. ESG-oriented fund managers are insistent on the presence of independent directors within corporate boards, as well as the separation of the CEO and Chairman of the Board positions. They argue that independent directors are better suited to oversee management teams and ensure they’re working for the benefit of all stakeholders, and not just lining their own pockets. They also believe that if one person is both the CEO and Chairman of a company, then this individual holds too much power. While I agree with the need to oversee management and ensure they’re working for the benefit of shareholders, the ESG view is myopic to the incentives that drive human behavior. Just because a board member is independent, it doesn’t mean they won’t be afraid of losing their well-paid job that requires them to show up once a quarter to sit at a table for a few hours, all expenses covered. More importantly, being independent doesn’t shield them from the fear of the hit to their reputation should they refuse to play ball and end up an outsider. It takes a special kind of character to be immune to these factors. And yet, for some reason, the ESG movement has decided board independence is the criteria to focus on, when aligning incentives via stock ownership would yield much better results. Perhaps the dumbest example of the ESG myopia at work has been the effort of some managers at large pension funds proposing to separate the roles of CEO and Chairman at Berkshire Hathaway, where Warren Buffett occupies both positions. Imagine investing in a company managed by the sharpest investor of the last 100 years, with an unparalleled track record, and pushing to establish obstacles for him to do his job. It’s hard to think of a dumber thing to do.
A second problem with ESG today is the lack of consistency in the outputs used to evaluate compliance with ESG criteria. The image below gained a lot of traction online a few months ago🤔
It is definitely curious that tobacco firms (BAT, PM, and Imperial Brands), and an energy company (Shell) have higher ESG scores than Tesla, the leading EV manufacturer in the world. Most people missed the fine print though, which is that scores are segregated by sectors. So BAT’s score of 88 is in relation to its peers in the tobacco industry and is not comparable to Tesla’s. This is not a defense of Tesla by the way, but there’s clearly an issue with the calculation and messaging around ESG scores. It’s also worth noting that different ratings firms (S&P, MSCI, Morningstar, etc.) calculate their scores with different methodologies, which can vary widely given the lack of consensus around the weights we should give to different factors, how to evaluate these factors, and how to ensure the reported data is not being gamed.
The last point is related to the third problem with ESG: the significant conflicts of interest. A sizable industry has grown out of the rise of ESG, and a bunch of companies are benefitting a lot from the fees generated.
Fund managers charge higher fees for their ESG or “Sustainable” products at a time when asset management fees are on a clear downtrend thanks to the growth of passive investing. Ratings firms have started ESG scoring businesses, while also selling data for clients to build their own scores. Consultants earn fees advising companies on how to become more ESG-friendly, and on, and on, and on. It’s tough to imagine any of these firms arguing against ESG when they’re building profitable lines of business from the movement.
It also doesn’t surprise me to see a high number of corporate executives embracing ESG so much, and making sure they let the world know about every single initiative they put forward. Many executives use their companies’ ESG milestones to distract away from poor financial performance. At the end of the day, they themselves are choosing the objectives, measuring the progress, and reporting what they want to report. For other companies, ESG has been a distraction, to the detriment of shareholders.
Take the case of Unilever. The Anglo-Dutch consumer staples company has been laser-focused on imbuing its brands with “purpose” for some time already. They constantly bring up the subject, and they have made it a key value proposition of investing in the stock. Unfortunately, this focus on “purpose” has been, at best, a distraction that has led the company to miss its targets put forward in 2017, after they rejected a takeover bid from Kraft Heinz worth US$143 billion. The market capitalization today is under US$130 billion, while enterprise value is below US$160 billion (debt has increased from ~US$16 billion then to ~US$33 billion today).
Terry Smith summarized this succinctly in his 2021 Annual Letter to Shareholders:
“Unilever seems to be labouring under the weight of a management which is obsessed with publicly displaying sustainability credentials at the expense of focusing on the fundamentals of the business.”
“A company which feels it has to define the purpose of Hellmann’s mayonnaise has in our view clearly lost the plot. The Hellmann’s brand has existed since 1913 so we would guess that by now consumers have figured out its purpose (spoiler alert - salads and sandwiches).”
Call me old fashioned, but I still believe that the people doing the most good don’t feel the necessity to tell everyone about it every chance that they get. I hope it’s clear by now why I don’t think outsourcing our moral decisions to a scheme like ESG is the correct approach to go about this.
This takes me to one of the main issues I see whenever anyone argues against the moral stance of a particular investment: failing to weigh the pros against the cons.
The Line in the Sand : Thinking about Net Value
Let me start by stating the obvious. There are some things such as child labour, human trafficking, sexual abuse, racism, among many others, that are not ok and that we, as investors, and society in general, should not tolerate. The discussion in this section revolves around grey areas and externalities, not around blatant violations of the law and/or morality. Take the graph below, which shows the % of US youths (12-17 years old) with a major depressive episode in the past year, from 2004 until 2021:
👆🏼 That is what I call a bad trend. Correlation does not equal causation, but it seems obvious to me that at least some of the blame lies with the proliferation of social media platforms. A company like Meta Platforms has also been accused of selling its users’ data and influencing the outcome of elections. Not great, right? Of course not, but I never hear anyone talk about the incredible benefit of platforms that allow billions of people around the world to instantly communicate with each other, read news seconds after they happen, and seamlessly find products that align with their needs and desires, for free. Or how about the hundreds of thousands of small businesses that are able to find a market for their products thanks to online advertising? These businesses employ millions of people and power economic growth, which helps improve living standards for everyone.
Along similar lines, companies that sell tobacco or alcohol are criticized for selling harmful products. It’s true that these products can cause issues for others in certain circumstances, such as second-hand smoking and drunk driving. And we should work towards ensuring we minimize the effect of these issues through education and regulation. Furthermore, as investors, we should hold companies accountable for doing everything they can to reduce the occurrence of these issues. This means responsible marketing practices, for example. However, beyond that, is there really an issue with an adult spending their own money and choosing to enjoy their time smoking a cigarette or drinking a glass of whiskey?
We make sub-optimal health decisions in exchange for a few minutes or hours of satisfaction all the time. Personal freedom to decide where and when to make that trade-off is an essential element of society. Freedom also comes with the responsibility to educate ourselves on the pros and cons of those trade-offs. This applies not only to tobacco and alcohol, but also to the consumption of sugar, the time we spend on social media, and the use of any financial product, among a million other things. In the case of cigarettes, people have themselves decided to consume less and switch to other, healthier options or just quit outright👇🏽
The key question then is, where do we draw the line? That’s a question each of us must answer after some careful introspection. It’s a decision we cannot and should not outsource.