“It’s not easy being green,” once crooned Kermit the Frog on his lily pad during a melancholy moment. However, as far as the purveyors of financial products are concerned, it has never been easier for investors to be green or socially responsible through the use of ESG funds. ESG (Environmental, Social, and Governance) funds apply non-financial criteria to choose companies that are helping to make the world a better place. What criteria makes the world a better place is certainly a point of contention; and even when people agree on what makes a company “good”, it is difficult to find ways to rank companies on goodness. Nevertheless, ESG funds have exploded in popularity in recent years and maybe the most prominent theoretical framework promoting ESG funds as a value-add to investors was recently documented by the activist hedge fund Engine No.1. The theory goes as follows.
Shareholders receive value from a company’s revenues and earnings. The broader community is also affected by the company in various ways, and thus should be considered stakeholders in the company. How they value the company goes beyond the balance sheet to include good things the company does for the community (called positive externalities) and the bad things it does to the community (called negative externalities). Hence, the stakeholder value of the company is the sum of financial shareholder value and positive externalities minus the negative externalities. A “bad” company is one where bad things it does to the community are greater than the good things (see the chart below).
In the long run, the negative effects of the “bad” business will be noticed by the broader community, causing the company to tarnish its brand, to lose customers, or to become more strictly regulated. These actions will cause the negative externalities to be “internalized” by the company: its financial standing will be weakened, thereby pushing its shareholder value down to the broader stakeholder value (see chart below):
Conversely, good companies where the positive externalities outweigh the negatives will see their stock values increase over time. Thus, investing in social responsible, good companies is the most profitable long-term strategy – according to this theoretical framework.
Is this valid? Well, as we mentioned earlier, determining exactly what is a good and bad and developing a goodness ranking system is an incredibly ambitious, probably impossible task. Unless a company is committing outright crimes, how readily people will recognize its negative externalities is questionable. And it is important for potential ESG investors to think about another prominent theory about socially responsible investing. If investors intentionally decide to not invest in companies that they think are bad, then they will reduce the supply of capital available to those bad companies. With supply down, the company’s cost of capital goes up. However, a company’s cost of capital will be the return that the people who still supply the company with capital (through stocks or bonds) expect to receive in the future. Thus, significant investment in ESG funds should cause the people who still decide to invest in the “bad” companies to see greater and greater returns.
With difficulties in classification and conflicting theories about profitability, ESG-focused investors may have to eventually agree with Kermit that it just isn’t easy being green.
On Monday, October 4th, the Fortunatus ETF Opportunity models underwent their monthly relative strength rotations. Both the Global and US Growth models increased their allocation to natural resource and energy company equity.
There were no other trades in the Fortunatus models during the week ending on October 9th, 2021. The major equity market sectors remain in a long-term favorable trend, and the Fortunatus Asset Allocation models are near their maximum allowable equity exposure with domestic stocks favored over international shares.
Past performance is no guarantee of future results. Trend signals are proprietary research of Fortunatus Investments, LLC, a Registered Investment Advisor with the Securities and Exchange Commission (SEC). Reference to registration does not imply any particular level of qualification or skill. Prior to June 2014, Fortunatus Investments was a wholly owned subsidiary of Executive Wealth Management, LLC and they continue to share common ownership and control. Data source for returns is FactSet Research Systems Inc. This chart is not intended to provide investment advice and should not be considered as a recommendation. One cannot invest directly in an index. Executive Wealth Management does not guarantee the accuracy of this data.
Quote of the Week
When he asks tough questions about sensitive subjects, including compensation and sales targets, he is interested in the answers, of course, but he also wants to see how an executive reacts to the interrogation.
“You can do that on Zoom,” [Evercore Senior Adviser Jonathan] Knee says. “But it’s very hard to see the sweat dripping down their forehead.”
An excerpt from a recent NPR Business article “Only ‘Wimps’ Phone It In: Why Wall Street Bankers Are Hitting the Road Again” which is apparently about the pecuniary value of perceiving perspiration in person.
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Returns are calculated as indicated below with reinvested dividends not considered except for the Barclays U.S. Aggregate Bond Index. Data source for returns is FactSet Research Systems Inc. The London Gold PM Fix Price is used to calculate returns for gold.
1 Week = closing price on October 1, 2021 to closing price on October 8, 2021
1 Month = closing price on September 8, 2021 to closing price on October 8, 2021
3 Month = closing price on July 8, 2021 to closing price on October 8, 2021
YTD = closing price on December 31, 2020 to closing price on October 8, 2021
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