Is there a more polarising term in investment than ESG? The mere mention of the topic can make a client’s ears prick up or their eyes roll depending upon their point of view. That the issue is raised at all – by the client or by ourselves – is not in question. This is 2019 after all.
The positions which underly either the interest in or scepticism of ESG are not inconsistent with one another. It is perfectly possible to believe that the environmental and social impact of a business, and the manner in which it is managed, are crucial considerations yet still be concerned that an excessive focus on them might leave other issues unexamined, or worse that the new language of ESG gives cover for cynical commercialism.
Jupiter’s Japan strategy does not carry any “responsible”, “sustainable” or “ESG” branding and nor does it have any hard exclusions1 on investible industries. However, ESG considerations – understanding the risks and opportunities of the environmental and social implications of our investee businesses as well as how they are managed – have always been central to the way we invest.
ESG star stocks: high demand, low supply
There are, however, an increasing number of funds, both passive and active, that do have overt ESG branding and have much more prescriptive lists of what they can and cannot buy. An increasing amount of money is chasing a finite number of listed companies which score highly on ESG factors and that is having a tangible impact upon the investment landscape for everyone. But what are these effects and how should we respond to them?
Let’s start with the example of Omron, a manufacturer of electronic components used in automation and a leading maker of medical devices including blood-pressure monitors. Our view is that Omron is a good business led by high quality management. It is not currently held in the strategy, however, because of one thing: a rich valuation.
In a recent meeting with the company’s President we noted that the earnings multiple on the company’s shares had expanded meaningfully, a function of falling profit forecasts and stable share price, and did the President have any explanation? He was unequivocal; he cited the company’s inclusion in various indices and the subsequent ETF-driven buying as the primary reason for the multiple expansion. Admittedly the most important of those indices, the Nikkei 225, has no ESG component but a further ten such indices very much do. The company is rightfully proud of its inclusion in such indices.
ESG indices which include Omron
DJSI – World
FTSE4Good Index Series
MSCI ESG Leaders Indices
MSCI SRI Indices
STOXX Global ESG Leaders Indices
MSCO Japan ESG Select Leaders Index
MSCI Japan Empowering Women Index
MSCI Japan Empowering Women Index
S&P/JPX Carbon Efficient Index
Euronext Vigeo Eiris World Index 120
Source: Omron, as at October 2019.
Omron is not alone. For stocks that we do hold in the strategy (and where we are obviously more comfortable with the prevailing valuation multiples), we see conspicuous recent share price strength for stocks represented in ESG indices. Companies like Nomura Research Institute and Marui spring to mind. Outside of the current holdings, many businesses on our list of “stocks we would like to own” also feature in these indices and have dauntingly high valuations that have so far kept us away.
Assessing the scale of the ESG premium
A 2018 study by Mizuho put total “sustainable” assets in Japan at $2.2tn, up more than 4.5x since 2016, much of which will be invested domestically. The global pool of such money is growing more moderately but is obviously much larger and will still contain a meaningful allocation to Japan.
A September report from Goldman Sachs looking at a universe of over 2000 ESG-focused funds globally found a premium of around 40% for the fifty most favoured names versus the wider market, a premium which has expanded over recent years (see below chart).
The median forward P/E of the 50 most favoured ESG stocks versus the global equity universe
Source: Bloomberg, FactSet, Goldman Sachs Global Investment Research, as at September 2019.
A self-correcting problem?
All of this poses interesting questions for investors, ourselves included. Is this a bubble, set to burst just like any other? Or does it represent a permanent reshaping of the market’s preferences?
Our working conclusion is that this is not a bubble, or at least not just a bubble. Whilst there will inevitably be ebb as well as flow to this money, the growing focus upon environmental, social and governance considerations of asset owners seems unlikely to reverse. But neither should we be content to pay ever greater multiples for qualifying businesses.
One of the reasons why this issue is so apparent now is because the available pool of ESG winners is insufficiently deep to satisfy investor demand. As companies respond to modifying investor preferences – by focusing more on ESG matters themselves – the pool of qualifying securities should deepen, easing the scarcity effect.
In practical terms for us this means being highly discriminating towards businesses on seemingly rich multiples where scarcity premium could dissolve whilst remaining alive to opportunities presented by businesses looking to improve, genuinely rather than cynically, in their ESG efforts. In other words – business as usual.
1 Apart from cluster munitions
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