Episode 1: You, Me and ESG

The Value of Time ® Podcasts

Episode 1: You, Me and ESG

In the debut episode, CIO Jim Ayres gives a Q1 Market update and interviews Sr. Research Analyst Bryan Carr about what it means to invest in ESG today.

Listen to the episode or read the transcript below!

Episode Transcript:

Jim Ayres:

Hi, and welcome to the debut episode of The Value Of Time Podcast. A new monthly offering from Pacific Portfolio Consulting, a Seattle Seattle-based wealth management firms, serving high net worth families and institutions since 1992. I'm Jim Ayres, chief investment officer here at Pacific Portfolio Consulting. Our goal is to provide some education, hopefully a little bit of insight and help make you better and more effective investors in order to allow you to maximize the value of your time by focusing on doing the things that you want. So without further ado, let's get started.

Jim Ayres:

So before we dive into our main event here, let's take a quick look at recent market action. We just put the first quarter to bed a couple of weeks ago. Now it's probably a good time to take a check of the scoreboard. On the surface the first quarter was pretty respectable. The broad market was up a little over 6% during the first three months of the year. That's a decent result. It's not exceptional, but it's pretty good. Things start to get a lot more interesting though once we start to dig a little bit deeper. For one thing, the 6% that we got in the first quarter came on the heels of some pretty impressive gains that we got over the latter part of last year. So once we start adding things up, the trailing return on stocks for the past 12 months is actually a massive 56%. One of the best 12 months returns over the past 50 years.

Jim Ayres:

Now, when I'm talking about stocks here, I'm talking about the S&P 500. So the stocks of large U.S. companies. Now let's stop and think about that for a second. Should this really surprise us at all? The end of the early 2020 bear market coincides pretty nicely with the end of March. So what we're really seeing here is a measure of just how dramatically stocks have recovered over the past year when the world didn't in fact wind up coming to an end as some had feared. There's something much more interesting though, that we can see when we look a little bit more closely at this market advance, and that is the dramatic change we've seen in market leadership in recent months. Most of last year, the market advance was dominated by large cap growth stocks, Apple, Amazon, Microsoft. A lot of these other companies that benefited from the stay-at-home dynamic imposed by the COVID pandemic.

Jim Ayres:

Ever since the Pfizer vaccine was announced in early November though, we've seen leadership in the market, turned on its head, particularly as vaccinations have picked up, as several measures of economic activity have continued to pick up, we have seen a big rotation towards the more cyclical segments of the market, specifically value stocks and small cap stocks. And the recent returns in these areas have been nothing short of spectacular. Now, one reason for that is that this rotation really was long overdue. A lot of stocks in these areas had really been very neglected for some time. What about going forward though? Well, our outlook for economic growth remains pretty healthy. We think the backdrop is going to be there to generate the sort of robust growth that can continue to support the cyclical segments. As we continue to move back towards normal, we've still got massive monetary accommodation in place. We've got increasing fiscal stimulus in place. This is a good backdrop for these sorts of companies.

Jim Ayres:

At the same time, though, we're not about to start counting out the growth stocks. They're certainly not cheap by any measure, but the growth and profitability of some of these companies remains impressive and the markets should continue to reward that. It won't do it as indiscriminately as it did last year though. So it's important to know what you own, why you own it and most importantly, watch what you pay for.

Jim Ayres:

My guest today is Brian Carr, senior analyst here at Pacific Portfolio, and soon to be my future cohost of this podcast. Brian, I don't think we could have chosen a more timely topic for our first podcast and then trying to tackle this whole issue of ESG investing. I know we poured a lot of resources into it at the firm level. You certainly, as our in house expert, probably know more than anyone what the level of interest in this topic has become. We've certainly gotten a good response from the few people we've spoken to about what we're preparing in this area, but in a lot of cases some people, I think ESG is still running very much under their radar. We're getting some confused looks from some people. Some people think they know what we're talking about, but they're not quite sure. Maybe you can start us off with some of the basics. Give us the ground view here. What are we talking about when we say ESG investing?

Bryan Carr:

Thanks for having me, Jim. Yeah, I think you're right. ESG is the super hot topic in investing right now. I think there's a lot of information out there coming from everywhere. It's coming from the news, it's coming from banks, it's coming from asset managers. And I think trying to take it all in at once, is like drinking from a fire hose, I think. In its simplest terms, ESG just means taking environmental, social, and governance factors into your investment process. Those are [inaudible 00:04:13] and the GPSG. What are these factors? Those are things like gender pay equity, racial diversity, greenhouse gas emissions, weapons manufacturing. Those were all considered ESG issues.

Jim Ayres:

So Brian, a lot of the things I hear you talking about sound an awful lot like SRI, the old socially responsible investing has been around forever. Has it's fans, never really seem to gain a whole lot of traction and my question to you then would be, how similar or different is ESG from SRI and is that belief true? Is it possible to actually do good and do well at the same time? Or is there a price to be paid in order to be responsible in your investing process?

Bryan Carr:

So I think when you look at SRI and ESG, it's important to realize that ESG as we talk about it these days is, it's an umbrella term. SRI falls under the term of ESG these days. But SRI is the grandmother of ESG. SRI, like you said, it's explicitly values-based. It's doing things like excluding stocks that violate your ethical principles. This sort of methodology, and this sort of mindset has its origins as much in environmentalism and do-gooderism as it does things like Catholic values or kosher or Halal investing. So back in the day when there was SRI investing was starting up, you'd have things where they would exclude alcohol, tobacco, firearms, gambling sort of generalized ethical principles. But then they'd also do things like exclude pork manufacturers if you're like a, I don't know, like a Jewish charity or something. These days it's evolved into what we're calling ESG broadly. Avoiding these sort of sin stocks is part of that.

Bryan Carr:

It definitely is part of that. That's called divestment. It's a naive screening process. But these days ESG encompasses a whole host of other investment options. The biggest one right now, the one that's trending if you will, is what's something called ESG integration where you're not just like excluding companies that violate your ethical principles, there's an emerging framework of research that shows that companies that are not thinking about things like workforce diversity or gender pay equity or the effect they're having on the environment, those companies are actually exposed to a world of risk that is not readily visible on something like a balance sheet or an income statement or a market research study.

Bryan Carr:

ESG integration aims to take these risks into account when doing traditional fundamental company evaluation. If a company is exposed to scandals, if a company is exposed to something like the Exxon Valdez or the Deepwater Horizon disaster, if the company is exposed to a Me Too thing by their executives, there's a lot of things that can expose a company to bad PR, to expensive manufacturing process retooling because of environmental regulation. There's a whole host of risks that companies can be exposed to that are not explicitly stated in financial statements. ESG integration aims to incorporate these risks into analysis of the company as to whether it's a good investment or not. I've had some people ask me, "Well, do these nonfinancial forces really affect things like stock price, stock volatility, those sorts of things?" I would say absolutely. And it's related to a change in our economy that's happened in the last 50 years.

Bryan Carr:

In the '70s, only 25% of the market value of the S&P 500 was from intangibles on people's balance sheets. In 2020, that number is over 85%. So then we're talking about things like brand, service model, customer relationships. If these things are making up 85% of your company's market value, if your brand gets tarnished, that's your market value taking a hit.

Bryan Carr:

So, that brings us to this conversation about doing good versus doing well. Because ESG analysis takes into account all of these sort of nontraditional factors, risk of scandal, risk of group think, risk of environmental catastrophe, risk of getting regulated, not only can you use these factors for risk management, as I've outlined before, you can also use [inaudible 00:07:42] start your values. So I'm going to pick on Chick-fil-A here for a second. I know they're a company that if you look at their balance sheet, by all means, they seem to be doing great. They had a scandal a few years ago where it turned out they were giving a bunch of money to a nonprofit anti-LGBT groups. And to this day, even though they've changed their corporate giving policy and they don't do that anymore, myself and basically everybody that I know doesn't eat there anymore.

Bryan Carr:

That's a ton of lost revenue. I still eat at other places. I eat at Popeye's. I eat at other fast food restaurants, and I would probably give my money to Chick-fil-A if they didn't have that scandal in their past. And so I think that paying attention to these things does have an impact on company risk that you're not just going to see that line item in their balance sheet or on their income statement. I think the same can be said for Nike in the nineties. I think that the sweatshop scandals they had in the late eighties, early nineties really was an albatross on their neck in a lot of circles for a long time. And I definitely think that it had an impact on company profitability and their valuation. They since recovered from that. I don't think any of these necessarily are bankruptcy inducing events, but if you're investing, nobody does risk management solely for these sort of black swan bankruptcy related events. They're looking for three-year, five-year, ten-year numbers and a scandal can definitely leave some stank on you for five years.

Bryan Carr:

You can also use this information to assert your values in your investing strategy. You can build portfolios that not only remove these worst ESG performers, but you can also put the best ESG performers in your portfolio. MSEI did a study recently that shows that companies that have positive or improving ESG scores also have lower idiosyncratic risk. That's where the rubber meets the road here. I think that instead of just excluding a bunch of stocks, willy nilly from your portfolio, based on whether they are tied into the alcohol, tobacco, firearms, prison industries, you can take an approach that says, "Okay, this company is an energy producer and they're proactively retooling to get away from fossil fuels. Most of the patents for renewable energies is owned by oil companies.

Bryan Carr:

And so if an oil company is the one that is going to be able to make the conversion over to renewable energy, that oil company is the one you want to own. You don't want to own the one that isn't making that change because when climate change comes and fossil fuels are things we're not using anymore, those companies are going to be out in the cold. Additionally, if companies really want to align their values with their investing, a lot of these firms that do ESG, do things like shareholder activism. They do active ownership. And so they're not only buying these companies that are improving or doing good. They're also engaging with companies to improve their ESG performance. They're engaging with companies to improve their track record on things like environmentalism or workers' rights, gender pay equity, racial diversity, all of these things. And I think that's a lot of the value that you get from investing in these ESG firms. It's not just not buying a gambling company. It's the way that they run their portfolio. It's the way that they are active owners.

Jim Ayres:

So it sounds like if I'm approaching this through an ESG framework, I might come to a very different conclusion than if I'm using a traditional investment analysis approach. So the example you gave before of the energy company. If I take the traditional approach, I would look for the company who has the best oil reserves and is producing the most oil and generating the highest revenues currently and prospectively for the next few years. The company that has the best renewable energy patents might not even be on my radar screen. They might not be a leader in the field right now.

Bryan Carr:

And I think that's where doing good and doing well comes in. If you think about it, your goal as an investor, let's say you're an environmentalist. And your goal as an investor is you want to do good for the planet. You want to stave off climate change. You want to have clean air and water for your kids in the future. Normally you would think, "Okay, I'm going to exclude this oil company." Well, if you exclude an entire industry from your investment portfolio, you're not going to look as good versus your benchmark, because right now, like you said, that oil company might be doing great. They have great reserves. Their operating efficiency is really good. They own a bunch of land with pipelines, everything, all these things that make a company valuable in the near term would induce you to invest in them. But they're not looking down the track. There's risks in the portfolio that would actually encourage you to exclude them that are going to increase your return or lower your risk.

Bryan Carr:

And so if you can construct a portfolio that takes all of these risks and return considerations into account, there're ways you can definitely keep up with your benchmark or exceed your benchmark that works a lot better than naively screening out entire industries.

Jim Ayres:

So listening to you tell it, it sounds certainly as though ESG has taken responsible investing to the next level here, and it covers a much broader universe of issues and is likely to appeal to a much broader group of investors. Not all of these people though, will be equally passionate about all of the same topics. What can these investors do to implement their passions and their values? Is it still a one size fits all the way it was back in the day of the socially responsible mutual funds? Or is there an ability to help tailor a solution to each investors specific value sets?

Bryan Carr:

So the market's come a long way in the last 10 or 15 years. I think back in the nineties and early two thousands, if you wanted to be a values based investor you were, like you said, you're kind of limited to the sort of broad-based ESG mutual funds, which hit all the big issues, but you couldn't really hone in on any one thing. If you're passionate about one thing in particular, you had to buy the basket. These days there's as many different ESG funds and ESG investing approaches as there are investors. If you're passionate about racial justice and gender pay equity, there's a fund for that. If you're passionate about deforestation and pipelines on indigenous land, there's funds for that. Any sort of issue you're passionate about, there's a fund that can get you where you want to go.

Jim Ayres:

So, what if I'm trying to pick one from column A and one from column B and one from column C and maybe one of them is environmentally related and the other one is socially related and the other one is gender equity related. How can I put together... Am I going to have to go out and buy three different funds? Or is there something that can address all of these things that are really important to me?

Bryan Carr:

So what's really cool is at PPC, we now have a solution that we can custom tailor to any client for their issues. So if you have three separate issues, you don't have to buy three separate funds. We can put together a solution for you that's an all-in-one package that hits all three of those issues for you. There's more than 20 different issues you can dial in and you can have one of them. You can have five of them. You can have all 20 of them. So whatever fits your passions, we can build a portfolio for that.

Jim Ayres:

So let me take the other side of that coin. Then going back to this theoretical investor I mentioned at the beginning of our discussion. They don't really know what ESG is because they haven't listened to our podcast yet. They kind of know they should know about it. They kind of know they will need to be a part of it that something needs to be done. They don't know where to start. They're completely overwhelmed. They can't even begin to tell you what their top priorities are. What can they do?

Bryan Carr:

So, in addition to being able to go really granular here, we at PPC have also thought about, well, what if someone doesn't have a very specific idea of one thing they want to do, or two or three things they really want to do? What if they want to do good, just in a broad sense, or they don't necessarily have their issues dialed in. We have a set of solutions that can work for that too. It hits the broad based ESG issues. Hits things in all three categories. It hits environmental issues and it hits social issues. It hits governance issues. You don't necessarily have to have all your homework done when you come in. We can get you something that's really specific, or we can get something really broad and you don't have to know everything when you come. You can talk to your advisor, you can talk to one of us on the research team and we can help you decide what's right for you.

Jim Ayres:

Thanks, Brian. This has been a great conversation. I think we've covered a lot of ground here. Really appreciate you being the first guest on our show here. I know it's been terrifying for you as it was for me.

Bryan Carr:

Thanks for having me. I'm glad to be done.

Jim Ayres:

That's our show folks. Thanks for listening. Thanks to my guest, Brian Carr. I hope you'll keep tuning in. We have some interesting topics coming up in the months to come here. Everything from cryptocurrency to value versus growth investing to why the heck you want to own bonds in your portfolio environment like this in the first place. So please tune in.

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