ESG Investing Isn't Expensive or in Bubble Territory

Environmental, social and governance (ESG) investing is all the rage these days – a phenomenon that started a couple of years and really crystallized last year.

Forgive the shameless plug, but I wrote piece last week detailing the impressive 2020 performances of ESG funds and the subsequent, massive inflows to those products. That article can be viewed here. To be sure, those are important details, but today I'd like to focus on other concepts that advisors are likely to encounter in the ESG conversation.

Assuming a savvy client base and with the wide proliferation of information, particularly on this topic, advisors likely serve increasingly knowledgeable clienteles, it's fair to say some clients will inquire about ESG valuations and whether or not this investing style is another bubble in the making.

It's easy to understand why the first point comes up a lot. Hear enough about ESG and one will hear critics assert it's simply an overweight technology strategy. Hence why ESG funds outperformed traditional rivals last year.

Indeed, the MSCI USA Extended ESG Select Index allocates 31.15% of its weight to tech stocks and roughly a third of that is devoted to just Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT). Conversely, the S&P 500 has a 27.90% tech weight.

Yes, ESG Valuations Are High...

...But it's not an alarming scenario. As measured by price-to-book and price-to-earnings (P/E) ratios, the MSCI series of ESG benchmarks tend to look richly valued, but many component companies have favorable systemic risk traits and lower cost of capital than firms with poor ESG scores.

Using the MSCI ACWI as the bogey, the index provider used a return-decomposition model to analyze valuations from mid-2013 to November 2020 and the findings are compelling for clients concerned that it's not worth paying up for strong companies that score well on ESG metrics.

“The return decomposition shows that during the study period the main reason high-ESG-rated companies (tercile T3) outperformed the equal-weighted benchmark was that they displayed higher earnings growth (2.89% per year) and — to a lesser extent — higher reinvestment returns (0.28%), while the P/E expansion was slightly negative (-1.86%) for high-ESG-rated issuers,” according to MSCI. “In contrast, the lowest tercile showed a clear relative decline in earnings (-9.22% per year), but the stock prices declined at a slower rate. This means the P/E ratio for the lowest-ESG-rated tercile expanded significantly (8.17% per year).”

Translation: Some stocks are cheap for a reason and that reason could be the potential for ESG risk, meaning investors aren't getting a good deal by embracing ESG offenders.

As for Bubble Talk...

Too often, market participants conflate enthusiasm with bubbles. With the benefit of hindsight, we know beyond a shadow of a doubt that 2000 brought a tech bubble and the global financial crisis was caused by a real estate bubble.

However, even when accounting for $187 billion residing in globally listed ESG ETFs at the end of last year and BlackRock's estimate that ESG funds could have $1.2 trillion in combined assets by 2030, that's not comparable to 2000 or 2008. Nor is it a prescription for an economic/market catastrophe.

“Overall, our findings deflate the notion of an ESG bubble during our sample period. If rising inflows into ESG investing had created a price bubble, we would expect to see rising valuations for these companies (as measured by increasing P/E ratios),” said MSCI. “Instead, our return decomposition showed little support for this theory. We found that outperformance of ESG was mainly driven by companies’ earnings growth and better dividend yields.”

Bottom line: A case can be made that ESG metrics provide a layer of safety and safe isn't a recipe for bubblicious scenarios.

Related: Netflix and Chill Isn't Just for Friday Night. A New ETF Says It's for Investors, Too.