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Sustainable investing—often referred to as ESG, for the environmental, social, and corporate governance criteria used to evaluate companies—has turned a corner. No longer an easily dismissed subset of investing, ESG has become a force in the markets and is finally getting some respect. By one measure, a staggering one-third of U.S. assets are now managed according to sustainable principles. That is likely to increase further under the Biden administration, which has taken steps to curb global warming and is actively friendly to ESG.
So, what’s next? Increased regulation of ESG funds, to be sure, and improved standardization of ESG metrics, and a more sophisticated investor base, too. More important, more companies are seeking to solve sustainability challenges.
Our second ESG roundtable features a trio of experts: Karina Funk, co-manager of Brown Advisory Sustainable Growth (ticker: BIAWX) and a renowned stockpicker; Katherine Collins, who just marked her three-year anniversary co-managing the top-performing Putnam Sustainable Leaders (PNOPX) and Putnam Sustainable Future (PMVAX); and Jon Hale, Morningstar’s sustainability research chief for the Americas.
In a recent discussion with Barron’s on Zoom, all three considered the outlook for sustainable investing and recommended an array of promising stocks and funds. Keep reading for an edited version of the conversation.
Barron’s: Pensions and other big institutions have long favored ESG investing. But this past year, it seems to have gone mainstream.
Jon Hale: We saw record flows, more than $50 billion, into sustainable mutual funds and exchange-traded funds—that’s nearly a quarter of all the money that went into funds in 2020. It’s more than 10 times that of 2018, and more than double the $20 billion of 2019. We’re estimating more than $20 billion in the first quarter of 2021 alone. We now have more than 400 funds in the U.S. that emphasize sustainable investing in some way. Last but not least, asset managers of all types are incorporating ESG information into their investment process. The pandemic underscored sustainability concerns, the climate crisis chief among them. All of that happened against a challenging backdrop, including an unfavorable regulatory environment.
Have we moved past ESG being a polarizing issue?
Katherine Collins: One of the main shifts was to think about sustainability as completely core to business strategy and, therefore, to investor considerations. I’ve been excited to see lots of investment peers saying “obviously” [ESG] matters for long-term business fundamentals. I see the same thing when we talk to company leadership teams, whose top concerns are 100% ESG—total concern for their teams, customers, suppliers. The other big shift is a recognition of interconnections: a much better systemic understanding that a public-health crisis is linked to an economic crisis, which is linked to a social-justice crisis, which is linked to a climate crisis. You have to analyze them together. It’s bittersweet to see strong flows and performance against such a terrible backdrop.
Karina Funk: ESG is already table stakes. You don’t need to call it ESG for it to be ESG. Investors who care about quality management teams, or long-term outlooks and attracting talent—they’re already practicing ESG. There are a lot of risks in our increasingly volatile and unpredictable operating environment, including political surprises, the pandemic, and the social and environmental interconnectedness we’ve been talking about. These are existential risks, not just ESG risks.
The past year was an inflection point that defines [corporate] culture and legacies: Are they choosing to connect the dots between the pandemic and environmental and social challenges? I expect we’ll get better at measuring, managing, disclosing, and understanding how these risks really flowed into companies’ financial statements, their strategies, and prospects for growth.
Jon, financial advisors are behind the curve with regard to ESG. Why is that?
Hale: There’s a legacy belief that ESG doesn’t perform well. They’ve been taught to tell clients to park their values at the door: “I’m here to help you become a rational investor. If you want to do good for the world, then make a bunch of money and give it away.” That’s not relevant today; ESG issues are important in terms of a company’s long-term success and the health of our global economic system. The next phase of ESG will focus on how investments impact people and the planet, as well as profits. There is a tremendous opportunity for younger advisors to take market share by talking to clients about ESG.
Collins: Pretty often, in a [financial advisor’s] practice, the conversation starts with, what are you against? By definition, you get a long list of complicated and sometimes contradictory answers. I’ve been encouraging the advisors who I work with to flip that around and say, what are you for? This is what active managers think about. Everyone is for thriving individuals, a thriving planet, effective systems. Flipping that starting point can close the gap.
Funk: If an advisor can get a little creative, they can see that not only do clients care about these issues but so do they. A technology CEO recently told me, “When I was last in Stockholm, I was approached by Greta Thunberg, the social and environmental activist. And she challenged me. She said, what are you going to do as CEO of this large company to be a part of the solution and not a part of the problem?” That has changed his life, and he’s making changes within the company.
Has the view that ESG underperforms been laid to rest?
Funk: There are increasing amounts of data, wonderful academic studies using large data sets over long time periods [that show outperformance]. There’s evidence of lesser drawdown risk [a measure of the time it would take, after a loss, for an asset’s price to hit a new high], and the potential for outperformance. The best data are among strategies that now have three-, five-, and 10-year-plus track records that have been integrating ESG consistently over the years, and outperforming in all major time periods.
Collins: For me, a key question is, has the opposite been shown to be true? There’s no evidence whatsoever of systemic, chronic underperformance. Anyone who has a fiduciary role has to do the same due diligence that you would with any other investments. And the flippant answer is, Barron’s wouldn’t be talking to us if our performance wasn’t great. Proof points.
Fair enough. A big opportunity for investors and the industry is the potential inclusion of sustainable funds in retirement plans, after the Department of Labor said it won’t enforce a Trump-era rule that would have made inclusion more difficult. What impact will this have?
Hale: Practically none of last year’s $50 billion in flows came via retirement plans. We’re waiting for a new rule that really makes it clear that ESG issues are material investment issues, especially over the long term, which aligns well with the time horizons of retirement savers. Not to mention that many American workers would like to invest this way, and helping them do so would make them better and more persistent investors for their retirement.
What should a new rule address?
Hale: I’d like the DOL to say explicitly: No. 1, consideration of material ESG issues is appropriate, if not required, for retirement plan fiduciaries; No. 2, funds that intentionally emphasize ESG issues are appropriate choices, provided their risk/return profile is competitive with funds in the same investment categories; and No. 3, ESG is an appropriate component for qualified default investment alternatives [QDIAs] in 401(k) plans. The Trump rule tried to outright ban them as QDIAs—the funds that plan participants are defaulted into if they don’t [choose their own funds]. We know that a lot of retirement plans are interested in and waiting for clearer regulatory guidance.
The European directive on sustainable finance eventually affects U.S. asset managers, too. And the Securities and Exchange Commission is weighing in to make sure funds aren’t greenwashing, or deceptively claiming to be sustainable.
Collins: It’s pretty clear that the dream of an elegant, principles-based global set of regulations isn’t going to happen anytime soon. The paperwork of ESG is accelerating at a dramatic rate. For the SEC, the description of your ESG process and your product needs to match what you’re actually delivering. The confusion is that we’re still streamlining language, refining the definition. We’re in that awkward adolescent phase where you can’t speak in shorthand and be immediately understood. The primary issue is lack of clarity in communications rather than a nefarious backdrop.
Hale: I don’t like to use the term greenwashing, because a lot of people use it to refer to anything that doesn’t go as far as they think you should go. What regulators are saying about ESG is, say what you mean and mean what you say. There are a range of approaches to implement an ESG strategy. One issue for financial advisors is that you can’t just go through the list of ESG funds and pick the cheapest, like you can with an S&P 500 index fund. There are different takes on ESG used to construct ESG index funds. At Morningstar, we’re trying to identify the various active approaches; there are at least half a dozen, and active managers have their own unique tics.
Funk: Standardization is important, but there are a lot of stakeholders with different use cases. There are worthwhile reasons to use different ESG information. For example, consumers might want to know if the product is clean and organic, and an endowment might want to know if company actions are consistent with the endowment’s objective. My hope is that we can find some common ground, but ESG will always be partly subjective.
Remember how long the evolution of financial transparency took: It was the 16th Amendment, in 1913, that created a federal income tax. In 1917, the Federal Reserve published uniform accounting standards for how to report financial gains. But during the Great Depression, a lot of accounting frauds were exposed. This prompted stricter measures. More recently, the Sarbanes-Oxley Act also was a reaction to accounting scandals. Lack of oversight and self-regulation and inadequate disclosures are major issues we’ll have to grapple with when it comes to ESG data. Let’s not confuse ESG data and disclosures that are important for that fiduciary process with ESG data that might have other use cases.
When will we see standard definitions?
Collins: We’re gradually getting to a point where more and more of the granular data, the primary data, is standardized in terms of how it’s calculated and verified. That’s a really big deal. The Sustainability Accounting Standards Board’s thinking around materiality is a well-established global framework that took 10 years to develop.
What are the challenges to standardization of ESG data?
Collins: What has accelerated is this deeply problematic idea that there should be a binary yes-or-no element. I can’t tell you how often I get asked, is this an ESG stock? Every investment consideration can and should incorporate the relevant ESG issues for that context. It’s not a yes-or-no question.
Now, we’ve spent a lot of time talking about the floor of ESG, about regulation and compliance and data standards. I worry that if we only focus on the floor, we’re going to miss looking up at the sky and what’s actually possible. We are equity investors. We are interested in the upside.
Engaging with companies is a big part of ESG. What trends are you seeing?
Collins: We’re fielding more questions and higher expectations from clients on engagement. There are three main pieces: the proxy process, external partnerships that focus on long-term stewardship, and then the most unique part is the engagement that happens within our investment process. It’s increasingly quaint to be an active manager, where you spend most of your time talking to leadership of companies. Yet those conversations are unique, powerful, and additive over time. In my 30-plus years as an investor, I cannot overstate the power of a different question, a better question, or a sincere, serious question. It is so rare for the CEO of any major company to be asked a sincere, open-ended curious question about a topic of vital importance. The dialogue that can ensue is amazing. It helps with our long-term understanding of the company and its strategy, and it helps the company to talk to other folks looking at this issue across lots of different contexts.
Funk: As active managers, we don’t have to wait for proxy votes to make our expectations known. As a concentrated investor, we have a voice and want to use it wisely. We gravitate toward high-quality companies, and aren’t likely to buy shares in order to change a company’s behavior. We set expectations right off the bat: We don’t come at management teams with a checklist of 50 different ESG issues. Each year, we choose three or four areas of engagement that are material to the business models we invest in. This past year, they included: No. 1, sustainability disclosures that are material to the business; No. 2, encouraging companies to set science-based climate targets; No. 3, diversity, equity, and inclusion—going beyond the data that are easier to see but that impact their business; and No. 4, artificial-intelligence ethics. We get up to speed on understanding if there are best practices out there, so we can encourage companies to adopt them. We talk to academics, AI experts, nonprofits, advocacy groups, workers. This kind of engagement makes a difference; you’re not coming to a company with the entire kitchen sink, and you’re focused and consistent in your expectations.
Hale: Shareholder resolutions are almost never put on ballots without accompanying engagement. It has moved from an adversarial process to a much more cooperative exchange of information [aimed at] helping companies improve. Recently,
management supported a diversity, equity, and inclusion shareholder proposal. That’s unheard of. Last year, we saw the highest average support ever for the 186 ESG-related shareholder resolutions; 20 received majority support, and at least a third received at least 40% of the vote.
Let’s move on to stock picks. Katherine?
Collins: At Putnam, we have a thematic map that starts with the question, what is needed for individuals, the planet, and systems to thrive? For thriving people, what solutions or opportunities are preventive in nature?
One business we’re excited about is
[COO]. You might use Cooper contact lenses. The business is three-quarters vision and one-quarter women’s health. Cooper has a $20 billion market cap. It has a terrific core business in corrective vision, and has research-and-development and manufacturing excellence. What really perked up our attention is a product called MiSight, which intervenes at the beginning of a child developing nearsightedness and changes that arc. This is a small business for Cooper now, but has interesting potential. Over time, up to seven million kids in the U.S. might be eligible for this product, roughly the same amount in Europe, and far more in China. At the current price tag of $750 per treatment, it could be a multibillion-dollar opportunity for Cooper and others in this space. Consensus earnings estimates for fiscal 2022 [ending in October] are $14 to $15 a share. The stock is at $385, so roughly 28 times 2022 estimates. If MiSight allows Cooper to continue to grow earnings at a consistent double-digit rate, the stock could hold this valuation level and generate durable double-digit returns.
What’s your “thriving planet” idea?
Collins: A lot of human creations are designed so that we extract materials, produce a product, and then discard it. It’s a linear model. In natural systems, waste becomes the input to the next process. I have two related ideas in the consumer area:
[LEVI], which came public in March 2019, has a $12 billion market cap and a longstanding focus on environmental sustainability. They did some groundbreaking work on lowering water intensity for denim production; on improving the efficiency of the cutting and finishing so there’s less waste in the manufacturing; and on the whole inventory chain. What benefited their cost structure is also becoming really important to their consumers and brand perception. There are signs that the company is weathering the rearrangement in U.S. retail apparel sales. Levi has also started to curate its own vintage jackets and denim, an accelerating consumer trend for next-generation consumers. The stock is roughly 21 times 2022 earnings.
The companion idea is [online consignment and thrift store]
[TDUP], which came public in March. It’s not yet profitable, and has about $1.6 billion in market value. ThredUp is designed from the beginning to help address the big issue of linear disposal. It has taken a big investment in automation and technology to come up with a system that can handle the volume and variety of an effective online retail presence. This mass fashion category is six to seven times bigger than the luxury category, and the whole resale market is currently only 25% online. You have huge benefits to the sellers, huge benefits to the buyers. And you have massive improvements in sustainability from that clothing not ending up in landfill.
My final pick is related to efficiency and effectiveness. For the health of a system to persist as scale develops, you need a quicker pace of innovation, and it has to be effective. So, a key question we ask is, what are the ingredients that allow for effective and accelerated innovation?
[AMAT] is my pick. Everything that makes our systems more efficient and reliable requires increased intensity of semiconductors. Applied Materials has gone from being one of many suppliers to a big importing industry to a leader in the technology road map. They have a $125 billion market cap, roughly 20 times 2022 earnings. Many people still consider this a deeply cyclical, highly capital-intensive business. Given long-term secular growth trends, you can argue that it’s a steadier and higher-quality business.
Karina, please share some of your ideas.
Funk: A sustainability lens helps us turn over more rocks, look at better information. Some of the most compelling investments today are companies solving critical sustainability challenges. They’re adding capital to sustainability strategies that demonstrably flow through their financial statements in the form of faster revenue growth, cost improvements, or increases in their franchise value. Long-term investing requires an ESG lens for a lot of reasons, but ESG investing doesn’t require a long-term horizon. I’m a growth manager, and I invest in great companies that are being rewarded today for doing great things.
We’re excited about
[CHGG], an online educational-services company with a $13 billion market value. In terms of a compelling customer value proposition with secular sustainability tailwinds, how about democratizing education? A quality education is among the 17 United Nations sustainable development goals. It’s key to escaping poverty and for upward social mobility.
Traditional colleges and universities in the U.S. are outdated, overpriced, and woefully under-invested in technology. Chegg helps students within that college environment with study questions, online tutoring, and access to textbook rentals through an on-demand, online, 24/7 platform. Renting is obviously less of a financial burden than buying textbooks. Chegg is also for people who are working jobs, taking care of families, and studying for tests at 2 a.m. and definitely can’t go to office hours. It has a low, monthly subscription rate, and a compelling new business in skills-based learning outside the traditional physical campus. It’s definitely a Covid-19 beneficiary. They’ve grown subscribers by more than 64% in each of the past four quarters: Sales will moderate off the very high year, and we still expect well over 20% growth. They have a long runway.
You also like
[SQ]. Its price/earnings ratio is 300. Isn’t that valuation stratospheric?
Funk: Square is a $100 billion-market-cap company with two ecosystems: the merchant payment system and their Cash App ecosystem, which is about peer-to-peer small financial transactions. In both cases, the return on equity is extremely high. For every dollar invested in that seller, from the merchant business and marketing perspective, Square returns $3 to $4 within a few years.
What caught our attention about Square is how fast they’ve been growing, because of [the focus on] financial inclusion. In 2019, the Federal Reserve reported that 63 million Americans were either unbanked or underbanked, and needed to rely on alternative financial services, like payday loans, money orders, pawn shops. Square has grown at least as fast as other peer-to-peer transaction apps, and works almost like a digital bank account, but revenue comes from small fees on services and transactions, rather than using the depositor’s money to make loans.
It’s also a Covid-19 beneficiary. When people put the stimulus payments into Cash App, if they waited one or two days, the deposit was available for free. Given the very healthy growth of Cash App, we see a long runway of value-added services, in reporting and inventory management, tax forms, and things like that. Merchants using Square for customers should soon be able to pay workers through Cash App. The Cash App business is growing by over 100% year on year. If you assign a healthy but nonheroic multiple to the Cash App business, we own the seller ecosystem at a discount to comparable peers.
What’s the thesis for
Funk: Before Covid-19, people heard of Etsy because of its tremendous brand presence. Go to etsy.com, without going through Google. Etsy developed a tremendous two-sided marketplace, and currently has well over 20 buyers for every seller. They went gangbusters during Covid-19 in providing masks. Those first-time users came back. The user base vastly increased. We like them because they have been living the importance of employees, attracting and retaining talent, and diversity and inclusion. Women represent 50% of the board, 66% of the executive team, and almost 40% of the technology roles, double the average of other technology companies.
Given the increased competition among technology companies to attract and retain talent, it’s imperative for Etsy to be able to manage that risk well. We think they can grow Ebitda [earnings before interest, taxes, depreciation, and amortization] well over 20% a year for the next several years. They have a good shot at being one of a handful of very, very large e-commerce vendors.
Jon, which funds and managers do you like, present company excepted?
Hale: There are several highly rated funds, based on performance and sustainability.
TIAA-CREF Core Impact Bond
[TSBRX] allocates 30% to 40% of assets to impact investments.
Parnassus Core Equity
[PRBLX] is an actively managed fund that emphasizes companies with competitive moats and ESG advantages.
There has been tremendous growth in ESG index funds over the past three years. I’d recommend Calvert’s suite of index funds, including the
Calvert U.S. Large Cap Core Responsible Index
[CSXAX], which is based on Calvert’s own proprietary ESG evaluations. The fund is behind the S&P 500 a little bit this year, but it has outperformed the S&P 500 over three-, five-, and 10-year periods. Calvert speaks out broadly about the impact and importance of ESG issues. Investors can count on the firm to actively engage with companies in the portfolio around ESG issues and vote proxies for proposals that are material and important to ESG investors, something that not all ESG index funds can be counted on to do.
For smaller-cap exposure,
Parnassus Mid Cap
[PARMX] is an attractive option; it owns companies with sustainable competitive advantages, still in their early growth stages. The portfolio managers are high-conviction managers. The fund generally provides good downside protection. Finally, more investors interested in sustainability are going to want to invest directly in companies making a difference in the energy transition.
Pax Global Environmental Markets
[PXEAX] is an attractive way to do that. It targets growth companies that derive a significant portion of revenue from clean energy, water, waste and resource recovery, sustainable food, agriculture, and forestry.
Thank you all very much.
Write to Leslie P. Norton at [email protected]
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