Shani Jayamanne: Welcome to another episode of investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. 

Mark LaMonica: So today Shani we are going to talk about ESG. And before we started recording, I asked what you do that’s good for the environment and you came up with two things. Recycling – which is primarily bottles of champagne and gin and seltzer cans, and you grow plants.

Jayamanne: I do, yeah.

LaMonica: Now you have a plant. You’re moving - you purchased a house you’re moving into your house soon. You purchased a plant named Fergus.

Jayamanne: I didn’t purchase it, you purchased a plant named Fergus as a gift for me.

LaMonica: Okay, I got you a gift a couple years ago of a plant and you took the plant on the bus.

Jayamanne: I did which is again, very environmentally friendly. Public transport.

LaMonica: Yeah, but you don’t have a car so probably didn’t have a choice. But yeah you took Fergus out to live at your parents’ house. So, I’m a little nervous that they’re not going to properly take care of him so.

Jayamanne: I feel like Fergus is going to thrive there.

LaMonica: Okay maybe he’ll get upset and he moves back into your new house.

Jayamanne: I feel like this has gone off the rails maybe we should talk about ESG.

LaMonica: It has yes, so ESG stands for environmental, social and governance and when we talk about investing, it’s an investment approach where certain standards are applied to what kind of companies are included in a portfolio and those that don’t meet the standards are of course excluded. Now this is the point in time where I think a lot of people are probably flicking through, trying to find another podcast to listen to but we are taking a very different perspective.  

Jayamanne: So, Mark – are you implying that ESG is not a popular topic with investors? 

LaMonica: Well, it is in a way. So ESG is very so global sustainable funds have attracted $2.4 trillion US in funds. 

Jayamanne: So, if ESG is so popular with investors why do you think people won’t listen to this episode? 

LaMonica: Well, because the problem is what do you talk about with ESG? There isn’t really a second conversation about it so once you understand what ESG is and you’ve made a decision to either invest in ESG funds or not what do you say after that? 

Jayamanne: And we did do an episode explaining what ESG is all about. So, what makes today different? 

LaMonica: Well today we are going to have the next of our round of interviews and we are going to put on our investing hats instead of our ESG hat. 

Jayamanne: So maybe I can expand a bit on your confusing reference to what we’re all collectively wearing. Investors are primarily concerned with risk. In fact, the whole act of investing involves weighing risk and return and making a decision if the trade-off is a good opportunity. 

LaMonica: And if we remove the desire to improve the world from ESG investing we are left with the fact that many of these issues are in fact risks that face companies that needs to be accounted for by investors. 

Jayamanne: Let’s use a simple example. Around the world we are starting to see governments not only encouraging a switch to electric vehicles but also introducing mandates about the percentage of electric vehicles that are sold.  For instance, the state of California has recently said all vehicles sold in the state need to electric by the year 2035. 

LaMonica: And you may listen to that mandate and say that is ridiculous or you may say that is a great thing and a worthwhile step for the state to take. But either way, as an investor in car companies you need to understand that it is a risk to traditional car manufacturers. 

Jayamanne: And like any other risk that needs to be accounted for when making an investment decision. And that is how our guest today is going to approach ESG. Our guest’s name is Adam Fleck and he is an equity analyst at Morningstar. So, he is going to talk a bit about how our analysts consider these ESG related risks when rating any company. 

LaMonica: So hopefully this approach will provide a different view on ESG and is an interesting conversation for all investors – whether ESG is something you feel is important or not.  


LaMonica: Alright, as mentioned we have our next guest on Invest Compass, so I will introduce Adam Fleck. Now Adam used to run our equity research team here in Sydney. He has since – and I don’t know why, but since moved back to Chicago where he is still working with Morningstar’s Equity Research. So Adam, I don’t know if you want to answer that back to Chicago question but anything you want to tell people about yourself.

Adam Fleck: Yeah, hey Mark, it’s great to be here thanks so much. Chicago right now it’s snowed today in mid-April when we’re recording this and it really does make me question why I left the sunny shores of Sydney. But you can probably hear my American accent painfully coming through – I’m not Australian. Back close to the family after 5 years in Sydney but we certainly treasured our time there.

LaMonica: Well that’s good a lot of people do write in and make fun of my accent so this will be an especially good episode for everyone. But as we mentioned in the introduction, we’re going to talk a little about ESG. We went though some of the stats during the introduction about how much investor interest in ESG has grown, and we wanted to try to do something a little bit different today. So, Morningstar is heavily involved in ESG. We do have a group at Morningstar called Sustainalytics – it does a lot of our research, but Adam as we said in the introduction, does work on our Equity Research Team and Adam and I did have a number of discussions between ourselves when he was still in Sydney about ESG. So, we want to take a little bit of a different angle and maybe just start out with, a lot of what we’re seeing in the news now about ESG is really around some of the backlash. So certainly, in the US and globally we’ve seen political backlash. We’ve also seen some backlash from inside the industry, so kind of the most famously one of BlackRock’s former global Chief Investment Officer for Sustainable Investing – a guy by the name of Tariq Fancy, he published a very long article, I think a couple of years ago now, about his thoughts on the issues with how ESG has been implemented. So, I guess maybe just to start out, just what are your thoughts on all of this noise we’re hearing on ESG?

Fleck: Yeah, I think noise is probably the right word for it Mark. You know when I think about ESG and what we’ve done over the past few years since I moved back to the US to take on a team focused on ESG and how we think about that at an individual company analysis level. What we’ve learned really is that many traditional investors have had an uneasy relationship with ESG, and I think that’s a large part because of how it has become defined. Many focus and define ESG as a focus on values and doing good if we can agree what good might be and that can be tough to reconcile with a valuation based financially minded view of investing. But when we put ESG and sustainable investing and all the criticism and benefits that we’ll talk about with ESG into one big monolith, I think that we lose the fact that this is really a big tent with lots of room for different viewpoints and different strategies. And I think a lot of the criticism – it really conflates two of those key viewpoints within the big tent of ESG. And that’s risk and impact.

And in my mind, those are critically important to separate. ESG risk ultimately, describes the effect of ESG factors on companies’ financials but the outside issues related to environmental, social or governance on the company itself – so it’s an outward in approach, you might have heard it called single materiality. And not always the opposite, but for the sake of this discussion, the opposite view might be one of impact. One that’s of double materiality or an inward out and that’s the effect that a company has on the world around it - the environment and society. Some companies may be helping those, some might be harming those, but really this aspect of sustainable investing focuses more on investor preferences and trying to drive impact and align portfolios with what investors might deem as the most impacted areas.

So I said they’re not exactly opposite. So certainly overlap. Investors across the spectrum are still seeking return obviously and companies driving what we might call negative side outcomes such as emitting carbon may involve consideration of its impact on the environment certainly. That inward out approach, that double materiality approach but it might also involve thinking about how that future regulatory environment might come back to the company say through carbon tax so that’s more of that risk factor. So there’s certainly overlap but as I see it, risk is really where we’re focused on as investors, as individual company investors. When we’re thinking about matching that with the traditional measures of cashflow, balance sheet and ultimately focus on valuation. So we like to say we’re valuation focused, not values focused. And we put ESG in context with all the other challenges or opportunities a business may face. So there’s lots of other risks that may be outside the sustainability lens that need focus too but equally ESG I think is ultimately essential and risk analysis from ESG specifically is essential to investing and criticising it, ESG, and calling it woke investing and all these things that get thrown around, I think is ultimately conflating risk and impact at the detriment of investors.

LaMonica: Yeah so it’s interesting because there’s different perspectives that I guess individuals take versus professionals. So you know generally what we’re pitched as individuals – we’re pitched funds and ETFs and they exclude certain companies that don’t meet ESG standards but I do really like the way you’re talking about it, taking a more holistic view of risk. So I don’t know, maybe if you have an example or how an investor should think about that cause obviously anytime we’re buying a company, there is risk involved and what we’re trying to doing right, is we’re trying to get compensated for that risk. So we’re trying to buy it at a valuation level where we feel, I don’t know if comfortable is the right word, but at least comfortable that we are hopefully going to get compensated for that risk. So yeah, how do you think about risk?

Fleck: Yeah I think it’s a great point and you brought up you know at the product level I think it’s really ultimately about communication and transparency. So when you’re buying into a fund for instance to answer the first premise of your question, that claims to be ESG tilted or has a sustainability focus and they’re excluding you know the common exclusions we see right – alcohol, gambling, tobacco perhaps, firearms here in the US. That is certainly one sliver of sustainable investing – a very valid one, but you’re inching closer there I think to preference-based investing rather than fundamental risk analysis and valuation.

And to get to the second part of your question. Ultimately we think about risk, and we do this in all the 15000 companies we cover as an Equity Research Team globally including the 200 or so that we cover in Australia. We think about what is the likelihood that this risk that we’ve identified might occur, so you can call that the probability, and what is the significance to our valuation – you know the magnitude, the potential hit to our valuation should this risk come to fruition, should it materialise. So you can think about for instance, a carbon tax, again now we think that this is a pretty low probability but there’s a potential, that there’s some form, say here in the US, of taxation put on companies’ carbon emissions that takes the form of direct cost – again we think that there’s a very low probability. Or some sort of cap-and-trade system expanding, or perhaps a border tax as a few examples to say. That would be probably quite material to heavy emitters of carbon there’s no doubt but the low probability I think offsets that. So it’s not just about you know, saying “oh this is potentially bad for the company therefore don’t buy this company”. It’s really putting it in context like you would any other risk.

You know I used to cover, when I was still public, Coca-Cola in Australia. And I certainly had to think about water, I have to think about obesity, I had to think about the sugary beverage taxes that occasionally get proposed, I had to think about container deposit schemes that were in place because of arguably environmental concerns related to waste. Those are all ESG issues that faced Coca-Cola and I would have been a pretty bad analyst had I not thought about those things. That doesn’t necessarily make me you know someone that is focused or advocating in some way for any of those, it really is just putting it in context and thinking about the probability of all that. Ultimately, we will recommend companies that face high ESG risk, just as equally as we’ll recommend investing in companies that face low ESG risk. Like you said it’s about the price you pay versus the valuation that you get. You want to be compensated for the risk there’s no doubt, but markets can become myopic and overly reacts to near-term issues and if we think that you know the ESG or otherwise risk that is captured in the market is overly pessimistic - doesn’t affect the company’s competitive position, doesn’t affect their long-term cash flow as much as the market seems to imply – we’re happy to recommend that.

LaMonica: And you know maybe – something that I was thinking about while you were going through there and that I have gotten questions from investors about is – as more and more funds, and we talked in intro about you know how much is flowing into ESG products, as more and more funds go in there, as investors do we have to think about, there just isn’t enough capital that can invest in some of these companies, could you get into a problem where you have permanently low valuations just simply because so many investors refuse to buy a coal company for example?

Fleck: Sure. It’s an often debated topic in the ESG and sustainable investing realm right. The opposite there just to cast a similar premises – if so much capital is chasing what people might agree to be the best ESG performers, won’t those stocks become overvalued and you’re locking in a lower rate of return in the future. Ultimately I think you’re going to get some technical gyration and volatility potentially, but I think that it’s important to focus on the long term valuation and not the short term price. You know, price is what you pay, value is what you get. The other old adage right is that in the short term in the market’s the voting machine, in the long term it’s the weighing machine. So capital can go into stocks, it can leave stocks pretty rapidly. But unless the marginal investor, unless every single investor in the marketplace agrees that we’re going to avoid coal companies to use your example, I don’t think there’s a permanent loss of value right, because there’ll be some investor at some price that says “hand on heart I really think this is overpriced risk, I think as a result this is a really cheap stock and I’m going to capture the return that is being priced in and offered to me”. And you know, while that investor may or may not care about the environment to the same degree, they may choose to donate to charity or volunteer or what have you to express their own preferences, but they feel like their preferences in investing is ultimately making money in this case. And so that marginal investor, that last investor that buys into a coal company to capture a really attractive valuation I think will still exist and in the very long-term we might see ESG risk continuing to grow and manifest right, over time, and I think it’s important to say that. But also, we might see it get priced into the point that there’s attractive options even in stocks that we think are not the best ESG performers.

LaMonica: Yeah and it’s interesting a book that I talk about a lot is ‘The Future For Investors’ and you know when I first read that – and it was a while ago – the thing that really struck me, is really analysis going back looking at US shares. And looking at a period from you now kind of the mid-20s up until the early 90s when the book was written and what they were looking at was, hey what was the best performing share? And interestingly enough it was Philip Morris. So Philip Morris is of course a tobacco company and part of that was attributed to – and this was including dividend reinvestment – and part of it was attributed to the fact that the company continually traded at a low valuation. And that it generated huge amounts of cash flows and basically they didn’t know what to do with it because you know over time they eventually couldn’t market anymore. You know smoking was actually reducing across the world during a big chunk of this time period and so they didn’t really have anything to do with the cash flows but give it back to investors and when I tell that story a lot of people will come back and say “you know that kind of sounds like coal right now”, not to keep talking about coal but you know generally a coal miner, they’re not approving new mines, so there’s really nothing to do so they just give it back to investors. So yeah there’s different ways obviously to make returns so yeah I thought it was an interesting point.

Fleck: Yeah think your example there has a really important point that I want to make which is that sustainable investing can be a preference and thinking about you know aligning with companies that you know are pursing strategies you think are highly perhaps impactful. ESG risks are critical and essential to incorporate but that’s part of the investing process, it’s not the whole thing – just like competitive advantages and economic moats are part of the process. And while there are some overlap there, that’s not a direct causation. So being sustainable and being arguably good does not lead necessarily directly to building a competitive advantage right? Philip Morris might be a great example of that. I think it’ still really important to measure a company’s competitive position on the more traditional measures of brands or cost advantage or network effect that we do here at Morningstar. And while ESG risk can play a part in that, right? It can certainly blow up a company before it becomes immensely profitable if it continues to capitalise on that for instance if high regulatory barriers become a problem for instance. It’s tough we don’t really see the direct correlation between being a good company from an ESG perspective and having a competitive advantage.

LaMonica: So if we take a step back and we think about an individual that’s going out there and buying shares, so they’re buying direct equities, they’re not going through funds and ETFs. And obviously you’ve talked a little about the research that Morningstar analysts do, trying to consider that holistic risk picture. But how should somebody think about that? And obviously read our research is one great way of doing it but someone who isn’t kind of rigidly investing in an ethical manner but someone that wants to kind of balance return objectives with their own concerns about the environment, corporate governance and how companies treat their employees. I guess how should an individual investor go out there and think about that?

Fleck: Yeah great question. I think what we can do as individuals is to be as – this is going to sound really easy and it’s tough to do – but be as cold and apolitical in our analysis as possible. Be as objective as possible. Really think through you know, like you would any risk or opportunity for a business, realistically what does this mean for the company I’m looking to buy right? What is the potential negative downside to the profits of this business? What is the upside to the profits of you know, maybe it’s a company doing elective vehicles for instance, you’re looking at Tesla right - how many cars can they actually sell? What’s the competitive environment look like in the future. You know I think that treating ESG risk as much as you can like any other when you’re doing your due diligence and really thinking through the upside and downside of what it means to the value of the stock price that you’re looking at – I think it’s super important. I think it’s also important to think about your own preferences and your own portfolio. You know now more than ever in a world where we have access to so much information and trading is so cheap. You know we can reflect our values if we’d like, in portfolios. But I think that is equally important to remind folks that when I say, “impact focused investing”, right and I think about the impact side not the risk side. So that’s one that’s more inward out there’s more preference-based type of portfolio construction, its still alignment, not direct impact right. If I were to go out and buy shares of Tesla, they don’t see any more capital right. Their shares are already in the market, they’ve done their IPO. I’m not directly putting capital and my money to work at Tesla. You know Elon Musk doesn’t wake up and say, “Thank God Adam Fleck bought 3 shares of Tesla, now we have more money, I’ve got the news that he wants to drive lower carbon”. It’s a secondary market investment. And you know for those that are more impact minded to drive specifically positive impact from an environment or social perspective I’d encourage folks to look at potential funds and private companies you know where you’re seeding companies. Here in the US admittedly we’ve got municipal bonds that are tied to specific social projects – we’ve just had some in Chicago for instance that are interesting. There are more of those direct investing opportunities where you’ve got specific and direct additionality right, you’re actually driving impact. So just be careful again, I think any funds that are out there saying “We’re going to change the world” and they’re buying a bunch or secondary market shares and excluding some sectors might be overpromising.

LaMonica: Yeah, no that’s a really, really good point alright so last question and maybe this one’s a little tricky because it is about the future, but you’re an analyst right so you’re supposed to be thinking about the future right so. Where potentially could ESG go from here? Just we’ve seen this enormous growth, I think everyone expects that growth to continue, we talked a little about the backlash, there’s still clearly internal debates both within the financial services industry and just investors in general about ESG. I don’t know what excites you I guess about ESG going forward or what are you curious about?

Fleck: We’re likely to get more evolution. So the industry continues to evolve. Tariq Fancy’s criticisms that he brought forth some years ago among many others that have criticised ESG as well – I actually agree with some of his points right, you know, but I think it’s led to the evolution that we’ve already seen. We’re seeing much more clear delineation between those items of risk and impact. We’re seeing much clearer regulation around what funds can and can’t say about what companies are reporting. And I think we’re likely to see more data and transparency and I hope consistency of that data as required by regulators, that allows analysts and investors to answer tough questions. We’ve had a lot of interest and information provided to us on the environmental side and there’s more to come right when you think about the SCC here in the US and other regulators requiring more carbon emissions data for instance. We’ve gotten less consistent data on the social side particularly around issues of diversity or stakeholder management and community relations. Occupational health and safety remains an area that you get kind of spotty data. So over time as this continues to be focus and companies try to differentiate themselves or regulators require it. I think we’re likely to get more information that allows us to answer questions like does a more diverse board help a company? Or is this company a high or low carbon emitter? Can they actually commit and deliver on the promises that they’ve made? You know, can a unionised workforce compete with a non-unionised workforce right. These types of questions that are just tough to answer because we’ve got really, really non-transparent data, I think over time will help us and help to evolve the ESG risk integration space. And from an impact perspective again I think also likely to help people understand what their companies are up to and whether they want to be owners in those companies.

LaMonica: Alright great well Adam, thank you very much for joining – I really appreciate it, I think our listeners will really appreciate it and at least in my opinion a fresh perspective on ESG kind of looking at it certainly in a more holistic manner which I think is helpful for everyone so thanks a lot Adam.

Fleck: Of course, thanks Mark.  

LaMonica: And thank you guys for listening. As always if anyone has any questions or comments you can send them to my email address which is in the show notes or of course leave a comment in your podcast app. Thank you very much.