The focus on sustainability across both the investment industry and around the corporate world has intensified significantly in recent years. One thing that may be driving this is the recognition that investment horizons have become too short. We can measure this empirically: In the 1960s, the average holding period for stocks listed on the NYSE was seven years; it is now around six months. We can also observe it anecdotally: again and again we see an obsession with quarterly results.
There is also a growing concern that such sentiments are creating — or at least exacerbating — social or environmental stresses that threaten to undermine the very system in which they operate whilst our place in it is becoming more vulnerable. We become like birds feathering our nests while ignoring the forest fire that threatens to engulf us.
So how best, in our capacity as an investor in public markets, can we play our part in creating a more sustainable future?
Is exclusion the answer?
The implied answer to that question, based on an observation of the explosion in ESG themed funds in the past few years, is that you build a portfolio comprising only “good” companies with strong ESG profiles, and exclude everything else. This isn’t de facto a bad strategy. It seems logical to us that companies addressing real social and environmental needs should, all else being equal, have better long-term prospects than companies causing harm to either people or planet. However, if a company is “doing good” but is unable to deliver sustained profit growth while doing so due to no enduring competitive advantage, then it is unlikely to prove a good investment. And even if it does have a lasting competitive advantage, if your entry point is at a stratospheric valuation, the returns are likely to be disappointing.
‘Sin stock’ industries such as alcohol, tobacco, gambling, sex-related industries, and weapons manufacturers are increasingly considered unworthy by typical ESG focused investors due to poor performers on ESG metrics. Would blacklisting such companies bring any value to a portfolio? We think this unlikely, especially in public markets, where selling a security necessarily means there is another buyer in the open market. In the public market, exclusions or divestments make it someone else’s problem — an abdication of responsibility, not the exercise of it.
Exclusion and the cost of capital
Proponents of exclusions suggest that excluding companies increases their cost of capital. In the large, liquid public markets in which most of the investable universe operates, we think this very unlikely, for three reasons:
1. The “passification” of capital is likely to undermine the ability of the capital market at large to exert a coherent level of pressure.
2. Capital is presently cheap and easy to obtain for companies, so the impact of restricting investment capital in one domain should be minimal.
3. There is no evidence we are aware of supporting the thesis that excluding companies affects their cost of capital or incentivises the type of management behavior that the exclusionary investor is seeking.
Engagement: A force for change
Sustainability-minded investors should engage as proactive stewards of capital – to use the power of the capital markets as an Archimedean lever – to create the point of leverage on which we can move the world.
We don’t pretend to understand our investee companies better than the people managing them, but we do know where our priorities lie. Companies should be managed for long-term value creation (not short-term profit maximization) that pay due care and attention to material social and environmental factors. And if constructive engagement bears no fruit, voting powers should be exercised to try to force the issue using engagement and proxy voting. Participating in collective engagement gives shareholders a powerful voice for communicating and influencing change. Overall, collective engagement can lead to more effective engagements that have the power to drive change in the real economy.
Most investors share a common goal: to generate strong, durable risk-adjusted returns. It is our obligation and fiduciary duty as investment managers to behave as long-term owners when we invest our clients’ assets. To us, exclusionary policies limit effectiveness and don’t help the industry achieve this goal for clients. Thoughtful engagement and proxy voting practices are vital to encouraging sustainable value creation and economic growth.