Over the past decade, ESG investing (environmental, social, governance) and “stakeholder capitalism” has taken the investment industry by storm. Arriving largely by stealth, ESG became a way for activists on the left to hector companies into pushing political issues under the guise that it is somehow good for shareholder value. Of course this begs the question what great pearls of wisdom do 20-something activists have to tell CEOs who spent their entire careers succeeding in their field. And if something was good for shareholder value, chances are the companies are already doing it.
Vivek Ramaswamy’s book Woke Capitalism shined a light on ESG investing, and a lot of people got to see how the sausage is made. The problem with ESG is that much of ESG decision-making is not done on the behalf of investors who made the decision to invest this way. If you want to change the world, and are willing to accept lower returns, great. As long as everything is disclosed up front, there is no big deal. Pension funds, church investment funds have long invested in ethical funds (which is what it was called before ESG became the preferred nomenclature).
The problem of course starts when passive investments start playing the ESG game without disclosing what they are up to. People who manage passive investment strategies (like following an index) have an unusual set of motivations, which are much different than the typical money manager. Most fund managers are paid to pick good stocks and bonds. Their bogey is whether they beat their risk-adjusted returns, which is represented by the term “alpha.” For a long time, ESG investing was about avoiding industry sectors. They would generally hold market portfolios, but would refuse to hold tobacco stocks, gaming stocks, or alcoholic beverage stocks. They generally didn’t try and co-manage companies.
That all changed when ESG investors turned their focus on natural resource companies, particularly coal mining companies and oil companies. ESG investors forced Whitehaven Coal to exit the coal mining business and to get in the renewables business. ESG investors have been pressuring Australian mining giant BHP to exit lines of business and have had some successes in getting them to wind down some of their coal business.
The problem with this is that shareholders in the past usually cared about returns, and ESG investors are not in that business. If getting a coal miner to wind down operations is bad for the stock, ESG investors don’t care. They achieved their aim.
Index investors (like passive exchange traded funds) are not paid to pick good stocks. They are paid to minimize tracking error with the index and to run the fund at the lowest expense ratio. This creates a perverse incentive, however. While the typical fund is in the business of picking good stocks, index funds are not. In fact, they are completely indifferent to the performance of the underlying stocks. Their buy / sell decision is based 100% on inflows and outflows, and the number of shares of each stock in the index is based precisely on the company’s weighting in the index. So, even if the index fund manager thinks General Electric is a lousy stock, if GE is in the index, the manager must own it.
The big takeaway is that index investors have no dog in the fight when it comes to corporate performance. This means they will be much more easily swayed to vote in favor of some of these ESG initiatives because they bear zero risk if the initiative backfires.
The “social” part of ESG investing has been in vogue for a while, and it gets interesting when companies begin to wade into divisive social issues. As a general rule corporations should be in the business of attracting as many customers as possible, and getting pulled into divisive social issues puts them in a no-win situation. Since the activist class is almost exclusively on the left, corporations were constantly pushed to spend on DEI initiatives and to demonstrate fealty to cultural apparatchiks in their advertising and social media.
That all came crashing down a year ago when Bud Light partnered with trans activist Dylan Mulvaney. Bud Light sales cratered and never recovered. Interestingly, the reaction was not driven by any top-down organization; it was a function of their customers reaching the exhaustion point of performative virtue-signaling. Bud Light sales have not recovered, and this decision to please ESG identity group nose counters will go down as one of the worst corporate decisions since New Coke. I think in time, this will become a Harvard Business School Case Study.
We saw another big company reject ESG this week - Tractor Supply. The company put out this statement on June 27:
We work hard to live up to our Mission and Values every day and represent the values of the communities and customers we serve. We have heard from customers that we have disappointed them. We have taken this feedback to heart.
Going forward, we will ensure our activities and giving tie directly to our business. For instance, this means we will:
No longer submit data to the Human Rights Campaign
Refocus our Team Member Engagement Groups on mentoring, networking and supporting the business
Further focus on rural America priorities including ag education, animal welfare, veteran causes and being a good neighbor and stop sponsoring nonbusiness activities like pride festivals and voting campaigns
Eliminate DEI roles and retire our current DEI goals while still ensuring a respectful environment
Withdraw our carbon emission goals and focus on our land and water conservation efforts
This statement is a wholesale rejection of everything that has been sacred to ESG investing over the past decade. Supposedly this was again due to customers (who are red state denizens) feeling like the company was more interested in pleasing liberal activists in New York than people who buy feed in Iowa. I suspect we will see more companies quietly ditch ESG, and a lot of these highly-paid consultants and DEI hires will lose their jobs.
Another poster child for ESG ruining corporate performance is Disney, which has consistently put out box office bomb after box office bomb by re-doing old classics with new diverse characters with a side of lectures. The stock has gone nowhere for almost a decade, as the company leaned heavily into the culture war. At some point, these companies are going to realize that ESG isn’t good for their bottom line.
I suspect that ESG and its effect on index investing will mean that good active money managers (i.e. people that pick good stocks) are going to outperform the big indices going forward. This will be a sea-change in the way professional money has been managed if ESG-backed initiatives continue to backfire.
“I think in time, this will become a Harvard Business School Case Study.”
Only if and when HBS itself decides to not be woke/leftist. How likely is that?
[Pretty good piece otherwise]