One theory of sustainable investing is that its objective is to make it more expensive for “bad” companies to raise money, and cheaper for “good” ones to (based on your preferred definitions of bad and good – there are many). This occurs by investors divesting from the bad companies and allocating more money towards the good ones.
The hope is that this will make it harder for bad companies to operate and grow, and encourage them to mend their ways to access the enviable financing terms on offer to their better-behaved peers. Through this process, the world will be made a better place. This is the theory, I’m not saying I agree with all of it. But some people do.
Another theory is that there is money to be made from investing in good companies and avoiding the bad ones. The bad companies face challenges to the sustainability of their business models – whether through changing regulation, consumer behaviour/preferences or otherwise. Because the market isn’t great at working out the likelihood, impact and timescale of these risks hitting home, savvy investors who do their research can get ahead of the game. I like parts of this theory. But it’s not a given that you can make money from it, as I’ve written before.
The link with valuations
One common aspect to both theories is valuations. In the first, if good companies trade on higher valuations than bad ones, they can raise capital more cheaply – although this should have a bigger impact through bond markets than equities, given that so little new equity capital is raised by listed companies, relative to the debt financing they raise.
In the second, if good companies trade on higher valuations than bad ones, then maybe the market has (at least partly) already priced in their differing long run prospects. If it’s already priced in, you shouldn’t expect that to drive higher returns.
Flipping this the other way, if companies which are run in an unsustainable way are punished by investors with lower valuations, then this makes it more expensive for them to raise money (a victory for people who sign up to theory one). But this lower valuation will also raise their return outlook, which leads to some problems if you believe in theory two. It might still be a dud. But the outlook for a dud when you pay $10 a share is better than at $50. And, at some point, that dud might be cheap relative to its prospects, no matter how toxic you think it is.
It should hopefully be obvious from the descriptions above that these two theories can run into conflict. And this push and pull is at the centre of lots of hand-wringing about what sustainable investing is supposed to be about.
I have a leaning towards a third way, where the market gets many of the big-picture calls approximately right, but there is still plenty of scope to identify areas where less prominent risks are not priced in effectively. And, under this framework, because good companies trade on higher valuations, companies have an incentive to become better. And investors who back companies which do so, and who engage with companies to encourage them on this journey, will make money from their rising valuations. This twist to the original theories means you can have your cake and eat it: impose a higher cost of capital on bad companies without giving up the potential for higher returns. Win-win.
So are sustainability risks reflected in valuations or not?
To answer this I’ve used data from Schroders SustainEx model. This quantifies and aggregates the dollar-value of the negative and positive impacts that individual companies have on society, and scales this relative to their sales. This scaling tells us how material these risks are for the company in question, and makes it easier to compare one with another. For more information on SustainEx, please see here here.
By splitting the constituents of the MSCI All Country World Index (MSCI ACWI) into four buckets (quartiles) for SustainEx, worst 25% to best 25%, we can answer the question: do more sustainable companies trade on higher valuations? I’ve also done the same but for each of the Environmental and Social metric-groupings within SustainEx. This is shown below:
Bad companies (based on the SustainEx overall figure) are valued at 17-times their last 12-months earnings. But good companies are on 25-times. In other words, if both companies had the same earnings, the good company would be worth roughly 50% more. It’s a similar story if we look at the forward price/earnings, or the price/book, valuation multiples. Good companies command much higher valuations.
Most of this comes through the environmental channel. Companies with top quartile outputs for the environmental metrics within SustainEx trade on much higher valuations than those in the bottom quartile. Differing social risks result in smaller differences.
It is also interesting that companies which are in the top quartile for SustainEx overall trade on higher valuation multiples than those in the top quartile for the environmental or social metrics individually. This poses an intriguing possibility. There may be an additional valuation premium on offer if a company can be great across a wide range of sustainability criteria, rather than, for example, environmental considerations alone.
If you’re a sustainable investor with a penchant for theory one, this should all make you happy. Worse companies have a higher cost of capital than better ones. Environmental sinners are hit hardest.
But, if you care about returns, this may be less welcome. It costs more to invest in the cream of the crop. The “sin-spread” between valuations of good and bad companies will eat into any return uplift you may have hoped for based on their differing prospects.
But hope is not lost. More limited differentiation between companies based on social credentials suggests that investors focussed on those areas may find it easier to unearth under-appreciated risks.
Is this the same for all sectors?
There is a high level similarity. But lots of differences. And this is where it gets interesting.
First, the similarity. In all sectors other than real estate (which includes a lot of REITs, which tend to be valued differently to regular companies), companies which are run more sustainably than their sector-peers trade on higher price/earnings multiples than those which are not (Figure 2).
But it is in a few high profile sectors where the difference really stands out.
The most sustainably run materials companies are valued at 23-times their last 12-months’ earnings, compared with 13-times for the least. It’s similar for energy companies (19-times for the best vs 11-times for the worst). In both cases, it is their differing environmental risks that are most priced in (Figure 3).
To me this makes sense. These industries are portrayed as the bad guys when it comes to environmental impact. They are under the spotlight more than most. So it goes to figure that the market will have differentiated more between them, marking up those who are better placed to navigate the coming decades, and down those who risk being in the firing line.
In the financial and industrial sectors, more sustainable companies also trade on noticeably more expensive valuations. (The price/earnings multiple is not commonly used to assess financial companies but it is also true that top quartile financials trade on higher price/book multiples, a more popular measure of their valuation, than bottom quartile ones.)
The IT sector is an interesting one. Investors appear to differentiate quite strongly between companies based on the environmental risks they run. But when assessed across the combined E, S and G criteria, that differentiation largely falls away. The extent to which the market has differentiated between good and bad companies in other sectors is much more limited.
The other thing which jumps out is that the market hasn’t really priced in the differing social risks that companies are running. The light blue bars are low for most sectors.
Some clear trends: investors have woken up to sustainability risks only recently
What is really interesting is that it is only in the past few years that the market has started to pay more attention to environmental risks. Before around 2017/18, it didn’t matter as much to investors (at least in aggregate) whether a company was damaging the environment or not. Valuations on good and bad companies were more tightly bunched (Figure 4).
But, as Figure 4 shows, many sectors have since gone on an uptrend. Yes there is noise around these trends, as you’d expect due to things like covid, the war in Ukraine, and other factors. But the direction of travel is clear.
Notably, even in some sectors where the level of investor-discrimination on environmental risk is still low, it has been increasing. Communication services (shown below) is a good example. As is consumer staples.
These changes roughly coincide with increases in the financial cost of emitting carbon. For example, for most of the previous five years, the price of carbon permits on the European Union’s Emissions Trading System (ETS) was less than €10. But that more than doubled to above €20 in 2018, hit €30 in 2019, and soared in 2021 and 2022. It reached close to €100 in early 2022.
The health care sector is worth a closer look. These companies have relatively low impact on the environment, certainly compared with many others. But, before covid struck, investors had been pricing more environmentally-friendly health care companies on increasingly higher multiples than their more damaging peers. Then covid happened and other priorities suddenly mattered more. The pre-pandemic trend went into a hard reverse. Even on a monthly basis (as opposed to the rolling 12-month average figure shown below) it is still the case that the less environmentally-friendly health care companies trade on higher valuations.
It is also the case that there has not really been any traction in the pricing in of social risks – the chart for the consumer staples sector below is fairly representative.
Opportunities for everyone
Whether you like theory one, theory two, or my third way, this should all make you happy. There is evidence that bad companies in the most high profile sectors already have to pay a higher cost of capital/trade on a lower valuation than good companies. And a potential 70-80% rise in company value is one hell of an incentive for bad energy and materials companies to become more sustainable.
But there is also evidence that, for many other companies and sectors, the market hasn’t yet held their feet to the fire. Which means there is scope for returns to be earned by researching and identifying the leaders and laggards.
Also, as a general rule and across most sectors, there appears to be more differentiation in valuations on environmental sustainability (an area where more investors and asset-owners have clearly articulated policies, and where industry-wide transparency and pressure has been greatest). And not as much for social risks.
Investors are essentially saying that it doesn’t matter to a company’s prospects whether it treats its employees well or if it sells products which cause ill-health (and the financial consequences of such ill-health). Maybe they’re right, but I suspect not. These social impacts matter to a company’s sustainable growth rate in the long run. And, if I’m right, then we should see investors start to differentiate more on these grounds in future. The differentiation we see today on the environmental front offers a glimpse as to what might be to come.
So, you can have your cake and eat it: punish bad companies and earn higher returns. But you’re more likely to be able to do so if you look beyond headline stock market indices and dig into individual companies and sectors.
No one said this would be easy.
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