Can ESG investing become a bubble?
Velox fireside chat series
The Velox Fund is a pan-European equity long short investment strategy that integrates technicals, fundamentals, sentiment and catalysts in order to source repeatable patterns of market behaviour within a controlled environment of risk disciplines. From 2018, Velox became an early adopter of ESG, integrating this ethos into the firm's mission statement and core values - and from the start of 2019, into the Velox investment strategy. We are joined by Jeremy Stone, portfolio manager of the Velox Fund. Jeremy has been a portfolio manager for over 20 years. He was CIO of the Tomahawk fund at Marble Bar and the founding partner for the Velox strategy. He has managed money through several highly volatile market environments with no negative years of return. We hope to tap into his experience on how the market and investing has evolved over time.
SC: Jeremy – thank you for taking time out to have a chat on ESG and how it fits your investment strategy.
SC: Before we dive into ESG, could you give a short summary on your investment process and how you dissect the market?
JS: The market is a treasure cove with temptations everywhere. My goal is to have a process that helps me to avoid most of the shiny trinkets and focus in on what is most valuable. I do that by identifying what is repeatable in stock price behaviour, so that I can find stocks that will consistently act independently from their counterparts and the broader markets. My part in Velox is to find these repeatable patterns in stocks that have reported earnings. This event provides a vast potential for shock and price trajectory accelerations or reversals. To identify these patterns efficiently, I need to make the best use of technology throughout my process.
SC: Do you think that ESG is a factor that drives share prices? Could you give an example
JS: Yes. The starting point for me is risk mitigation. It helps me try to avoid land mines. A good example is Boohoo. The company has provided phenomenal growth and investor returns. As an internet retailer, it could not have been better positioned for the pandemic. Over previous years, we have successfully invested in Boohoo, believing in the growth trajectory and management delivery. There were always concerns around its supply chain, but the information wasn’t easily available on these type of factors as historically they have been less of a market focus. During the implementation of our ESG framework, long signals fired a number of times in Boohoo. However, the amount of concerns were steadily increasing, and the controversies were key to my decision to avoid investing in Boohoo, despite on-going strong numbers. The stock subsequently collapsed under the publicity of a press investigation into their supply chain practises.
SC: When and how did you start noticing ESG being rewarded by the market?
JS: ESG is a better articulation of something that has often been represented in companies identified by our investment process. We have always believed that the qualities of winning stocks would help them continue to win over time (and the opposite for poor companies.) So we have historically attempted to find qualitative and quantitative ways of measuring the factors that lead to that success. For us, valuation is an important consideration, but not a key driver, which meant paying up for this quality has never been much of an issue. What has changed is the articulation of these factors, the acceleration of underlying environmental and societal changes that have supercharged their importance, and the huge influx of capital that now dictates that ESG is at the forefront of investor’s and company’s minds. The exploding nature of the available data set is helpful in measuring it all. It all began to take off about 24 months ago and, as a fund that looks to adapt our signals towards what the market is rewarding/punishing the most, it meant that we had to develop more structured ways of measuring the ‘ESG’ impact. Our signals were driving us towards stocks that had strong/weak ESG metrics and these have accordingly been some of the best performers in the portfolio. As we look for repeatable patterns of behaviour, we were therefore increasingly driven to look in these areas. With a still nascent data set, there have been big gaps in how efficiently the market can price ESG factors.
SC: Is ESG more a risk factor or an opportunity factor?
JS: It is both. As above, the ability to quickly summarise key ESG metrics helps us to avoid land mines in the market. The exciting thing is that the data is still developing, and so is our functionality. For example, we are currently looking at an artificial intelligence driven machine learning data source that can measure the acceleration in controversial data points around a company. By integrating ESG factors into our risk management principles and disciplines, we are attempting to automatically remove sources of temptation and noise.
As the market, and inherently our signals, are increasingly driven by ESG related factors, there is a big opportunity available to those that have an effective process that is pre-moulded around ESG. We can be nimble as new data sources become available and we can exploit inefficiencies in the measurement of current data sources. By combining a traditional bottom up approach with an investment process rooted in more systematic patterns, we can both adapt our signals to reflect the importance of ESG factors while also engaging with companies to understand where the data may be behind or incorrect to help us build conviction. The market has traditionally focussed on the ‘E- Environment’, but there excellent opportunities in sourcing information around ‘S- Social’ and ‘G- Governance’. And, in a similar fashion, it is exciting to source ESG winners and losers within less fashionable industries.
For the Post Results signal, using our VIA app, I can be well prepped on ESG level analysis coming into the event and quickly able to assess new information as it arises in the announcement. A good example of an investment is in Corbion, a company that delivers biobased products made from renewable resources. I was attracted to the stock following its stellar Q1 results, triggering an all-time relative high in the stock price. These showed the company’s food based products benefitting from COVID-19 related buying patterns. Furthermore, positive commentary around the accelerated developments in their bioplastic manufacturing JV where they supply lactic acid, provided a further boost to the companies ESG credentials. However, as a less well known Dutch mid cap, these credentials were underappreciated. This investment was a good example of where the Post Results strategy combines well with the fundamental strategy, which had previously identified the structural opportunity. Contact with company also confirmed that MSCI data was behind when it came to incorrectly penalising them for a lack of CO2 reduction target, another point that helped build conviction.
SC: How do you currently think of an ESG premium/discount that you apply on a stock?
JS: For my investment process, applying a premium or discount is not of central importance. I look for shocks around earnings events that alter a company’s trajectory. The starting point is often to see significant technical dislocation. This drives me to look at an individual name. As in the last question, ESG has become an increasingly important factor in the outperformance of stocks, so I would look to overweight these data points when considering the potential for the stock to act independently of the market. These data points can often be closely linked with a quantitative and qualitative analysis of the underlying fundamentals, such as the track record of the management team. I would most look at the companies closest peers to interpret what the market is willing to pay for strong ESG outcomes. In my sphere, the market often has the potential to underestimate this premium/discount, so I am more focussed on looking for reasons to press an investment as this comes to fruition.
SC: You spoke about market rewarding certain corporate behaviours and the presence of repeatable patterns in the market. Thinking of the evolution of ESG into the future, do you think good ESG will always have a premium and be rewarded or will that become a norm?
JS: I think we are still so early in this energy transition and societal/cultural journey that it would be naïve to look for a normalisation of the ESG premium. Every day we are seeing new types of analysis, and the market is continually shifting its focus as the information becomes available, and this transition moves on. For example, current ESG winners in the big tech space may come under increasing pressure for the negative behavioural impact of their products in children or the resource wastage caused by their end product and endless upgrade cycle. The pace of capital inflows to ESG related investments will dictate that companies behave in a way that takes advantage of these trends. PWC recently forecast that strategies that invest sustainably will outnumber conventional funds in Europe by 2025, with assets predicted to jump threefold to reach €7.6 trillion. That said, as data sets become more widely available, it is inevitable that some of the initial inefficiencies will close.
SC: Good ESG companies have been outperforming the broad market for 2-3 years now. Do you think this is at a risk of being a bubble?
JS: There are now more than 3000 PRI signatories representing around $100tn in AUM in 2020. For PRI compliance more than 50% of AUM must be ESG integrated by the end of 2020. That means that around $50tn of "ESG-aware AUM" will be a part of the market. Predictions estimate that ESG strategies have generated $135bn in inflows since 2019 (Source: Goldman Sachs).
The numbers at first might seem large. However, over the medium term, ESG represents an era defining structural change in the market. So, outside of a low interest rates driving markets and quality stocks higher, I do not believe that the ESG factor in itself is causing a bubble. However, it does combine with some other structural and market elements such as technological change, to create crowded areas of the market. In the shorter term, I would hope that we can be nimble in spotting these areas of crowding and hedge to protect against an unwind.
SC: What do you want corporates to do better to make it easier for you to analyse the ESG credentials of a company?
JS: The silver bullet is a universal ESG reporting matrix for all companies. Perhaps along the lines of SASB. If more corporates get on board with SASB, it will be easier for them and for investors to compare them to their peers. This may be closer for large companies depending on the geography, but will continue to be out of reach for smaller size ones. However, the potential incentives on offer in terms of cheaper financing and capital inflows will make better ESG reporting a goal for all. And we have seen a significant positive change in how corporates are presenting around these issues and reacting to ESG related questions.
The other points would be alignment with EU taxonomy. With better disclosure around taxonomy alignment on corporate activities, the flow of capital towards greener activities will become faster and more efficient. Investors will quickly be able to identify the use of capital and corporates should find it easier to raise capital.
SC: Lastly, for our readers, what industry/theme/company related to ESG are you most excited about?
JS: I think the hydrogen value chain is one of the most exciting areas. Increased urgency to decarbonise has accelerated interest in green hydrogen as a solution, especially as government incentives and economies of scale lower the cost of production.
In the UK, my traditional investment heartland, signals have fired in two smaller companies deeply connected to this narrative. These are ITM Power and Ceres Power. Ceres has an asset light fuel cell technology model and ITM is exposed to PEM electrolysers. Both companies have seen investments from major corporates and have demonstrated significant technological progress. Most recently, we took part in a capital raising for ITM Power that came alongside a new blue chip partnership announcement. This doubled its order backlog, accelerating capacity build out and technological development.
Finally, it has been incredible to observe how the pandemic has super-charged some of the underlying ESG trends. As we hopefully move towards a successful vaccine, understanding where these gains are persistent will give significant investment clues for the future.