Many stocks with poor environmental, social & governance (ESG) credentials are being heavily disrupted, several investments experts told Trustnet, and could be potential value traps.
Christopher Rossbach, manager of the offshore $115.9m J. Stern & Co. World Stars Global Equity fund, said investors backing value stocks could actually be investing in some of the worst ESG and climate “culprits”.
He said: “If you really think that value stocks are going to perform, for the most part you’re saying that it’s actually the climate culprits, the ESG culprits, that for some reason are going to start performing now for cyclical reasons or [that] because they are out-of-favour people are now going to put money into them.”
Rossbach questioned whether any investors were still buying into fossil fuel companies, which are the most obvious example of the ‘climate culprit’ value stocks.
“Their big capital assets are effectively becoming stranded,” he said. “It’s just becoming increasingly obvious that there’s actually much more oil in shale than is ever going to be needed.
“All these expensive offshore reserves that they pumped money into when they didn’t know how to replace the oil they produced, are now heading towards a marginal value of zero.
“We’re heading into a renewable world where we are going to be able to produce all the energy that we need within our lifetime, from solar, wind, alternative technology, and where we’ll be able to transmit it and store it.
“Then what will we do with a nuclear power plant that has to be decommissioned or oil reserves that are 20,000 feet under the ocean?” he asked.
Meanwhile, Chris Iggo, chief investment officer of core investments at AXA Investment Managers agreed that fossil fuel companies are most at risk of climate change and becoming value traps.
He said: “If they are the contributors and therefore they’re going to get kind of punished in some way, or if their business model has a real need to transition, they are value stocks that might get stuck in a value trap.
“If you’re an oil company that doesn’t change, and the world moves in the way we think it’s going to move, you’re going to have oil reserves that are stuck in the ground, and they’ll be worth nothing. Whereas today, they’re valued at something.
“Once those assets become valueless – i.e. stranded assets – the value of those companies never recovers.”
Polluting carmakers were another example that Rossbach highlighted. Manufacturers who do not adapt their businesses towards electric vehicles will be left behind, but even if they do, he believes they are still exposed to becoming disrupted.
“I think we’re heading towards car sharing and towards autonomous driving,” he said. “It’s going to be systems providers.
“Who knows whether it’s VW, or Toyota, or GM, or Tesla, that are going to be the systems providers for global urban mobility or Google through Waymo, but it’s coming.”
Performance of growth versus value over 3yrs
Source: FE Analytics
Over the last few years, ESG investing has risen in popularity as has the divergence between the performance of growth and value stocks, with growth outperforming value by over 60 per cent over three years.
However, Axa’s Iggo said whilst many growth companies may have strong ESG practices, or are directly helping the climate transition, or are disrupting industries with new technology, there are still pitfalls.
Iggo said: “It’s alternative energy, it’s electronic vehicles, it’s carbon capture, it’s all these things that contribute to a cleaner energy, and a cleaner economy and they are growth stocks.
“This is because they're starting from year zero, and if they’re successful, they’ll be the Microsoft’s and the Google’s of the future, at least for the next 30 years, but at the moment, you don't know which one’s going to be successful.
“It’s like 30 years ago, you didn’t know which technology company was going to be the most successful,” he said. “When I started working in the city, as Nokia was launching its mobile phone, everybody thought Nokia would be the winner, but it was Apple.
“So there’s a lot of private equity venture capital betting on new technologies.
“The successful ones will come into the public market domain, and they will grow, and they will be the growth stocks of the future, and those that are left behind by climate transition will be the ones that get stuck in the value trap.”
Looking at it from the societal and governance perspective, Rossbach believes banks are another example of an ‘ESG culprit’ and could be value traps.
He said: “The problem is the big balance sheet-driven banks are effectively systemic, have had to be bailed out by the government and by taxpayers, and will continue to have to be bailed out because they have not been able to adapt their business models to an asset-light model.
“This is not because of what they do to provide necessary financing to people and businesses, but because they continue to have enormous exposure to structured financial products whose goal it is to generate high returns,” he explained. “Those are too many of the assets that they have.
“They’re balance sheet driven, they trade on returns on equity and multiples of book, and they have stranded assets they can't get rid of.
“A bank has assets, liabilities and equity. The assets have to be funded by the liabilities, and ultimately both are supported by equity. As investors we ultimately have no idea what the assets or liabilities of a big bank are. We learnt that in the financial crisis.”
“All we know is that regulators, I think quite rightly, want to increase the amount of equity that’s required to support them. So, the long-term return on equity of a big balance sheet-driven bank will be highly uncertain and will always be capped by what regulators allow.”
Indeed, Guy de Blonay, manager of the Jupiter Financial Innovation fund, who specialises in investing financials, has avoided costly value traps in the sector by screening for ESG before investing.
He explained: “We have decided not to invest in companies that we thought were trapped value, or could really restore their former glory, simply because of the amount of controversies that they have been involved in the past, and it was not clear that business ethics or practice has turned the corner.”
On that basis, there are a few stocks that he decided not to invest in, including one payment processor that he chose not to name, that eventually was discovered to be tied up in fraud.
De Blonay recalled: “We’d had numerous conversations with the company prior to the final findings, but we were exercising or implementing our screening process on an ESG basis on business practice and controversies.
“We were not happy or comfortable with what we were hearing from management, despite the fact the stock was looking very attractive on a trapped value basis.
“So, sometimes screening helps you to avoid disasters.”