Weekend Reading #17
This is the seventeenth edition of our weekly newsletter, Weekend Reading, sent out on Saturday 18th May. Sign up here and receive a copy each week direct to your inbox.
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The case for long/short ESG investing.
Earlier this year, Bloomberg Businessweek published a scathing critique of the ESG investing world, especially ESG ETFs.
The article points out that while large investment houses discovered a gold mine by marketing ESG funds to millennial investors seeking a worthwhile cause to back, the “greenwashing” required to make these ETFs investable has resulted in ESG criteria so broad and all-encompassing that ESG ETFs find themselves invested in the likes of Phillip Morris, ExxonMobil and Coca-Cola.
To us, the idea of a passive socially responsible fund is oxymoronic (if not moronic). Even more incomprehensible is the idea that socially responsible funds must be long-only.
A look through Morningstar’s top 10 ESG funds of 2017 list confirms the broad hypothesis – the methodology that most investment houses apply to ESG investing is an exclusion criteria. So if you don’t support cigarettes, the funds cannot buy them. Same for alcohol, gambling, arms dealing or environmental exploitation.
These funds are limited by a mandate that reads something like, “The fund is not permitted to invest in securities issued by companies assigned the Global Industry Classification Standard (GICS) for the tobacco industry.” Others have slightly broader descriptors, and some even have caveats to say investment performance may be affected by taking ESG factors into consideration.
Such exclusion criteria also lend themselves to easy screening methodologies, hence the ease with which passive ETFs are created.
Both of these approaches sorely shortchange investors. After all, the opposite of “support” is not “not support”, it’s “oppose”. Going passive and “not investing” in companies with poor ESG isn’t as bad as investing in them, but it’s a long way from making a statement of conviction. Similarly, “not irresponsible” is hardly the same thing as “responsible”.
Being passively responsible actually makes very little sense. Moreover, simply applying sector classifications allows many things to slip through the gaps. A consumer staples company (not excluded) may be making highly sweetened drinks for children in Southeast Asia, while a defence contractor (excluded) in Turkey may be creating jobs and driving independence from foreign arms imports, arguably a positive externality for the Turkish economy.
So here’s our take on ESG investing. We believe poor ESG makes for poor business in the long run, and is similarly a poor reflection of the management of a company. Specifically, ESG is a driver of long-term fundamental performance. As such, ESG should not be a specialised investment class that's set aside and labelled as such (implying that every other investment we make is by extension “irresponsible”). Nor must the criteria for ESG be a box-ticking exercise. The role of the investment manager is to understand each business and evaluate it for what it is, according to the spirit, rather than the letter, of the mandate.
Therefore, ESG considerations form a core, natural part of our investment theses. Bad management sneaking cash out of the business makes for perpetually poor profits; irresponsible farming practices leading to environmental sanctions leads to fines and losses; unhealthy products leading to a widespread pushback by consumers precipitate stagnating or falling revenues. These are the very stocks that make for great short positions – they provide protection for the rest of the portfolio and carry optionality for big moves to the downside once consequences come back to bite. Long-only investing misses out on these opportunities by placing an exclusion criteria – again, “not long” isn’t the opposite of “long”; “short” is.
As economic agents in a market, our role is to seek out the fair price of assets. Simply avoiding them doesn’t solve the mispricing, but taking an active short position in these stocks in anticipation of a correction downwards does. One caveat – we’re not in the business of naming and shaming.
That’s the case for long/short socially responsible investing: because it’s not only about supporting the good guys, it’s about helping those that misbehave correct their ways via market incentives. Responsibility is active in both directions, not passive and one-sided.
What we're doing.
Silicon Valley's best kept secret isn't a piece or hardware or software. It's a man. His name was Bill Campbell, and he coached some of the world's most successful entrepreneurs (including leaders at Google and Apple), helping to create well over a trillion dollars in market value. His genius was to ask, "If sports teams hire coaches to manage star players, why don't companies do the same?" This week we've been thinking about Campbell's legacy and the nature of teamwork, after reading a brilliant book called "The Trillion Dollar Coach" by Eric Schmidt, Jonathan Rosenberg and Alan Eagle. This has really got us thinking. We're open minded about finding a coach for our team here at Three Body Capital, so if anybody springs to mind, please drop us a line.
What we're reading.
Alignment of interests is a concept that's close to our hearts and one that's informed our business from the bottom up. Nassim Nicholas Taleb’s latest masterpiece, catchily entitled “Skin In The Game”, challenges conventional wisdom about risk and reward, politics and religion, finance and personal responsibility. Taleb once traded options, so he knows a thing or two about asymmetry. In this book he does a great job laying out the intellectual framework that underpins our intuitive approach to managing and connecting capital here at TBC.
What we're watching.
Here at TBC we love to cook recipes inspired by our travels in emerging markets. And now we've found the perfect show to recreate that experience at home. In Salt Fat Acid Heat, chef and food writer Samin Nosrat travels the world to explore the four basic keys to wonderful cooking. The show demystifies the core principles of what makes food delicious and shows how everybody can incorporate them into their cooking. It's a beautifully filmed series that's about more than food – it reminds us of the enduring importance of culture and tradition in contemporary life.