With the current turmoil in capital markets, high inflation, geopolitical crises and political winds blowing like a hurricane on ESG, there seems to be a strengthening movement to look for something other than stock price and ESG-focused investment strategies as a way to find specific economic value in ESG initiatives. Many articles attempt to couch that in terms of “integration of ESG” which to me is ambiguous, so I take a different approach. Some may believe this is simply semantics, but in this case I disagree. I believe clarity is critical in communicating the business value of ESG – especially now.
For years, I preached the value is best conveyed and managed in terms of operational business fundamentals – the “blocking and tackling” of revenue generation, cost management and new market development. I believe if a company is profitable and manages itself well, stock price and capital market recognition will follow. Conversely, managing a company without regard for fundamentals is, well – problematic (recall Enron in the past, Nikola and Theranos not long ago and FTX today). In the ESG context, I call that “sprinkling ESG fairy dust on shares.”
The anti-ESG movement has a strong foundation in ESG fairy dust as the accusations leveled against companies, law firms and investment firms claim that ESG conflicts with business fundamentals and fiduciary responsibilities. In my opinion, one of the best ways to remain unsnared by those arguments is to find and execute ESG initiatives that obviously and directly benefit operational fundamentals. There aren’t going to be too many politicians (or others) pushing companies to not make money or be more profitable.
Below are my thoughts on this topic with are perhaps more timely than ever. This is adapted from a post earlier this year and the 2022 update of my book Killing Sustainability which is now available on Amazon in Kindle and paperback.
If Cash is King, Let it Reign
It frustrates me in discussions about ESG and finance that revenue, cash flow and operating environments tend to be ignored. I don’t know why that is. Without revenue, there is no sustained return on investment – and no company.[1 While a company can operate at a share price of zero or with no public shares at all, its options for operating at zero revenue are limited.
It is almost silly to mention that operating revenue/profits and cash flow are separate from stock price. Although theoretically, capital markets value shares based on an assessment of future revenue/profits and current asset value (e.g., plants, property, equipment and intangibles), stock prices fluctuate wildly for other (sometimes irrational) reasons.[2] Nobel laureate Robert Shiller once said, “Fundamentally, stock markets are driven by popular narratives, which don’t need basis in solid facts.”
There is opportunity in ESG-based revenue. During a December 2021 webinar sponsored by Responsible Investor, then CalPERS Managing Investment Director, Board Governance & Sustainability Anne Simpson mentioned specifically that CalPERS seeks out revenue growth opportunities with their ESG criteria – pointing out that they buy stock based on the expectation of future revenue. That view of “revenue first, then market value” seems uncommon with respect to ESG and finance.
As an example, there was a feeding frenzy by investors for new electric vehicle manufacturers in the U.S. going public through special purpose acquisition companies (SPACs) in the first part 2021. These automakers had no manufacturing or automotive experience or proven revenues. As the year wound down, the lack of revenue reality set in for those that didn’t appreciate fundamentals initially, and shares in those companies plunged.
McKinsey valuation guru Tim Koller is an advocate for real earnings growth, criticizing earnings per share (EPS) and “growth” based solely on cost cutting: “… earnings growth without a return on invested capital exceeding the cost of capital will destroy value. Similarly, earnings growth based purely on cost cutting, not organic revenue growth, is not sustainable.” He is also critical of company actions like earnings smoothing as “wasted energy” especially since “investors see through earnings smoothing that is unconnected to cash flow.”
On the other hand, some companies make revenue-losing decisions based specifically on ESG initiatives. Presumably, they thoughtfully consider the financial losses incurred and are willing to take that loss, or they will make it up in other ways. These companies are essentially making investments in their future revenue. They likely see a PR benefit in taking these actions, expecting to gain new customers that are philosophically aligned with these moves, or strengthen loyalty of existing customers.
Privately held Patagonia refuses to sell corporate co-branded merchandise to companies that are not aligned with Patagonia’s own environmental ethos. Global PR powerhouse Edelman – also privately held – announced in January 2022 they will cut ties with clients that are not allied with their views on climate change (i.e., carbon intensive industries).
Publicly traded companies have made similar moves, although it is fair to ask whether their actions were initiated by shareholders (and therefore if the companies responded to investors rather than revenue drivers organically). Examples include:
• Walmart eliminated the sale of handguns, sporting rifles and certain ammunition;
• CVS eliminated the sale of tobacco products; and
• Dick’s Sporting Goods eliminated the sale of assault rifles and high-capacity magazines.
Further support comes from McKinsey, which contends that one of six features of the Net-Zero transition through 2050 is that it will be “rich in opportunity.” They highlight prospects for new revenue and reducing direct operating costs, which then improve profitability/margin. Meaningful cost savings will be harvested over the long term from decarbonizing processes and products. In the near- to mid-term, new customers (i.e., revenue) will increase with demand for decarbonized products and suppliers from multiple directions:
• Decarbonizing process and products;
• Replacing high emissions products and processes with low emissions ones; and
• New service offerings to aid decarbonization, such as supply chain inputs like transportation.
I sum it up by ripping off the old “parts is parts” Wendy’s commercial from the 1980s – fundamentals is fundamentals. The disparity between business fundamentals reality and “artificial” investment management barriers creates massive opportunities for some.[3] Share price is frequently influenced by fantasy, hopes, internet memes, Reddit groups or worse – generating returns for high-frequency and stock manipulation traders. But it is antithetical to long term ESG benefit and can be illegal. As Ulrich Atz of NYU Stern School of Business stated in his study of studies (Does Sustainability Generate Better Financial Performance? Review, Meta-analysis and Propositions), “mechanically linking ESG to alpha can lead to specious results for a range of reasons.”
[1] Interestingly, in A Framework for Avoided Emissions Analysis from Singaporean investor GIC and Schroders, the authors specifically tied avoided emissions to revenue: “The analysis further substantiates that companies with positive Avoided Emissions exposure saw revenues grow by an annualised rate of 7% over the past three years, which are 20% faster than the MSCI ACWI IMI stock universe as a whole.” Similar results were published in another study by global asset manager Fulcrum in 2022. Neither study offers an explanation about causation and it isn’t immediately apparent to me. In my opinion the old adage “correlation is not the same as causation” applies here. Alex Edmans has also cautioned about this specifically in relation to climate matters and capital markets.
[2] For instance, stationary exercise bicycle maker Peloton saw their stock drop 16% over two days when their product was visually associated with the death of a fictional character on the 2021 reboot of the TV show Sex and the City. Peloton felt compelled to respond and attempt to reclaim the loss in value by making a commercial with the real-life actor saying he was fine.
[3] The attempt by investment fund Third Point to break up Royal Dutch Shell is an example. One observer said that Third Point “might have done Shell a favor by highlighting how cheap the stock is. By [Third Point’s] own calculations, the market is assigning zero value to the upstream, refining and chemical businesses, which still generate the bulk of operating cash flow. So, while a separation might not occur, share price appreciation could just be based on traditional business fundamentals.” Another example of capital markets disrespecting fundamentals of cash flow.
