Professor Damodaran’s Latest ESG Takedown Overlooks One Important Group of Investors
Valuation matters. So does understanding financially material ESG risks.
Safe to say, Professor Aswath Damodaran of New York University--often called the “Dean of Valuation”--is not a fan of ESG investing, or investing according to environmental, social and governance factors. In his latest salvo against the topic, he says, “I believe that ESG is, at its core, a feel-good scam that is enriching consultants, measurement services and fund managers, while doing close to nothing for the businesses and investors it claims to help, and even less for society.”
And the criticism only intensifies from there; in his concluding remarks, Damodaran writes, “I am convinced that there will soon be room for only two types of people in the ESG space. The first will be the useful idiots, well-meaning individuals who believe that they are advancing the cause of goodness, as they toil in the trenches of ESG measurement services, ESG arms of consulting firms and ESG investment funds. The second will be the feckless knaves, who know fully well the void behind the concept, but see an opportunity to make money.”
But we see one yawning gap in the professor’s argument. There’s a third group that Damodaran overlooks: investors who want to better incorporate E, S, and G data into their analysis and aren’t prioritizing “saving the world” in their investment holdings. This group is focused on valuation of its investments, rather than expressing its values in its investments--the latter being a secondary consideration to the former.
That’s not to say that ESG considerations are unimportant; it stands to reason that, as companies disclose more environmental and social information (because of mandated disclosure or their own volition), investors may increasingly incorporate this data into the pricing of stocks. In addition, consumers may make choices with their dollars that align with their own sustainability preferences. Understanding financially material risks that consumer choices, increasing regulation, and scrutiny of management governance practices have on a company’s future cash flows is a prudent part of a holistic investment decision, not a foolish endeavor meant to “do good” or bilk clients.
We view ESG akin to any other potential risk or opportunity facing a company. It may be that carbon emissions mean nothing for a software-as-a-service company and can be safely ignored. Likewise, a coal company may be substantially undervalued if a large pension fund is unloading shares to such a degree that it overly discounts how quickly demand will erode.
Ultimately, we believe investors’ primary goal should be to seek opportunities to purchase shares of businesses trading at sufficient discounts to their fair value estimates, in order to generate a suitable rate of return. Understanding key ESG risks and opportunities as part of this process is a feature of greater ESG disclosure and focus--not a bug we should squash.
So, where does this leave sustainable investing? We think it’s critical to separate risk from impact when considering ESG goals, especially when the relationship between the two can be positive, negative, or even nonexistent depending on the situation. When considering ESG risk specifically, investors focus on potential threats (or opportunities) related to companies’ bottom lines; any consideration of a company’s potential positive impact relates only to the future return on investment it could generate. It’s possible that a company driving positive impact may reap solid returns for doing so, but that fact is not a given. Many firms have been punished by investors for ESG-friendly activities that have weighed on the bottom line, while some negative-ESG firms haven’t faced a comeuppance.
To this end, some of Damodaran’s sharpest comments focus on the merits of investing primarily to drive positive societal change. To sum: The secondary public equity market reflects the blended opinion of billions of investors, and the continuous change in prices reflects constant debate about the future of each company. It’s those disagreements that create opportunities to purchase shares at discounts. If all investors agreed and were always right, every asset would be priced perfectly. Thus, trying to drive societal improvement through these same markets is like trying to write a book by crowdsourcing. Something legible may come out, but most would argue it wouldn’t be very good. It will be watered down, rife with conflicting opinion, and subject to outside pressure; as one example--as Damodaran notes--“all that ESG activists have managed to do is move fossil fuel reserves from the hands of publicly traded oil companies in the US and Europe, who would feel pressured to develop those reserves responsibly, into the hands of people who will be far less scrupulous in their development.” After all, someone has to be on the other side of that trade.
This line of thinking holds some merit. That said, while we also harbor concerns regarding the positive impact that can arise from simply divesting “bad” companies and investing only in “good” ones, we acknowledge that there are ways investors can influence companies, such as proxy voting or active engagement with management. This is, of course, difficult for individual investors, but pooled funds seeking to drive these benefits have means to do so. Moreover, the landscape will likely continue to evolve to open new opportunities for impact-minded investors.
But for primarily return-minded investors, there’s an important distinction to consider when incorporating ESG into an investment process--what “needs” to happen and what’s likely to happen. For a more sustainable future, science will prevail, corporations will successfully balance the fine line between shareholder and stakeholder capitalism, and externalities (like carbon prices) will be fairly shared as internalized costs by consumers and investors alike. But, as investment professionals, we must always focus on what is most likely to happen; that is, what has the highest probability of occurring? In this case, the judgment should not be focused on good versus bad but on separating the ideal future and the likely future--perhaps a cold truth, but a pragmatic one.
Editor’s Note: The views expressed in this article are the authors’ and do not necessarily reflect the views of Morningstar.