Burton Malkiel’s Misguided View of ESG Investing

Forward-looking corporate management teams see ESG issues as foundational to their ability to successfully transact business in a world of complex supply chains and competition for skilled employees. These perspectives are borne out by hundreds of corporate sustainability or responsibility reports, many of which zero in on the most financially material and industry-appropriate of the United Nations’ 17 primary sustainable development goals (SDGs).

These reports are encouraging, but to prove that ESG investing is not a fad, we need to look deeper, into the interplay between ESG investors and corporate management teams across a broad spectrum of industries.

The value and ESG mindsets

As a value investor, I look for stocks that are cheap. Active value investors like myself try to identify companies with attractive valuations relative to their intrinsic value, with an expectation that eventually – due to a business-specific or macroeconomic catalyst – more investors will come to see a company’s inherent worth and reward it with a higher stock price.

The discipline of active value investing has been around for decades. Both empirical evidence and academic research support its usefulness as part of a broader investment portfolio. It's not a fad (just ask Warren Buffett).

At an intuitive level, value investing is about seeking out companies that are or may be getting better. Value investors seek to recognize business improvements in beaten-down stocks, among others, because what’s beaten down today may be leading the way next month or next year.

The value and ESG mindsets have much in common . Both require attention to financially material areas for improvement in companies’ businesses. Both may actively support positive change. And both require an awareness of the larger context in which a company does its business.

With all this in mind, let’s circle back to Malkiel’s theory. He argues that if investors shy away from certain stocks for ESG reasons, eventually those stocks should become cheap and therefore attractive to non-ESG investors; eventually, shunned stocks will outperform and ESG investors will therefore underperform.

That theory misses how companies themselves are likely to respond to that cheapness. Like other companies in value-stock territory, those hypothetical firms will take avenues to improve their businesses. And some of those avenues will be along ESG dimensions.

And many already are incorporating ESG. In a 2019 study of 1,000 CEOs at companies across 100+ countries in 25+ industries, 99% of CEOs said they recognize sustainability as important to the future success of their business, and 48% are actively implementing sustainability into operations.

In our work, as is true for many actively managed ESG strategies, we are focused not only – and not even primarily – on companies that are already functioning at a high level across ESG factors. As both value and ESG investors, we are particularly interested in companies that are improving.

Both investors and management teams understand that. Malkiel’s hypothetical beaten-down stocks, therefore, are just as likely to attract ESG investors as non-ESG investors.

Broad industry relevance

But what about energy-related stocks? That’s another topic raised by critics of ESG investing, who hold that leaving out energy stocks may goose returns when energy is underperforming as it has for many years. Malkiel also made this argument.

Here, too, the value investor’s mindset applies. We are interested in improvements in ESG factors, which does not prescriptively eliminate all energy or energy-linked stocks.

One example from our current portfolio is Valvoline Inc. (VVV). Valvoline runs its oil and lubricant production facility with close attention to water use, employee safety and other material – and measurable – ESG-related metrics. The business is not high growth, but it generates substantial free cash flow that Valvoline is channeling into its other business, Valvoline Instant Oil Change (VIOC).

We think VIOC is undervalued by investors for its potential to service electric-powered cars, many of which are not sold in a traditional dealer model with accompanying service departments. VIOC is paving the way to add this growing market to the cars that it currently services.

Valvoline is a good example of a company excelling in material ESG factors in its current businesses and positioned to further benefit from important environmentally positive macro trends.

ESG analysis is integral to our investment analysis because sound ESG fundamentals are innate characteristics of sound businesses – not just a pleasant add-on.

Closing thoughts

As more companies and management teams incorporate sustainability into their operations, the most skeptical investors, and possibly even Malkiel, will be hard pressed to argue that ESG is a fleeting or “self-defeating” strategy. The more mainstream it becomes, the more ESG investors – like value investors – will be there to analyze the results

Neither is a fad. Both have long histories of success (ESG since the early 2000s and value investing for decades more). But more to the point, both support investors’ ability to make money.

Further proof of its staying power can be seen by its steady growth, incorporation of ESG factors by hundreds if not thousands of public companies, and the desire of investors to invest in companies that focus not just on profits but how profits impact the environment and our communities. All this plus a chance for investors to do good with their money, means ESG investing is not a transient trend. And that is a very good thing for all of us.

Adam Peck is founder and chief investment officer at Riverwater Partners, which manages ESG strategies for institutions and individuals with a focus on small- and mid-cap stocks. Learn more at https://riverwaterpartners.com/.

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