Fund managers from RWC and Fidelity have warned a dotcom-style bubble could be forming in ‘ESG stocks’ as socially conscious investors begin allocating their money to companies based on their ability to tackle climate change rather than generate cash.
However, their peers at Liontrust and Hermes have rubbished this idea, pointing out that while there is always a risk of valuations becoming excessive when a theme becomes flavour of the month, there is no evidence of this so far.
Many commentators have referred to 2019 as the year ESG (environmental, social & governance) investing went mainstream, with the major asset managers either launching specific funds to tap into this theme or claiming to incorporate it into their investment processes.
With strategies such as Kames Global Sustainable Equity and Liontrust UK Ethical delivering top-percentile returns in the IA universe last year, it would appear this is a powerful trend that investors should think about tapping into.
Performance of funds vs index in 2019
Source: FE Analytics
However, Graham Clapp, manager of the RWC Continental European Equity fund, said that valuations in this area have started to detach from fundamentals.
“We have seen numerous examples where markets are being driven by theme investing – buying companies just because they have an ESG angle, regardless of whether or not they're actually executing very well,” he explained.
“For example, we've had multiple profit warnings from the largest manufacturer of offshore wind turbines globally, yet this is not being reflected in the share price. Whilst we may see a short-term drop immediately following a warning, this very quickly rallies back and then moves higher, despite the stock looking quite expensive.”
Clapp attributed this to a focus on the longer-term potential for wind-turbine energy generation, regardless of what the individual company can deliver.
He believes such behaviour could create a bubble akin to the one seen during the dotcom boom of the late 1990s, when anything related to the internet surged before ultimately collapsing.
Back then, he said, “people wanted to have exposure to the new economy stocks, so a lot of money poured into certain kinds of business models and valuations were pumped up and incredibly stretched”.
“When such large influxes occur – as we’re currently seeing with ESG – then supply and demand means the price is going to change.”
Clapp added: “Back in the late-90s a lot of these tech stocks went from 20x to 80x earnings, before subsequently falling back to 30x.
“We’re not quite there yet but it’s getting to the point where anything related to hydrogen or other green technologies, for example, is all up 100 per cent in six months, despite the fundamentals not having changed.
“Clearly some of these businesses may well be the future, but what we are saying is investors must look at the fundamentals, or else they may suffer the same fate as investors in the early 2000s.”
Himsworth accepted that the desire to live more sustainably is gathering momentum, which will create compelling long-term investment opportunities. The problem, he said, is that too many investors are now chasing the same small number of sustainable stocks, an issue that is likely to be compounded as the growing appetite for divestment means trillions of dollars of assets pulled from oil & gas stocks will need to be reallocated.
“Investing in companies who are already sustainable or are transitioning towards being more sustainable has to be made at a controlled pace, otherwise we could find ourselves in bubble territory,” he explained.
“For instance, moving capital from traditional oil companies to renewable energy companies is difficult to perform quickly due to the relevant size of the sectors and companies – BP has a market capitalisation of nearly £100bn, whereas ITM Power, a manufacturer of hydrogen energy solutions, is only just touching £600m.”
“I would argue other larger bubbles currently exist in the market, although in some cases these areas overlap and stretch valuations,” he added.
“But it is important to remember that ESG is not an asset class, it is rather a category of information and considerations that needs to be integrated into any and all investment decisions.
“Some companies solving some of the world’s environmental and social problems have the potential to thrive. But as investors, the price we pay for such companies matters as we need to make a return on our investments and therefore buying today’s greenest companies regardless of price is naive.”
Peter Michaelis, manager of the Liontrust UK Ethical fund, admitted there have been a couple of occasions over the past year where he has taken profits on stocks when their earnings multiple has exceeded the price in his model. However, he pointed out this is simply a function of stock markets and active management.
“It is always very hard to comment on the whole market. All I can comment on is the way that we see the stocks that we are investing in,” he said.
“I am not sitting here thinking every stock I want to own is overvalued. The Investment Association periodically says how much is in sustainable investment strategies and it is under 5 per cent of the market. To liken it to the dotcom era when every single asset manager was going like fury into tech is wide of the mark.”
The manager has been running Liontrust UK Ethical for nearly 20 years and said that overexcitement about renewables is nothing new – he has seen it all before with solar energy and biofuels.
He noted that he has been able to outperform throughout this period due to a strong discipline based around earnings and valuation, while gaining exposure to areas that look set to deliver strong growth over the long term.
Performance of fund vs sector and index under manager
Source: FE Analytics
Responding to the managers who warned that investors shouldn’t blindly buy up ESG stocks without first assessing their business fundamentals, Michaelis replied: “Well, thank you Sherlock. I guess it's a valid point to make, but it's such an obvious one.”
He added: “The reason why active management can deliver strong returns is if you take a different approach and that approach is right.
“The way we differ is we believe most investors underestimate the persistency and strength of growth that companies exposed to these sustainability themes will experience.
“If you believe nothing's going to change in the world, and the economy in 10 years' time is going to look exactly like the economy today, then you're going to come to a very different view and you are going to think it is a great idea to buy BP, Shell and British American Tobacco.
“We have a very different view – we look around, we see the world is changing and we see it is changing rapidly,” Michaelis finished.