Can I summarize the results of a long-running debate about investing for good, in a few bite-sized takeaways?

Investment ESG (Environmental, Social and Governance) studies show certain quantitative anomalies.  However, many of these can be criticized for their cherry-picked data reflecting random biases that benefit from hindsight.  Manipulating a study to show a predetermined result isn’t proof of anything.  Here’s a summary of some findings that do shine through:

Investing for bad can be rewarding.  Theoretically, buying what others shun, it might make sense intuitively, should be profitable since the price of entry would be lower than it otherwise might be, and these types of badie companies often pay dividends accruing over time regardless of their poor corporate behavior.  For example, “badie” companies like alcohol, gambling, tobacco, weapons, and fossil fuel companies, each have their ups and downs.  However, unless a study’s start or end points are set at their highs or lows, respectively, the total returns of badie stocks are in fact pretty good.

As far as the G in ESG, a company’s governance, significant profits can be gained by investing in companies for policies and practices promoting board independence, oversight, diversity and accountability over management.  Many technology companies have poor executive compensation or weak shareholder rights, yet they are frequently included in ESG funds and have been quite profitable despite poor G marks.
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Moving on to the S, social, employees are motivated by more than pay and benefits.  Happy, educated, diverse and motivated employees, given the opportunity, do better work.  This can be surveyed directly or scraped from social media sites like LinkedIn or Glassdoor.  We utilize such data for individual stock picking or purchase it in the form of the Human Capital funds.

Human capital is not accounted for on financial balance sheets and can otherwise be difficult for investors to measure.  Studies show higher investment returns associated with superior human capital, as much as 4% higher returns annually according to one study of historical data.

Finally, an analysis of the E factor is great at identifying future environmental risks but has actually been shown to have been a bad predictor of enhanced stock market returns.  This makes sense, as a company dumping into the environment spends natural capital whose toll will be paid by the ecosystem, to the detriment of future human generations and life on Earth, rather than by shareholders and the companies themselves.  Poisoning the environment can be profitable, unless corporations are held to account for their misdeeds, so the hope is that reporting their environmental records and management policies publicly might in the future hold them accountable,  Still, regulators must do their jobs because the investment markets reward shareholders for their companies’ future profitability, not for their pollution control or renewable energy investments (as evidenced by very poor stock market returns of most solar cell manufacturers).

One example, while not a corporation, is the recent case of a Maine seacoast homeowner who poisoned her neighbor’s trees with the herbicide Tebuthiuron to open up her ocean views.  The neighbor had their soil tested.  This led to $1.7 million in fines and settlements for killing the trees and leaching poison into adjacent parkland and waters.  If the perpetrator were judged in high regard only for her service as head of the half billion dollar St. Louis Community Foundation charitable endowment, which I suppose would be the S or social contribution if we’re looking at it from an ESG perspective, then she might be rated well ESG-wise, even though obviously environmentally atrocious.  If nobody paid attention, she would have gotten away with it.

Pay attention.  If we don’t like what we see, we stay away, period.  As the saying goes, there are plenty more fish in the sea.

The top six Big Tech stocks, as represented by Alphabet (Google), Amazon, Apple, Microsoft, Meta (Facebook) and NVIDIA, are big, profitable businesses to be sure.  Likely to get bigger?  What can be said is that the rest of the world has gotten smaller, relatively speaking.

Combined, the six Big Tech stocks are worth more than all the national stock markets of Europe.  They are worth nearly half the stock market capitalizations of Asia, including China, Japan and India.
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The market value of the U.S. technology sector is worth almost 40% of the U.S. stock market.  The six Big Tech stocks compose two-thirds of all U.S. technology stocks.
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Big Tech, bigger than Europe’s stock market.  Big Tech, greater than China + Australia.  Big Tech, larger than Japan, India + Canada.

I recently attended talks on residential energy conservation and the Massachusetts state energy and climate action plan, at the local Hitchcock nature center.  This followed a conference I attended by Historic New England on sustainability themes, environmental, social and economic, not exactly the traditional stuff of stuffy museums or historic homes.  I came away with the following investment ideas:

First, diversity and inclusion were featured.  Done well, as with anything, these initiatives enhance the entire organization, revitalizing the organization’s mission and making its work more productive.

Second, the process of addressing climate change is underway.  Questions have been asked yet answers about who will pay for constructing new physical infrastructure remain.  The expensive stuff won’t get built out of charity.  Expertise and skilled workers are needed.  It’s going to require policy changes and planning, along with a broad mandate politically.

Third, the state’s climate plan doesn’t address embodied carbon, energy that had been used to construct what is already in place, and affordable housing.  Historic structures require labor (along with insulation and updated equipment) to restore and modernize.  In New England, developers have repurposed vast mill complexes for housing, schools and businesses, as well as local community housing trusts have worked to enhance historic neighborhoods within the center of walkable, bikeable towns and cities.

The seeds of several potential investment ideas came out of attending these conferences, especially with regard to investing in community development financial institutions.  I met many wonderful people, no investment advisers … without a doubt, everybody has their thing that matters most to them.

The role of dividends has been overlooked by stock market investors in recent years.  Particularly outstanding investments these days for their dividend yields are utility companies, whose stocks are among the highest yielding, 3½ to 5%, or even more in some cases.  Utility company stock prices have been battered by rising interest rates, i.e., the highest short-term rates since 2001 and for long-term the highest rates since 2007.

Companies that buy back their own stock instead of paying cash dividends could also be solid gainers, although returns would come from their rising stock prices rather than from cash deposited into your account.  For example, Apple has bought back $400 billion of its own stock over the past five years.  Some managements and corporate boards prefer stock buybacks because they increase the price of the stock as well as the stock option compensation executives and employees receive, often the primary means of compensation for managements and board members, while Apple investors meanwhile are paid a measly 0.5% cash dividend.

This is why it can be better to have cash in hand than dreams, but it would be a sad life indeed without hopes.

The best part of cash dividends is watching them increase over time.  Dividend growth stocks are those with a long track record of dividend increases, many we’ve held quite profitably for years.

​What to do with the cash received from dividends?  We both reinvest the cash and pile it up to reduce your overall portfolio risk, within Fidelity’s cash money market funds, whose interest rate yields are among the highest available and among the reasons why we chose Fidelity to safeguard your account.

Decades ago, market consensus held that stocks were valued for their dividend yields. Further back in history, more than a century ago, investors thought a company that paid no dividend was no good.  While such a belief might be old-fashioned, there’s still a role for dividends in an uncertain world. 

The greatest financial crisis currently in the making that few media outlets have reported on is private equity investment funds.

​Unlike the publicly offered, publicly traded portfolios that we manage, private equity is, like its name says, private, with limited oversight and transparency, maybe an audit which few investors read.  The managers of the investments are in charge and set their own valuations.  Managers pay themselves and to a great extent report whatever information they decide to.

Private equity, often structured as partnerships, has been all the rage over the past decade.  During the steep market declines last year, most private equity investments reported positive returns.

Why don’t investment managers want to show negative returns?  Simple, private equity managers are paid a percentage of their funds’ investment returns.  The higher the valuations they set, the more they get paid.

If investors exit private equity, they either sell their investments back to the fund, on a set schedule in defined amounts (for example, once a year and a maximum 5% of the fund) or they find another partner to sell to.

Over the past year, limited partnership transactions in the secondary market have been made at prices -15 to -20% below valuations set by even higher-quality partnerships’ investment managers, i.e., the general partners, many -30 to -40% below.

Private equity investment funds might sound like smart deals, but I’ve found few are.  In the past, good times have bailed out bad managers, allowing losses to be recouped.

As we’ve all heard, good times and dark secrets, they don’t last….

Banking crisis underway, but a different sort from past crises.   Most will do fine. Those who should be cautious have combined balances for a single bank above the FDIC-protected $250,000 per depositor.

So far, the FDIC has agreed to cover unlimited balances, even those above their maximum.  In the end, a failed bank gets sold to a healthy bank.  The FDIC absorbs banks’ losses.  This has put the deposit insurance fund at risk.  To cover its $23 billion in losses, the FDIC is raising the insurance premiums that banks pay.

Failed bankers had been reckless.  These weren’t community banks like in the film It’s a Wonderful Life, in which the bank finances our local businesses and neighbors’ homes.  These banks failed because they re-invested the cash from their huge corporate depositors into long-term, fixed income securities that dropped sharply in value due to rising interest rates.  When large depositors heard their bank was in trouble, they withdrew their money, forcing the banks to sell securities at massive losses.  One problem led to another, all of which could have been foreseen. 

Millions of individuals have since been rethinking their banking arrangements.  Money market funds at Fidelity Investments and others are higher-yielding alternatives, as is the safety of U.S. Treasury bills, and all the local community banks I’ve reviewed recently should ride through the tumult just fine even after recording losses.

As a result of the crisis, banks are restructuring their balance sheets to avoid becoming case studies for failure in the future. 

​Trust is earned and recklessness will eventually fail.  The same could be said of investing.  

Researchers find little evidence that investment managers help the companies they invest in become greener.  Much of what passes as ESG (environmental, social, governance) investment is little more than investment managers’ telling clients their portfolios are green.  “There could be a couple of bad apples in Europe, but it’s not the entire cart that’s rotten”, as in the U.S., says London Business School finance professor Alex Edmans.

ESG in practice can amount to a pile of marketing, i.e. telling investors their money is green.  Numerous studies show companies’ ESG scores are notoriously difficult to pin down, especially when trying to measure smaller companies, due to smaller companies’ reduced public oversight and fewer resources to devote to their investor relations.

“In the U.S., we observe a substantial disconnect between what institutional investors claim to do in terms of ESG and what they really do. We do not find better portfolio ESG scores for US PRI (Principles for Responsible Investment) signatories, not even for those that report full ESG incorporation…. We also find no evidence that US PRI signatories improve the ESG scores of portfolio companies after investing in them”,  according to the research paper “Do Responsible Investors Invest Responsibly?” in Review of Finance, November 2022.

In Sweden, environmentally oriented investors are more likely to buy mutual funds with pro-environmental names, but they are not more likely to buy funds that are labeled as ESG-compliant as written in the more complex financial statements that households receive every year.
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ESG investors beware.  The name ESG or “sustainable” might be there only to draw you in.

Since its all-time peak on the first day of the year, the stock market has fallen, in waves, likewise for bonds.
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Where have we read this before?  Right, in our last letter.

Significant dislocations and mis-pricings of investments play out as governments and central banks attempt with varying degrees of success to address imbalances and problems amidst supply and demand dislocations.
In a few words, investors aren’t happy when good times end.

Over the first nine months of the year, the U.S. stock market benchmark declined -24.6% and the bond benchmark index dropped –14.6%.

I can’t say when it’ll get better.  It looks to me like an unwinding of a super-charged economy and speculative investment price excesses.

Correcting these imbalances will require time and uncomfortable declines in market prices.  Governments and central banks will, under such pressures, be tempted to lean against the tolls required to set things right.

Rising to meet the challenges, negotiations among interests will be where it’ll get interesting indeed.

This quarter was a rocky one, as has been the year.  Since the all-time peak on the first day of the year, the stock market has fallen in waves, likewise for bonds.

From an economic standpoint, inflation is triggering a hawkish central bank interest rate policy, i.e., higher short-term interest rates.  While the U.S. Federal Reserve has acted strongly according to its stated commitments to markets, they cannot insure the survival of financially at-risk organizations.  We’ve seen this occur with the bankruptcy of badly financed vehicles, e.g., the Celsius Network crypto fund (not one of ours).

Markets look to the future, not the present.  Anything can happen.  Ahead could be a short-term recession or a longer-term one.  The current level of high inflation could be temporary, or it could be more enduring. Evidence suggests we’ll experience something at least in the middle of the spectrum.

​Markets are not fully pricing dire possibilities.  That said, markets tend to predict future upturns fairly well, historically advancing about half a year ahead of a turn toward positive economic growth.

How far down have markets dropped?  Not far, relative to history.  There’s nothing to be said that prices have fallen enough to bring in buyers and exhaust motivated sellers.  While we’ve performed well in this downturn so far, it’s very possible that the downturn might not yet be over.

There’s a difference between active, responsible investing and passive, ESG (Environmental, Social and Governance) investing.  This quarter, we’re taking over the featured investing spot by sharing an aspect of what we do, and what we don’t do.  

ESG investing applies non-financial factors, i.e., environmental, social and governance criteria, to analyze financial returns, opportunities and risks.  When passively managed, ESG funds reflect a broad portfolio of holdings representing a benchmark index.  For stock funds, this might mean holding shares in hundreds or even thousands of individual companies.  It’s a matching exercise.  Whatever the index says, that’s what the passive fund owns.

On the eve of Russia’s invasion of Ukraine, ESG funds held an estimated $8 billion of Russian investments, mostly in the form of the oil companies Gazprom, Lukoil and Rosneft, as well as the financial conglomerate Sberbank and the nickel miner Norilsk.

Since the war began, passive fund giants such as Vanguard and Blackrock have sold their Russian stocks, realizing huge losses in ESG and non-ESG funds alike.

Passively invested funds, also known as index funds, have grown to $11 trillion in value, 1/4 of the American stock market.  For those who manage a passive fund, whatever is in the benchmark index must be bought.  What drops out must be sold.

The decision made by index providers MSCI and FTSE Russell to deem Russian stocks uninvestable meant cutting them from their ESG indices, thus passive funds sold their Russian holdings.  At Pennyfarthing, in contrast, we’ve never held a Russian stock, neither via direct ownership nor by recommending a fund.