The Ignored Siblings in the ESG Family: S and G
Much of the attention in the ESG discussion has been on the E. And understandably so. E is more visceral and tangible, and also just much easier to quantify (i.e. carbon emissions, climate change, etc.). How does one quantify social and governance impact? What does even mean? And, of course the question that always comes up during these discussions – what is the ROI on social and governance impact? We can already feel CFOs and corporate boards nodding their heads in skeptical approval regarding that question.
But just because one cannot precisely measure something does not mean that it’s not worth anything. More controversially, not everything has to have a direct ROI, in our view. It’s a bit of a double standard when comparing to other areas of corporate investment. Sometimes the unintended results of our actions are more powerful than our intended efforts.
We also realize that we are currently in an obsessive data-centric environment where we are to “measure what matters”; however, perhaps this mentality potentially blinds one to analytical opportunities that are more ephemeral, ambiguous, and multilayered, and involve multiple sequential steps that are difficult to visualize initially (which are the vast majority of the major problems in this world, in our view).
Case Study: American Water – an ESG Darling Company
Be that as it may, let’s attempt to put some parameters around this equation and solve for the S and G. As usual in this research series, we’ll turn to a case study to try to illustrate this
concept. American Water is the largest publicly traded water utility in the U.S. with the very unique distinction of having a female CEO and CFO, and a board of directors that is majority female. The company also views diversity as a core strategic and operating principle as evidenced by more than half of job promotions and transfers being filled by minority, female, veteran and disabled people during 2018, as one visible “walk the walk” example.
American Water is a company that has been very forward-looking in implementing not only the “letter” of ESG, but the commitment to the spirit of ESG and what that means on a day-to-day basis, and especially regarding the S and the G. The investment community is very much divided on the impact or even the relevance of ESG. One side is all-in and realizes that this perhaps is the future of “business.” And the other side believes that this is more political correctness gone awry and another fashion trend that will fade over time. And even though money is pouring into ESG more than any other asset category recently, there is an undercurrent of cynicism that underscores the view that this is something that one is forced to do rather than a true belief that this is a fundamental supply and demand paradigm shift.
Exhibit 1
AWK vs. S&P 500 – Five Year Performance
(AWK in white and S&P 500 in blue)
Source: Bloomberg.
American Water has Objectively Been a Stellar Investment
Let’s begin by looking at stock performance as an objective starting point. As shown in the chart in Exhibit 1 above, American Water (symbol: AWK) has been up 148% the past five years vs. the S&P 500 up just 61%. A strong return by any measure. But, how can one “measure” if these returns have been driven by ESG factors? Well, akin to astronomy, equity analysis is not a straightforward exercise, as oftentimes we have a lot of more unknown variables than known variables. And this exercise is exponentially more difficult as we are trying to analyze something as ambiguous and relatively nascent as ESG.
But Let’s Give it a Shot Anyway
We’re going to attempt a very simple exercise to try to put some parameters around the impact of E, S, and G. By no means are we going to settle this issue in this piece; however, this will be just one of many illustrations that we will highlight throughout this Research Series to at least get us closer to some type of analytical framework that will help us get on a path to a better understanding of the overall puts and takes.
In Exhibit 2 below, we compare valuation multiples of American Water to NextEra Energy (symbol: NEE) and the S&P 500 over the past five years. Why NEE? As the world’s largest producer of wind and solar energy in the world, we view NEE as an interesting comparative company to AWK due to NEE’s emphasis on the E vs. the S and the G in ESG vs. AWK which is arguably more tilted toward the S and the G (both companies are great in ESG overall, so this is a relative comparison).
Therefore, we can attempt to algebraically deduce and separate, in a very crude and inexact manner, the E and the S and G. Let us try to explain. As shown in Exhibit 2, AWK enjoys a substantial premium to the S&P 500 – a large 65% premium as of year-end 2019. As does NEE – a not as large, but still impressive 43% premium to the S&P 500.
What’s interesting is that when comparing AWK vs. NEE, AWK’s relative valuation premium to NEE has been shrinking the past two years from about 45% at year-end 2017 to just 16% at year-end 2019. Of note, AWK’s absolute 12-month trailing P/E multiple has expanded during this period from 30.8x at year-end 2017 to 33.9x at year-end 2019. So, what’s happening is NEE’s valuation has just been expanding faster on a relative basis as compared to AWK, but both have been rising while the S&P 500 P/E multiple has stayed relatively stable from 21.5x at year-end 2017 to 20.6x at year-end 2019.
Exhibit 2
AWK Valuation Analysis vs. NEE and S&P 500
Source: Bloomberg.
Solid Earnings Growth for AWK and NEE Supports Multiple Expansion
On a fundamental basis, AWK’s and NEE’s earnings growth has been similar the past five years – about a 9% EPS CAGR for AWK and a 11% EPS CAGR for NEE (in comparison, the S&P 500 has had about a 7% earnings CAGR). To boot, both AWK’s and NEE’s EPS growth during the past five years has been much more stable, less cyclical, and less volatile than the S&P 500. So, the simple combination of more growth and less volatility naturally generates multiple expansion. This is valuation 101. And the outlook for the coming years suggests that this dynamic will continue. With some market participants fearful of an impending economic downturn, the steady regulated returns that AWK and NEE can generate should garner even more of a premium, in our view.
AWK and NEE have been Solid Absolute and Relative Investments
As shown in Exhibit 3 below, NEE’s stock performance has been almost identical to AWK the past five years – NEE is up 150% and AWK is up 148%. Importantly, about a third of this move has been driven by EPS growth and the other two-thirds has been driven by P/E multiple expansion. The market is clearly rewarding these companies for continued visibility and duration of the aforementioned steady earnings growth.
Exhibit 3
AWK and NEE vs. S&P 500 – Five Year Performance
(AWK in white, NEE in blue, and S&P 500 in red)
Source: Bloomberg.
So, Back to E, S, and G – the Core Fundamental Argument
So, you may be wondering what this all have to do with ESG? The simple interpretation is that this multiple expansion is where the impact of ESG is expressed by the market, in our view. This is not a fund flows argument, nor do we discount the fundamental factors that have driven earnings growth for these companies, as well as the regulatory factors (i.e. higher allowed ROIs, favorable rate base treatment, etc.) and the massive technological advancements that have made these regulated businesses significantly more effectively and efficiently run.
And when one teases out the relative “E” heavy characteristics of NEE (i.e. renewables) vs. the relative “S” and “G” heavy characteristics of AWK (i.e. executive and board gender parity, and workforce diversity), one could argue that the market is being very discerning in rewarding both companies, but on a discrete basis (again, relatively speaking). One could argue that embedding ESG as one of the main contributors of their core strategies has had a material impact on this financial performance – valuations multiples have expanded because of the ESG impact on their earnings trajectory – E, S, and G are discrete, independent variables.
AWK Has Always Been Rewarded for S and G; NEE Has More Recently Been Rewarded for E
So, putting it all together, AWK’s has always been rewarded by the market for their excellence in S and G, as evidenced by their premium valuations. And this premium has been steadily increasing over the past few years (please refer again to Exhibit 2 for details). NEE however, has really been rewarded only during the past two years for their asset and earnings power strength driven by their renewables strategy (i.e. “E”).
Apples vs. Oranges in ESG – More Info Does Not Equal More Insight
We do realize that there could be a bit of comparing apples and oranges here. We never claimed that this is an exact science and it will never be – neither is classic securities analysis, so we all live in glass analytical houses. Just saying. Looking forward, there will be a sea change in what companies will voluntarily disclose and involuntarily be forced to disclose in terms of ESG information in the coming years. However, we’re not sure that more information will result in better analysis. In fact, it will probably result in something that is the exact opposite, at least in the near to medium term. We believe that there will be great opportunities available for market participants who can cut through the noise to come and who can get analytically ahead of the curve. We hope to be one of them.
The Penalty for Being Really Bad in ESG
Just to point out an obvious contrasting example, we wanted to illustrate the cost of being really bad in ESG. In Exhibit 4 below, we’ve added ExxonMobil (symbol: XOM) to our five-year stock performance chart. As you can see, XOM has massive underperformed (down 32%) during this period. What’s interesting is that the stock underperformance has largely been driven by declining earnings. One should be concerned by what could potentially happen if valuation multiples start to contract as well. If there was one simple chart one needed to see to explain what’s going on regarding ESG and the impact on valuations, this is it.
Exhibit 4
AWK, NEE, and XOM vs. S&P 500 – Five Year Performance
(AWK in white, NEE in blue, XOM in purple, and S&P 500 in red)
Source: Bloomberg.
ESG = or > Technology?
Just for fun, we included Apple (symbol: AAPL) in our five-year chart as well. As seen in Exhibit 5 below, AAPL has had a similar stock performance (up 162%) as compared to AWK (up 148%) and NEE (up 150%) during this period. This is actually a topic that we’ll devote a lot of time to going forward in this Research Series – could ESG be as economically impactful as big tech has been the past twenty years?
We could make an argument that ESG will be even more impactful than “technology” because it is more of a potentially fundamental economic change. A paradigm shift, to use a hackneyed term. Technology has always been a driver of economic change since the dawn of humanity, but ESG is fundamentally different, in our view. We believe that the market is vastly underestimating the magnitude and the duration of the impact that ESG will have in our global economy. More to come.
Exhibit 5
AWK, NEE, XOM, and AAPL vs. S&P 500 – Five Year Performance
(AWK in white, NEE in red, XOM in yellow, AAPL in blue, and S&P 500 in purple)
Source: Bloomberg.