Keep a cool head when it comes to sustainability

The history of investing is littered with periods when investors have become irrationally enthusiastic. For example, in the 1970s they became transfixed by a group of “bulletproof” stocks, known as the Nifty 50, for which no price was deemed too high. The late 1990s saw the dotcom boom.

The important thing to note is that the investment theme underpinning these moments makes perfect sense; it is the market excess surrounding them that is irrational.

Today’s hot story is sustainability. There are many good reasons to consider ESG factors, but none to disregard the fundamentals that drive returns.

Share prices reflect measurable factors. First, expectations about future earnings growth and, second, the price that investors are prepared to pay to participate in that growth. Add in a third key factor, the weight of investment money, and it is hardly surprising that shares spend almost no time at the “right” price but move widely either side of it.

Growth is where the ESG story is on firmest foundations. The need to combat global heating, even out the inequalities highlighted by the financial crisis and its aftermath and align corporate governance with changing social mores creates many investment opportunities.

The problem is that many investments are being wrongly identified as growth opportunities. Just as adding dotcom to the name of a company did not make it a good investment in 1999, labelling a business as sustainable will not change anything of substance in 2021.

The second driver, price, is where ESG is on shakier ground. A key argument for investing in sustainable companies is that directing capital towards them makes the world a better place, by lowering the cost of capital for well-behaved businesses. But the flipside is a low expected return for the investors who provide it. The more you pay for a given cash return the lower its effective yield to you.

The weight of money is perhaps the most dangerous factor of all. It disguises what is really going on by driving prices higher in the short term.

This matters because ESG matters. When the Nifty 50 or the tech bubble blew up it was not the end of the world. The ESG stakes are higher. A little less exuberance now might not be a bad thing in the longer run. Tom Stevenson, investment director, Fidelity International.