Erika Hubbard :

Larry is a real expert in this field, and we’re so lucky that he constantly comes back and does these sessions with us. He’s made appearances on NBC, CNBC, CNN, and Bloomberg Personal Finance. So with that, I’d love to get started, and again, please, submit your questions. We are really excited to get questions directly from the live room, but in lieu of having those questions right now, I’m going to ask Larry a question that we, that I came up with before the webinar specifically about socially responsible investing. So, Larry, I know that there has been a rise in interest in ESG recently. Can you discuss this trend and any implications that this trend has had on the larger market or on corporate behavior? And I think a lot of people are also interested in learning about whether, on balance, ESG returns are similar to non-ESG traditional funds?

Larry Swedroe:

I got a lot to unpack there. That’s why we wrote this book. Your Essential Guide to Sustainable Investing, which I coauthored with a friend, Sam Adams. Let’s see if we can put this in some context. So, first, what might be called socially responsible investing goes back hundreds, if not even thousands of years. The best example might be in more recent times. Quakers during the Civil War were against them, or even before that investing in any business that was related to the slave trade. That got expanded over time into exclusionary strategies, eliminating from portfolios companies involved in what you might call the trinity of sin, stocks, tobacco, alcohol gambling. Some people have an offense to pornography, and that came under the banner of socially responsible investing.

Larry Swedroe:

Around 2005, with the United Nations addressing the issues with their principles on this issue. We got to see a much broader trend that instead of focusing on your personal values, began to focus on company behavior. And this became the E, S, and G or environmental, which is related to climate change, of course, as well as pollution, social, which is things like diversity and equal pay, and then governance that should be shareholder-friendly. That trend started to pick up, but it was very slow. We got, some billions of dollars every year, moving in out of markets that are in the tens of trillions, but around 2018, my guess is, or assumption would be that it’s related to the big changes that we’ve seen in the climate and causing people to become much more focused on it. All of a sudden, you had tens of billions of dollars flowing in every month. And today, starting from almost zero 20 years ago, about one-third of all U.S. assets are invested with some kind of sustainable strategy. Outside the U.S., it’s more like 50% in Europe and that trend is increasing. Those huge cash flows have had a big impact, which I’ll discuss in a minute, but here’s the general economic theory about the risk and return of a sustainable strategy.

Larry Swedroe:

That’s always the right place to begin. It’s with economic theory and then we’d like to see that the empirical evidence matches up with that theory to make sure your theory is right. One of my favorite expressions is if your theory doesn’t align with the data, then you don’t throw out the data, you throw out the theory and rethink what your assumptions are. So, here’s the very simple, clear explanations for why, what you might call green stocks or companies that have high ESG scores should have lower expected returns and lower risk than the brown or the sin stocks. So, the first we could call a taste or a preference based explanation. And that is if lots of people, millions of them, start screening out companies from their portfolios. Those companies are going to end up with much lower price-earnings ratios than companies that are favored.

Larry Swedroe:

You might think of it as a very simple example. Two companies both earn $10 a share, but because lots of people are piling into stock A because they have high ESG scores, their PE might trade at 20. So, the stock is at 20. You have earnings of $10. So, your earnings yield is 5% and that should be your expected return. On the other hand, you have the brown stocks that people are avoiding because maybe they have bad behavior to employees, consumers are boycotting them, whatever it might be, had environmental spills. People are just screening them out for those reasons. They may be trading at a 10 PE. So now you have, you only paid a hundred dollars to get those $10 of earnings. You’re going to get a 10% return. So it’s a taste or a preference for companies that are green, drives their valuations up, and it holds down the valuations of the brown or sin stocks. The empirical evidence supports that beautifully right up to 2018. There was a study done on what was called the vice fund, only owning the stocks in these sin industries: tobacco, alcohol, and gambling, and they had outperformed over about a hundred years, two and a half to 3% a year, depending on what model you use. So the theory and the evidence lined up beautifully.

Larry Swedroe:

Now, there’s one other point before I talk about what’s happened recently. These green stocks are going to have fewer environmental incidences like the Exxon Valdez. They’re going to have fewer consumer boycotts related to people not wanting to buy their products because of bad behavior. They’re going to have better risk control so, there’re fewer incidents of frauds. There’s even a recent study showed that the green companies were spending more money to get high quality audits, which of course protects investors from future evidence of companies manipulating or managing earnings. So the evidence and theory would say green companies have less risk. Well, if you have less risk, then you should be willing to pay a higher PE ratio and you get lower returns for that.

Larry Swedroe:

So there is both a risk and a taste and a behavioral explanation for why green companies should be expected to underperform in terms of returns, but compensate to some degree for that, by having less risk. Now, what happened in 2018 is all of a sudden we got a massive amount of cash flows coming in and that drove up the valuations of the green stocks dramatically. There was a study done called Dynamic Equilibrium, which we discussed in our book and here’s what it found. They looked at what happened to the performance of the green and brown stocks over the period 2018 through 20, and they found that even though one should have expected the brown stocks to outperform, let’s use 3% as an example, the green stocks actually outperformed by 7%. So what caused that? Was it a change in their earnings so green companies became much more profitable and brown less profitable?

Larry Swedroe:

The answer is no. All of that outperformance was explained by cash flows coming in, temporarily driving those valuations up and giving investors what you could call a short-term capital gain. But, since you don’t change their earnings, what that means is you get lower future returns. So you have these conflicting forces going on that brown stocks should have higher expected returns, but green stocks, if you get enough cash flow coming in, have higher realized returns in the short term. We think that we’re in the early innings of this transition to a more green economy, green markets, more investors investing with sustainable strategies. The survey shows that somewhere 80 to 90% of people are interested in sustainable investing, willing to sacrifice, maybe some returns, getting better risks or reduced risks, and also hopefully driving corporate behavior. So we think we’re still in the early innings because we’re only at about a third in the U.S. and 50% internationally.

Larry Swedroe:

So this trend could continue for several more years, maybe even a decade or longer, and if you get that, you could see green stocks at least matching or coming closer, maybe even continuing to outperform the brown stocks. Now, the last point which we cover, the last part of the question I think on this that was asked was about, is it changing corporate behavior? And the answer is there’s really good news here. Companies that have low scores are getting screened out from investors portfolios. That’s leading to them having lower valuations than their competitors in the same industries. Now, that means that if you have a low score, your debt is going to have a higher interest rate, your earnings PE multiple would be lower, which means your cost of equity capital is higher. You have to give up more earnings to get the same dollar of equity capital, and companies don’t want to be at a competitive disadvantage because they won’t be able to raise the dollars to invest competitively.

Larry Swedroe:

So companies with lower scores are acting in more favorable ways to try to get those higher scores, improving their ratings, and then they get more cash flows from investors driving their valuations up. That creates a virtuous circle here by companies trying to get ahead and get the best scores in their industries, and we are definitely seeing that behavior. I’ll add one last point: that we are in the tightest labor markets we’ve ever been in history with where we now have almost two job openings for every unemployed person.

Larry Swedroe:

Companies are having a hard time attracting employees and the evidence is very clear. People want to work for companies that express their values and live them. So companies with green scores are having an easier time attracting employees, those employees, by the way, turn out to be much more satisfied with their job. They stay longer, they become more productive and that leads to more profitability. So companies are aware of this as well, and you can see how this need to attract employees, make sure they’re productive, etc., is changing not only investor behavior to invest sustainably, but it’s actually making corporations change their behavior. So hopefully we answered all of those questions that were packed into that first one there.

James Lange:

I have a couple of follow-up comments. First, this is not coming from somebody who is a pure environmentalist without much of a financial background. You’re talking about one of the top financial experts in the country. Erika said that he wrote, I think, 10 books and coauthored a whole bunch of other books. There are two books in particular that I think would be very appropriate for our audience to have. The first one, which at least up to now, has kind has been my favorite, and maybe Larry, I’ll ask you to hold it up. I’m moving and I don’t have my copy handy, which is, well, let’s say the part that I can read, is the Successful and Secure Retirement, or maybe it’s Your Guide to Successful and Secure Retirement, which is just a terrific book.

James Lange:

I think that really everybody should have that book. It’s so valuable. That’s what’s called, I would say, classic investing and actually beyond investing. I think what has happened with Larry and it’s happened to me to some extent, but even probably more with Larry is as he grows and matures as a national prominent expert, things about retirement isn’t just purely about money. This most recent book, I think does the best job of anything that I have seen Larry, or for that matter anybody, write about some of the let’s call it non-financial aspects of money, but it’s written by somebody who is truly like the guru of money. So I think that is a valuable, very valuable book that Larry has written. Then, the most recent book, what he is talking about now regarding socially responsible investing, and Larry, maybe I’ll ask you to hold that one up, I think is really important for somebody who is perhaps now newly interested in sustainable investing. I think they are both important and I got my marketing team really flustered five minutes before the call. I got the idea, I know, why don’t we give everybody who stays till the end of the call, a free copy of these books? And can you put up a little link and can you do this? And can you do that? And they said, no, there’s no time we can’t do that. And the other thing is this is on zoom, which is a different platform, the webinar gym, where it’s easy to do that. So anyway, here’s the upshot of it. If you stay till a buddy end, which frankly you should to do this anyway, Larry’s just such a great source of information. If you send an email and what is it, Erika to requests help you with that?

Erika Hubbard:

Absolutely. Sorry. I tried to unmute myself and I actually turned off my video. So I was sending, as you were talking to the chat, a little message telling people exactly what email address to send the message to, but it’s requests@paytaxeslater. com.