Some ‘green’ stocks have been pushed up to trade at a premium because of the surge in interest in environmental, social and governance (ESG) and sustainable investing, according to fund managers and market analysts.
Strong performance from a number of mega-cap tech stocks in recent years – especially the so-called FAAMNGs of Facebook, Apple, Amazon, Microsoft, Netflix and Google parent Alphabet – has led some investors to fear they are traded on too lofty valuations.
The FAAMNGs have made up a high percentage of the S&P 500’s returns, especially last year. Their high returns combined with resilience during the Covid-19 pandemic has meant that even more investors have piled into the FAAMNGs and their peers, pushing the companies’ valuations to record highs.
But some investors are seeing the same pattern appearing among ESG and sustainable stocks.
Investing for better environmental and social outcomes has been a brewing trend in markets over the past few years as investors sought to align their personal sustainability ideas with their finances. This saw a massive acceleration in 2020 as the pandemic highlighted the demand to tackle these issues.
ESG and sustainable-focused portfolios have seen a huge influx of investment. The Calastone Fund Flows Index (FFI) shows that ESG funds took the lion share of inflows into active equity funds in the last two years, with $84 out of every $100 going into them.
This has contributed to a green premium, or ‘green-ium’, hiking the valuations of stocks which seem to fit ESG and sustainable focused portfolios.
“It's definitely happening. 100 per cent,” said David Osfield, manager of several sustainable portfolios at EdenTree Investment Management.
A case study of this was biorefinery Borregaard, which Osfield bought back in 2016 for his EdenTree Responsible and Sustainable Global Equity fund.
“We bought it at 13 times P/E. It was just under €1bn and not really in any portfolios. And we like to find those companies that are not in very few portfolios in that space.
“But as they become more and more popular as we start talking about them in factsheets etc, people get to know and that drives it up. And certainly now it's on 27 times, we're sitting there thinking: ‘well, how much more re- rating as it got to do in terms of its awareness and people start to notice it?’”
Teodor Dilov, fund analyst at interactive investor, also highlighted that with the growing popularity of the sustainable investment space it is becoming harder to find a well-priced sustainable company.
He said: “There is no question that ESG will be continue to receive a lot of attention and government support going forward. However despite the recent rotation in the market towards undervalued assets, which include many of the ‘non-ESG’ options, it is difficult to find bargains as valuations of ‘greener’ companies still look high relative to the broader market.”
The market is seeing more and more fund managers place an emphasis on ESG and sustainability in their portfolios, although EdenTree’s Osfield had some scepticism about the genuineness in some cases.
He added that while a widespread adoption of sustainable investing is in the early stages, it could create a “scarcity” issue around potential companies.
He said: “When we start to see people putting the sustainability solution at the genesis oof the idea … then we have a scarcity challenge around the number of companies listed on the market if the mainstream fully adopts that, because there's huge amounts of investment to move on. We're still in the very, very beginnings in terms of mainstream adoption of sustainability.”
Osfield did add that there has been a significant growth in the past five years of companies becoming sustainable investment options compared to the past.
“That's the other side of the scarcity story. Let's say five years ago, [energy company] SSE wasn't talking about the ‘just transition’ and what they were doing for workers and for renewable energy. Now, it's a really interesting company in that space,” he said.
“So there is a broader investment set globally as companies really start to understand what it means for their operations to be to be genuinely sustainable.
“We have to hope that that goes ahead of the money flowing otherwise [we’ll] fundamentally get those bubbles that [we're] talking about.”
But some companies might actually deserve a ‘green-ium’ according to Rathbones fund manager Will McIntosh-Whyte.
McIntosh-Whyte, who runs several growth portfolios and the newly launched sustainable multi-asset portfolio range, said that it could be worth paying a higher valuation if the company is delivering better corporate practices.
He explained: “Where you've got a business that is genuinely sustainable, doing the right things, treating its employees the right way, to certain extent that I think that's worth a premium because you're taking out certain risks.”
But there are cases where the premium is down to the “hype”, McIntosh-Whyte noted, which investors should be wary of.
He said: “I think there are many companies out there that don't tick those boxes. And I think the valuations can look a little bit lofty.
“And so our big focuses are on unpicking that and saying: ‘look, those are stocks trading at a slight premium, do they deserve that premium? Have they got a strong balance sheet? Are they able to finance their own growth? Do they have genuine long-term structural growth opportunities? And are they able to take advantage of that higher? Are they going to be the market leader? Are they going to be able to keep competition out?’
“When those kind of areas are covered off, those are the kind of companies that we are looking for, we're trying to make sure we avoid those where you pay a lofty premium. And actually, plenty of other players can be successful in this space, there's a risk of disruption. It's an untested market.
“I'm sure some of those will be winners. But there's slight element I think of investing on hype of just investing in a story rather than genuine business opportunity.”