In January, during the market frenzy which saw GameStop Corporation stock go from approximately $20 to nearly $500 intraday within two weeks, some asked why the company did not capitalize on the demand by issuing shares. At Zeo, we saw this as a potentially notable governance case study. While some directors did make a few stock sales at much lower prices, the company itself did not take advantage of the markets at that time. Some governance advocates might even applaud the company for understanding that it would be wrong to benefit at the expense of retail investors who could lose substantially when the stock returns to a more fundamentally reasonable price.
It is also possible, however, that the company acted out of fear, worried about the image of profiting from Main Street investors who might not have understood the underlying fundamental value of the stock, which even the company could have determined was much lower than the $483 where it traded at its highest point on January 28. We suspect it wouldn’t take much for this to have become a public relations debacle for the company, but even if this less altruistic reason was indeed the consideration, we agree with the decision.[1]
Should investors take any of this into consideration? The debate over the importance of ESG factors has two major factions. There are those who believe any priority placed on ESG factors comes at the expense of investment performance and always will. We will call them the Cynics, as there is an inherent distrust that doing good and doing well can coexist as motivations. On the other hand, there are those who believe that, at some point, the world will see that ESG priorities are good and necessary, and eventually the default assumption of both investors and companies will be to prioritize ESG factors. We will call them the Idealists, as there is an inherent expectation that today’s progressive ideals will be tomorrow’s prevailing truths - it’s just a matter of time.
This battle between the Cynics and the Idealists is one of ideology. Neither is likely to convince the other that they are wrong for the simple reason that they are starting from fundamentally different views of what motivates people and companies. And in some ways, they are both right. The Cynics are probably justified in saying that a focus on ESG will not put an end to fossil fuels or casinos anytime soon. The Idealists are equally justified in their view that recent increases in boardroom representation of women and minorities (in part due to their activism) will become the norm for companies at some point in the future. But this presents a rarely discussed conundrum. If both are correct in at least some of their basic assumptions, neither can be correct about their overall ideology or vision of the investing world, now or in the future, as ESG continues to mature.
In between these two factions, we find the Realists, with an assortment of views, not all of which are compatible, but which generally focus less on ideology and more on financial materiality. The Realists look for ways to tie ESG factors to better performance. Returning to our example of GameStop, the Realist mindset, due precisely to its big tent and results-oriented nature, doesn’t welcome only companies which are motivated by ideals; there is also room for companies motivated by fear instead.
But does this distinction matter? Does the motivation affect the impact of the good behavior? The answer to this carefully worded question is no. Regulatory frameworks illustrate why this is the case. In the financial services industry, investors are better protected not because companies are motivated to limit their self-interest but because they are compelled to do so. One may not agree with all regulatory requirements in a given industry, but taken as a whole, regulations enforce a better alignment between companies and their consumers, employees and communities.
Today, technology has made it easier than ever for “citizen regulators” to organize and potentially punish companies who don’t behave responsibly. As a result, the fear is no longer limited to whether they get caught by a regulator but is more pervasive, as the bar is lower for groups of people to organize online around an issue and aim to hold companies accountable for their actions. Admittedly, not every criticized action should be punished, and I expect we will eventually see the pendulum swing to a longer-term balance while honoring the newly enabled role of citizen regulators. But especially because this is now possible, we believe the most societal change will come from an environment as accepting of companies acting to avoid sticks as it is hopeful for those seeking carrots.
The strength of the Realists is that they are the only group who, for lack of an ideology, use ESG factors to make investment decisions all along the spectrum from fear on one end to ideals on the other, which is objectively better for the world. The flaw of the Realists is that, with their varied investment strategies, they are a group that is all-encompassing precisely by not committing to a specific ideology. As ESG has gained prominence, the Realists are probably the group most at fault for diluting the meaning of ESG and impact to the point where these terms have no meaning and all meanings at once. But for what? As addressed in "ESG: A Data-Driven Definition", the majority of ESG investment styles that might be best classified under the Realist umbrella don’t deliver better investment results.[2] So how do investors reconcile this problem and find the intersection between performance and progress? They do it by focusing on intentionality.
Intentionality must sit at the very core of motives and decision-making. Everything we do, both in our portfolios and in our business, is done with an intentionality that borders on obsessive. To manage fundamentally and sustainably strong portfolios, one cannot simply start with an index and throw out the undesirable companies. You must start with a blank slate and proactively select every security in a portfolio, each with its own fundamental reasons for meeting the high standards for creditworthiness. Those standards go beyond snapshot “good” and “bad” ratings, whether they come from credit agencies or ESG assessments. Indeed, an approach to credit would be incomplete if ESG factors were not treated as credit factors, on equal standing with other credit factors in more commonly considered value-investing risk areas (e.g. financial metrics, competitive landscape, management strategy, etc.). Focusing on investing in good companies which will exist not just long enough to pay off the debt, but long enough to pay off the debt that comes next and the debt after that. A creditworthy business is one that can be resilient in the face of both short- and long-term risks. Such risk management cannot happen by accident; it is the result of an intentional strategy to mitigate the material risks to which a business is exposed, including ESG risks.
In other words, a company’s sustainability is a key ingredient in evaluating its longevity. The overwhelming majority of actions related to sustainability which are deemed unnecessary are not unnecessary because they accrue no benefit. Rather, they are deemed unnecessary because the perceived benefit is too far away and/or too costly in the short term, or, even more commonly, because those making the assessment are too myopic to evaluate the impact of both actions and intentions beyond a short-term timeframe. In our experience, there is a material difference in a fundamental assessment between those companies that take deliberate action to ensure sustainability, those who are simply acting out of fear and those who aren’t paying attention at all. Issuers which act with intentionality are the ones in which our confidence is highest. An investment process should be designed to evaluate not just a company’s strategy but its motivations; not just ESG but ESGI™ - Environmental, Social and Governance with Intentionality.
This is crucial because bondholders, like Zeo and our clients, don’t get to vote for a company’s directors. Activism is an equity investor’s weapon in the fight to compel companies to make changes, act responsibly and ensure their longevity. But debt capital is critical to many businesses and allocating to one company instead of another does send a message. However, generally in fixed income, this doesn’t even make much of an impact, as many companies are too large to pay attention to stakeholders they don’t deem as important as stockholders. On the contrary, in the credit subset of the fixed income universe, there is an opportunity to work with companies who better recognize their dependence on debt capital. Perhaps this is because they are smaller; perhaps because the cost of capital is high enough that small changes can make big differences; or perhaps because many of them do not have publicly traded stocks to soak up their available time and mindshare. Regardless, the opportunity to engage with companies as a credit specialist is an advantage other asset classes may not have.
This gives the investigation into a company’s ESG issues dimension and depth. More importantly, issuers often (though not always) embrace the inquiry; they don’t get these questions as frequently as others, and quite frankly, they don’t see the consequences of giving answers we don’t like. There is an untapped opportunity not just to gather information for a passive snapshot but to identify patterns over time and influence and guide in a collaborative way. Without voting rights, credit investors would get nowhere trying to use a stick, antagonizing a company publicly and privately until they do what we want just to make us go away and not because they want to. Rather, we must recognize what most equity investors don’t have to: Change can be effected through a dialogue in which “good” and “bad” is not determined by where a company is at a moment in time but by where it wants to be, why it wants to be there and how intentionally it works to make progress toward those goals. This is a growth mindset,[3] applied to ESG, and in this way, we strongly believe the approach results in more ESG impact from our companies’ actions than would come of snapshot screens or overlays.
Let’s reword the earlier question then: Does the motivation affect how one should evaluate the good behavior? [4] This answer is a resounding yes. As we discussed earlier, fear may indeed be a powerful motivator and can force companies to do what is in the best interest of society whether they want to or not. However, just as companies often trip over their false motivations and run into financial trouble, they may do the same with ESG issues unless they intentionally focus on them. Here, we find a key difference between what’s best for the world and what’s best for a portfolio.
We made the case that the Idealists, to achieve their goals, must give room for all ESG investment styles and should allow for companies regardless of their motivations. After all, carrots and sticks can lead to the same goal. But to execute on a long-term, fundamentally focused mandate, intentionality matters; finding issuers motivated by the carrots. Those include companies appropriately focused on their risks; recognizing the ESG issues which are material to their long-term sustainability; and intentionally aiming to improve their own and their industry’s issues in environmental, social and governance areas. If they succeed, they will have made an impact on the world in the process, but not at the expense of financial performance.
In a way, we have proven our original thesis, that both the Cynics and the Idealists are mistaken. But we’ve done so by disproving both their means and their ends. The biggest impact on the world comes from a willingness to disregard motivation and to accept actions rooted in materiality rather than ideals – the Idealist’s goal needs the Cynic’s worldview. Yet performance may be enhanced by taking those very motivations into account – the Cynic’s goal needs the Idealist’s worldview. Meanwhile, the Realists have fallen prey to the same game of musical chairs that has plagued the investment industry since long before our time: ignoring fundamentals in favor of a quick buck. Integrating both motivation and materiality into a cohesive investment approach should be the goal for investors. By doing so, we believe investors can find the biggest tent: strategies with competitive performance which deploy capital to companies who are intentionally improving their impact on the world. And in doing so, can have a real impact with their investments without compromising their performance goals, through a differentiated focus not just on ESG but on ESGI™.
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Zeo Capital Advisors is a fundamental investment manager to a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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[1] The company has since announced it will do an equity issuance to raise capital, but only recently after investors have had ample opportunity to understand the consequences of investing at the current valuation and after the stock price settled into a more stable (if elevated) range.
[2] Two observations further demonstrate the challenges for investors here. First, the Idealist approach can fit under the Realist tent if the end goal was the only priority, without considering the underlying motivation. Second, there are Cynics who openly hide among the Realists and aim to capitalize on the growing interest in ESG without believing in the thesis even in its most reductive form. In the previous section, we noted that independent research has revealed these Cynics in Realist clothing to be among the best asset gatherers using the least effective ESG-based strategies, with the strategies designed to appeal directly to Idealists nor faring much better.
[3] Among the most influential books of my lifetime, Carol Dweck’s Mindset is easily in the top five. As many readers know, I recommend it to anyone who will listen. If the term “growth mindset” is new to you, I highly suggest you put this book on your summer reading list.
[4] In addition to being the topic of the current section of this letter, this is also the subject of Season 1, Episode 11 of The Good Place, a philosophy course cleverly disguised as a top-rated TV comedy series.
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