Matt Damon as Sonny Vaccaro in AIR
Some movies not only entertain and inspire but convey broader lessons. “Air” is one of them. The film is about Nike’s efforts in 1984 to secure Michael Jordan’s endorsement of its basketball shoes, which soon after became the iconic Air Jordans. But it also tells anyone who will listen that ESG investing—environmental, social and governance—is a trap.
When the company begins its quest for Mr. Jordan (played by Damian Young), Nike is an underdog. He and his parents are leaning toward a Converse or Adidas sponsorship, as these companies are more established in basketball. Adidas is a front-runner until Nike alerts Mr. Jordan to a problem with that company. Nike’s determined employee, Sonny Vaccaro (Matt Damon) tells Mr. Jordan’s mother, Deloris (Viola Davis), that because the head of Adidas has just died, there will be turmoil at the top of the company that would hurt her son’s interests by creating uncertainty about his sponsorship.
These are the opening paragraphs of Donald J. Boudreaux and David R. Henderson, “Air is a Cautionary Tale About ESG,” Wall Street Journal, April 13, 2023 (April 14 print edition.) I don’t love the title because I think it’s an overstatement. Our point is that if you understand Sonny Vaccaro’s point in the movie that uncertainty about who will run a company hurts stockholders, then a fortiori, you should understand that uncertainty about whether the company is trying to maximize stockholder value or conform to ESG will hurt stockholders. (Or, as the character in the play Other People’s Money put it,“stuckholders.”)
I’ll post the whole thing in 30 days. This, by the way, is the first time I’ve co-authored with Don. I hope and think that it is the beginning of a beautiful writing relationship.
READER COMMENTS
Dylan
Apr 14 2023 at 1:31pm
I think people use ESG to mean a lot of different things, both proponents and detractors, and that tends to lead to confusion when discussing the issue.
I used to work at a stock exchange, and there when we talked about ESG it was almost always in the context of disclosures. The exchange was getting pressured from institutional investors to make ESG disclosures a mandatory part of financial statements. The investors saw this (mostly at least) as an issue of risk management. I want to know what the carbon emissions of the company is in case a carbon tax comes in to play. I want to understand the governance of the corporation, in case there’s a too cozy relationship between board and management. That sort of thing. These disclosures have been mandatory on European exchanges (at least some of them) for a number of years, and are mostly non-controversial (as far as I can tell)
There are some investors out there that have then decided to use ESG measures as a screening tool. Many investors think that companies that score well on ESG will outperform, but others are more contrarian and want to invest in companies that perform poorly on ESG metrics. So far, so good. Both are just investment theses for which stocks will have the best risk-adjusted ROI. Again, I think this should be fairly uncontroversial to most people.
There is another way that people talk about using ESG, which is putting ESG metrics in the investment charter at, for example, the Harvard endowment. Mandating that the endowment can’t invest in certain types of companies. This is seen as punishing the companies in these unfavored sectors, by raising their cost of capital. This approach is however often confused and used interchangeably with the “good ESG stocks will outperform” thesis, even though they are kind of the opposite from one another, since by raising the cost of capital to the firm, you are raising the expected return for the investor. The proponent of withholding a source of capital for oil companies, should be talking about how they are willing to settle for lower returns in order to make it more expensive for oil companies to do business, but they rarely do.
Yet another way that ESG is used, and the way I suspect you’re using it in the article is basically the idea that company management needs to take the concerns of a wide variety of stakeholders into account, not just shareholders. This is sometimes referred to as the triple bottom line, and is distinct from ESG, although often confused or used interchangeably with it.
Again though, I think you can make an important distinction between managers that take ESG considerations into account and act upon them because they think that makes the best long-run business sense, i.e. they are anticipating regulation, or they think that the positive reputational effects will outweigh any short term costs. Or, they could be taking an action because they sincerely think it is the right thing to do, even though it will lead to lower profits.
As a shareholder, I’d probably prefer my company to be managed by the 1st type of manager. (But, given that the first type is likely to pretend to be the 2nd type, it is going to be hard for me to tell the difference.)
Either way though, I really wish people would be clearer on what exactly they mean when they talk about ESG.
Jon Murphy
Apr 14 2023 at 4:47pm
Which is part of the point. If a company is committing to ESG but nobody knows what that means, it’s surely going to cause the problems of uncertainty that cost Adidas
David Henderson
Apr 14 2023 at 11:06pm
Exactly.
David Seltzer
Apr 14 2023 at 5:09pm
Dylan, excellent observations. One definition of ESG is the S&P 500 ESG Index. The annualized volatility of the S&P 500 ESG Index was slightly lower than the S&P 500, at 14.63% and 14.86%, respectively. The annualized return was 0.02% higher for the S&P 500 ESG Index than the S&P 500. Sharpe Ratio is better for the ESG Index. The .02% difference may be due to random error. Given this data, I would ask if there are other benefits I would receive if I invest in the ESG Index such as limiting GHG emissions in addition to risk adjusted market returns.
Dylan
Apr 14 2023 at 6:34pm
Interesting numbers, David. Thanks for sharing. I’m curious what time frame you’re using? I just took a look at the factsheet for the ESG Index and was surprised to see the ESG outperforming the benchmark in annualized returns for every period going back 10 years (granted, that includes back tested numbers pre-2019). Given that big tech would be more represented in the ESG index, I would have expected more negative numbers in the recent past.
Knut P. Heen
Apr 17 2023 at 5:12am
Dylan, you should expect weakly lower returns for ESG for identical risk in equilibrium because discrimination always hurts the people who discriminate in the market place (choosing stocks based on ESG rather than expected returns is a form of discrimination). On the way to equilibrium, however, this will lead to higher returns for ESG because the price has to increase to lower the expected returns. If ESG becomes hot slowly over a period of time, people bid up the price until expected returns are low. The bidding up period will have high returns.
David Seltzer
Apr 17 2023 at 2:02pm
Knut, except the S&P ESG INDEX returns were comparable to the bench mark adjusted for risk. The shareholders were compensated fairly or they would have found a better return given the same beta. You said choosing stocks. The S&P ESG is an index as I suspect you understand. If an investors preference is to be respected, they are free to choose. The ESG Index has 308 tickers. Well diversified and returns represent equilibrium in terms of EMH and CAPM.
Knut P. Heen
Apr 18 2023 at 9:53am
David, the CAPM does not take ESG into account. The EMH is still correct if preferences changes slowly. Let me give an example.
Suppose you split all stocks into two portfolios with identical risk and return, portfolio A and portfolio B. For simplicity, let both pay out $100 once at the same time in the future, and let both trade at $50 today. Both offer 100 percent return for the same risk.
Suppose you learn that portfolio A is an ESG-portfolio and that a significant number of investors suddenly have a preference for ESG-portfolios. What will happen to the prices? The investors will bid up the price of the ESG-portfolio to more than $50 simply because they like the ESG-portfolio more than the other. The immediate/past return is thus higher for the ESG-portfolio, but the future return is lower because it only pays out $100 in the future even though you paid $55 for it.
Now, a slow change in preferences in favor of ESG over a period of 10 years for example, will produce higher ESG returns over those 10 years, but future ESG returns will be lower as soon as the preferences stop changing in favor of ESG. The shareholders are compensated fairly here because they derive utility from being an ESG-investor (which compensates for the loss of return).
Here is a paper looking at what ESG really is.
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3826357
Knut P. Heen
Apr 17 2023 at 5:20am
The entire point of ESG is to cause confusion. Maximizing shareholder value is a clear and difficult objective, and the CEO may be fired if he does not succeed. It is at this point the CEO says “unfortunately, profits are down, but we reduced emissions because no one bought over product”.
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