Industry Voice: Navigating the ESG "bubble"

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Jamie Harvey, Fidelity Sustainable Global Equity Fund

Jamie Harvey, Fidelity Sustainable Global Equity Fund

Companies at the forefront of sustainability-related innovation, such as electric vehicle manufacturers and companies enabling the hydrogen economy, have seen their share prices soar by as much as 10 times over the last two years.

Such stocks have captured the imagination of retail and institutional investors alike, and in many cases, we think valuations have become detached from fundamentals. These stocks show many characteristics of a bubble. However, with the help of Fidelity's global research team, we dig a little deeper to find opportunities in stocks with under-appreciated ESG qualities, a group that trades at only a modest premium to the market's valuation, yet offers significantly higher quality and growth prospects.

ESG takes off

It is not difficult to see why the share prices of the highest-profile ESG stocks have taken-off. Interest in sustainable investment strategies has accelerated significantly over the last two years, driving record investor demand for ESG funds.

Although many of the changes brought about by the Covid-19 pandemic doubtless accelerated this trend, awareness of the growing issues around climate change, social injustices and other sustainability challenges has been on the rise for some time. Governments have also started to meaningfully increase their ambitions, both in terms of long-dated targets but also immediate spending plans.

The last piece of the jigsaw, company management teams, continue to increase their focus and capital expenditure on the sustainability agenda. With the three powerful driving forces of consumer preferences, government policy and corporate behaviour aligning, the outlook for companies with strong sustainability credentials is strong and the investor attention they are gathering looks deserved.

Assets under management in global ESG equity funds has doubled year-on-year

(AUM in US$ billions, Jan 2015 to Sept 2021). Source: EPFR Informa Financial Intelligence, BofA US Equity & Quant Strategy, 21 October 2021.

"ESG Superstars"

This increased attention has unsurprisingly led to strong performance in a small number of the most commonly owned stocks. For this group of well-loved stocks, share prices have risen significantly faster than earnings, pushing up valuations.

A recent study by Empirical Research Partners found that this small group of high-flying "ESG Superstars"1 trade at a PE ratio that is 50% higher than the market compared to a 17% premium for the broader group of less well-owned "ESG Leaders"2. For the latter group, the valuation premium actually disappears when considering free cash flow yield, given the stocks are on average higher quality companies with superior free cash flow conversion.

This wider group of ESG Leaders deserve a premium valuation because they are fundamentally better businesses. Not only have they historically generated significantly higher returns on invested capital and free cash flow margins than the market, but the long-term growth outlook is undoubtedly stronger and more visible.

The combination of persistently high returns, cash flow generation and growth is an extremely powerful one. Indeed, for companies addressing the greatest environmental and social challenges confronting us, the duration and scale of the growth opportunities ahead is huge. Larry Fink, CEO of Blackrock, recently described decarbonisation (just one of many important areas of ESG investing) as "the greatest investment opportunity of our lifetime".

Large-cap stocks return on invested capital**

** Equally-weighted data over a trailing four-quarter period. Source: Empirical Research Partners Analysis, 2021.

Navigating the challenge of high valuations

Fortunately for us, the group of expensive, high-flying ESG Superstars comprise only a small portion of the total investible universe. We focus our efforts elsewhere, working closely with Fidelity's global research team to conduct rigorous due diligence to uncover stocks with equally strong ESG and financial credentials but that trade at more defensible valuations.

Fidelity's proprietary ESG rating is an important aspect of our research - this forward-looking assessment of a company's sustainability profile gives us unique insights upon which we can build an investment case - and has historically shown a close correlation between strong ESG ratings and outperformance.

Fidelity Sustainable Ratings Cumulative Performance Comparison

Source: Fidelity International, Data as of 30 September 2021. Sustainability ratings relative average of A&B and D&E stocks, equal weighted, to MSCI AC World Index. The Fidelity Sustainability Ratings were launched in June 2019. As of 30 September 2021, they cover a universe of c.4,200 issuers in equity and fixed income. Fidelity have a five scale rating of A (best) to E (worst). For illustrative purposes only.

However, a best-in-class ESG profile is not enough by itself to warrant inclusion in the fund - they must also have a compelling financial and valuation profile. The investment process underpinning the Fidelity Sustainable Global Equity fund is focussed on finding exactly these types of companies: alongside the potential to have meaningful positive impact, we look for stocks that have the potential to significantly exceed the market's expectations for earnings and cash flow over the coming 3-5 years, as well as having valuations that are firmly underpinned by medium term cash-flows and high visibility over future growth prospects.

One such example in the fund is SSE, the UK-based electricity distribution and renewable energy business. The business has a best-in-class ESG profile as a key enabler of electrification which requires a modern and robust grid, it has MSCI's highest ESG score of AAA and has committed to a >70% reduction in carbon emissions by 20303. SSE have the UK's largest renewable energy pipeline, and are leading the construction of more offshore wind capacity than anyone else in the world, with output expected to rise fivefold by 2031. Despite these attractions, the stock trades at a discounted valuation vs the global equity index, and trades at a share price below the levels reached in early 2020, which we think represents an excellent opportunity for investors.

Following our disciplined investment process naturally steers us away from the more highly valued areas of the market, and toward more established, high quality businesses generating free cash flow today and with a strong growth outlook. We think this leaves our investors well placed to enjoy excess returns over time whilst also being a driving force behind positive societal change.

1 ESG Superstars are stocks that appear in the highest quintile of ESG fund ownership and ESG funds' active weight.

2 ESG Leaders are stocks that appear in the top quartile of ESG fund ownership and ESG funds' active weight.

3 70% reduction in scope 1 and 2 carbon emissions by 2030 versus 2018 baseline.

Further information

Jamie Harvey is the Lead Portfolio Manager of the Fidelity Sustainable Global Equity Fund and is Associate Portfolio Manager of the Fidelity Global Special Situations & World Funds.



This post was funded by Fidelity International

Important information

This information is for investment professionals only and should not be relied upon by private investors. The value of investments (and the income from them) can go down as well as up and you may not get back the amount invested.  Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of an investment in overseas markets. Investments in emerging markets can be more volatile than other more developed markets. The Fidelity Sustainable Global Equity Fund can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. A focus on securities of companies which maintain strong environmental, social and governance ("ESG") credentials may result in a return that at times compares unfavourably to similar products without such focus. No representation nor warranty is made with respect to the fairness, accuracy or completeness of such credentials. The status of a security's ESG credentials can change over time.  Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (KIID), current annual and semi-annual reports free of charge on request by calling 0800 368 1732.  Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority and Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0122/370207/SSO/NA