Value investors are naturally inclined to be sceptical of new trends and promises of future growth. They rather invest in stocks that have a real business that has lots of earnings that are underappreciated by the market.
No wonder then that so many value investors have their reservations about green stocks which have come out of nothing and are bid up to sometimes very high valuations based on a promise of strong future growth. Meanwhile, good old-fashioned utility stocks together with energy stocks and mining stocks have largely been ignored by the market and trade at cheap valuations vs. the market and their own history.
And now, those pesky investors come along and want value investors to integrate ESG into their portfolios. The knee-jerk reaction would be to expect that value investing and reducing the carbon footprint of a portfolio would be at odds with each other. The more you reduce the carbon footprint of a value portfolio, the more likely it is that you have to sell attractively valued stocks in energy, mining, or utilities and that will reduce your long-term expected returns.
Enter David Blitz and Tobias Hoogteijling from Robeco’s quant team. They have shown that value investors can reduce the carbon footprint of their portfolios by up to 50% without giving up any return. But before I discuss their report let me tell you a little secret. The folks at Robeco Quantitative Investments produce some of the best quantitative research for practitioners out there. You should definitely bookmark their webpage because their research is without fail of the highest quality and relevance. The only other asset manager that does similarly good work on a consistent basis is AQR.
In their latest white paper, they took the stocks in the MSCI World from 1985 to 2021 and asked themselves what the impact of a carbon tax is on the portfolio of value investors. In a more technical section, they show that introducing a carbon tax is the same as forcing a value investor to reduce the carbon footprint of the portfolio. And since that is for most professional value investors the practically relevant metric, I will go with the reduction in carbon emissions as an additional constraint on the portfolio.
Using EV/EBITDA as valuation metric or EBITDA/EV as the target earnings yield of the portfolio, they then examine if it is possible to reduce the carbon footprint of a value portfolio without reducing the earnings yield, essentially by calculating an optimised value portfolio with the additional constraint on carbon footprints. The chart below shows that for carbon taxes of up to $100/tCO2e or roughly a reduction of the carbon footprint of the unconstrained value portfolio by half, the earnings yield of the constrained portfolio stays virtually the same as for the unconstrained portfolio.
The impact of carbon footprint reduction on the earnings yield of a value portfolio
Source: Blitz and Hoogteijling (2021)
More importantly, the outperformance of value portfolios based on EV/EBITDA as a valuation metric remains virtually unchanged for carbon footprint reductions of up to 50% from an unconstrained value portfolio. And if carbon footprints of an unconstrained value portfolio are reduced by half, the resulting value portfolio has about a 25% lower carbon footprint than an equal-weighted average of the stocks in the MSCI World. IT is only when one tries to reduce carbon footprints by more than half that the returns start to suffer.
Cumulative outperformance of value portfolios vs. MSCI World for different constraints on carbon footprints
Source: Blitz and Hoogteijling (2021)
Of course, the concern for many professional investors will be that the reduction in carbon footprint comes at the expense of different sector or regional exposures, so the researchers repeat the same exercise for a portfolio that is sector and region neutral vs. the MSIC World and they find that there is no practical difference. For carbon footprint reduction of up to 50% vs. an unconstrained value portfolio, there are no reductions in earnings yield or outperformance vs. the market. And to back it all up another time, they also show that the same results hold true in emerging markets.
Thus, one can be confident in saying that value investing and reducing the carbon footprint of a portfolio are not mutually exclusive. Value investors can be green and still remain true to their investment philosophy.