A Value Investor’s Guide to Impact Investing
By: John Mullins, Lyrical Asset Management
For impact investing to succeed and continue to attract investor interest and flows, it has to do more than just deliver a social or environmental return; it must also generate a good financial return. This is where a value approach can help.
This is an excerpt from NCPERS Fall 2023 issue of PERSist, originally published October 24, 2023.
Impactful businesses are hard to screen for and measure. There is no standardized measurement methodology and ESG ranking services don't help. For example, if we consider Refinitiv's top ESG rankings of the largest 2,500 developed market stocks, you'll find an oil and gas powerhouse and a provider of shale drilling equipment in the top 15. Industry classifications don't help. Of Standard & Poor's' 158 sub-industries there are only two obvious impact categories—Renewable Electricity and Environmental Services—which comprise only 22 stocks.
Impact is also difficult to measure – it is complex and not standardized. We think measurement must be done on a bottom-up basis. For example, take Elis, a cleaner of linens and uniforms, based in France. Elis purchases linens for their clients and cleans them using efficient industrial washers in a centralized location, reusing them as much as possible before recycling them. Elis is an obvious promoter of the circular economy, but that won't show up in ESG rankings or emissions data. To validate and measure the impact of Elis, we worked with the executive team to estimate that the company's operations use, on average, 48% less water and 29% less energy than onsite cleaning. Because it is both a cheaper and more environmentally friendly option, Elis is taking share from insourced cleaning, and we expect volume gains from the company to result in 54 billion liters over 4 years. This process might sound arduous because it is. However, the result is a true assessment of how a company's products impact the world as shown below.
Perhaps because identifying Impact is hard, we observe that most active and passive sustainable funds look similar. The two largest passive funds look much like the S&P 500 with >75% overlap. These passive funds essentially remove bad industries like tobacco and leave everything else. Most active impact funds crowd into the same names. Of eVestment's 15 largest actively managed “Sustainable” or “Impact” funds, 14 stocks are owned in at least five of them. What's more, none of these funds qualify as value funds, trading on average for more than 20x earnings.
We believe combining value investing with impact is important to driving strong financial returns. Going back to 1975, the cheapest quintile of global stocks has outperformed the MSCI World by almost 600bps, annualized. This is why we believe valuation should be the bedrock of any investment strategy.
Investing in impactful public companies is necessary to achieve the UN's 17 Sustainable Development Goals, but finding and evaluating impactful companies is difficult. We believe you must employ a bottom-up approach, working closely with companies and industry experts to identify and measure impact. For impact investing to succeed and continue to attract investor interest and flows, it has to do more than just deliver a social or environmental return; it must also generate a good financial return. This is where a value approach can help. Using our portfolio as an example, it currently trades at a 10.5x forward P/E despite producing the impact shown below. Bottom-up value investing is achievable with impact.
About the author: John Mullins, Portfolio Manager joined Lyrical in February 2017. He has more than 15 years of experience investing across public and private markets. Prior to Lyrical, he served as a Senior Analyst at Clearfield Capital Management from May 2016 to January 2017 and as an Analyst at Elm Ridge Capital from September 2014 to April 2016. He worked as an investment analyst in the San Francisco office of Orbis Investment Management from 2011 to 2014. Before attending business school, John evaluated early-stage investment managers and financial services businesses as an analyst at MD Sass Macquarie Financial Strategies. John graduated cum laude with distinction from Yale University and received an MBA from the Stanford Graduate School of Business.
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