Sin stocks vs ESG stocks: is it good to be bad?
The globalisation and digitalisation of trades have resulted in significant economies of scale for growth labelled stocks (the New Economy) over the last decade. In contrast, value stocks (the Old Economy) fell out of fashion amid consistent underperformance, which sent investors to capitulation grounds. This phenomenon was amplified by reflation trades and the “work from home” fad, which have both exacerbated the valuation of a plethora of high duration stocks.
On the eve of MIFID II extension (August 2022) and the new EU taxonomy, asset managers hastened to launch strategies sporting the SFDR 8 or 9 stamp in order to collect funds from non-sustainability-savvy investors. A few COVID stimulus checks and ESG scandals later, sustainable investors suffered a double whammy effect. The disappearance of the Fed Put and the resurgence of the heated debate about ESG have both hammered ESG stocks.
All this brings us to late 2021 when the style rotation began and investors progressively switched their bets from growth to value stocks. Without playing the devil’s advocate, sin stocks – who often belong to the value style – tend to offer stable cash flows, high dividends and recession-proof business models. Putinflation and the Zero COVID Policy in China added fuel to the fire and pushed energy and commodities to the top of most performing assets in 2022. Oil, gas and mining stocks thus posted record high performances while other equities, bonds and cryptocurrencies collapsed in sync.
In Figure 1, we compared the return of two clusters of stocks through the lens of an ethical investor. Value-driven investing consists in using negative screening to avoid companies whose products and services are deemed morally objectionable from the investor’s perspective. We used well-known stocks as proxies for sinful or laudable industries. Companies can hardly be classified using a Manichean approach, because no single business can ever be in perfect harmony with the Triple Bottom Line (People – Planet – Profit). However, for illustrating the performance of sin stocks vs ESG stocks, we have opposed companies whose businesses are generally regarded as laudable or controversial.
The Nice side
• Sustainable Energy (Vestas Wind Systems)
• Sustainable Food (Chr. Hansen)
• Sustainable Industry Schneider Electric
Subjective selection based on Corporate Knights’ 2022 most sustainable corporations
The Evil side
• Tobacco (British American Tobacco)
• Alcohol (AB Inbev)
• Weapons (Lockheed Martin)
• Oil (Exxon Mobil)
• Gambling (Las Vegas Sands)
• Adult Entertainment (RCI Hospitality Holdings)
Subjective selection based on brand awareness
Figure 1: Monthly return of ESG stocks vs Sin stocks (June 2017 – June 2022)
(subjectively selected equities were used as industry proxy for the purpose of the analysis)
The table below shows the average monthly performance of the two clusters mentioned previously. Over the last five years, ESG stocks (ESG) was 1.19% vs 0.85% for Sin stocks (S). ESG stocks thus exhibit a long-term monthly average outperformance of 34 basis points. The difference is even more blatant if we exclude the Adult Entertainment, which is responsible for most of the performance on the “bad side”. After discounting this outlier, ESG stocks’ outperformance climbs as high as 94 bps.
How could we explain such dichotomy? There are several possible ways to respond, but the most obvious one is the moral victory. Alarmist news flows on climate change, wealth inequalities and human right abuses are all converging to support “feel good stocks” among investors willing to make their contribution. Beside institutional support induced by fast moving ESG regulations, Millennials and Gen Z retail investors are buying the conscious capitalism narrative.
If we shrink our observation period to the COVID era, the tide turns in favour of sin stocks (S=3.31% vs ESG=2.40%) unless we discount adult entertainment once again (S=2.05% vs ESG=2.40%). Adult Entertainment, an online business, has particularly benefited from COVID lockdowns, so as most technology stocks. We can further witness this phenomenon if we zoom in on the poor year-to-date performance of ESG stocks, who tend to be classified as high duration stocks.
We have also compared the historic performance of two diversified Good vs Bad equity funds to look beyond the idiosyncratic risk of our arbitrary cluster selection. In this perspective, we have opposed the USA Mutuals Vice Fund (VICEX) - invests in stocks generating at least 25% of their revenue from alcoholic beverages, defense/aerospace, tobacco or gaming - and the Pax World Fund International Sustainable Economy (PAX). We chose PAX as a proxy for diversified ESG stock funds because Pioneer Fund, the original company launched in 1928, was one of the first ethical asset managers by integrating religious screening.
The three year performance (21/06/19 - 17/06/22) of PAX was -3.6% vs -24.5% for VICEX. Since the beginning of the year, advantage changes hands with VICEX -8.2% vs PAX -22.2%. The dichotomy observed with poorly diversified clusters is thus verified by the two diversified funds.
Sin stocks performed well lately for structural and psychological reasons. Their business is perennial because government regulations keep competitors at bay, and people keep drinking and smoking regardless of a tanking economy – maybe even more. In addition, ESG exclusion policies binding large institutional investors have created attractive entry points for smaller investors looking for pure value.
Figure 1: Monthly return of ESG stocks vs Sin stocks (June 2017 – June 2022)
(subjectively selected equities were used as industry proxy for the purpose of the analysis)
The table below shows the average monthly performance of the two clusters mentioned previously. Over the last five years, ESG stocks (ESG) was 1.19% vs 0.85% for Sin stocks (S). ESG stocks thus exhibit a long-term monthly average outperformance of 34 basis points. The difference is even more blatant if we exclude the Adult Entertainment, which is responsible for most of the performance on the “bad side”. After discounting this outlier, ESG stocks’ outperformance climbs as high as 94 bps.
How could we explain such dichotomy? There are several possible ways to respond, but the most obvious one is the moral victory. Alarmist news flows on climate change, wealth inequalities and human right abuses are all converging to support “feel good stocks” among investors willing to make their contribution. Beside institutional support induced by fast moving ESG regulations, Millennials and Gen Z retail investors are buying the conscious capitalism narrative.
If we shrink our observation period to the COVID era, the tide turns in favour of sin stocks (S=3.31% vs ESG=2.40%) unless we discount adult entertainment once again (S=2.05% vs ESG=2.40%). Adult Entertainment, an online business, has particularly benefited from COVID lockdowns, so as most technology stocks. We can further witness this phenomenon if we zoom in on the poor year-to-date performance of ESG stocks, who tend to be classified as high duration stocks.
We have also compared the historic performance of two diversified Good vs Bad equity funds to look beyond the idiosyncratic risk of our arbitrary cluster selection. In this perspective, we have opposed the USA Mutuals Vice Fund (VICEX) - invests in stocks generating at least 25% of their revenue from alcoholic beverages, defense/aerospace, tobacco or gaming - and the Pax World Fund International Sustainable Economy (PAX). We chose PAX as a proxy for diversified ESG stock funds because Pioneer Fund, the original company launched in 1928, was one of the first ethical asset managers by integrating religious screening.
The three year performance (21/06/19 - 17/06/22) of PAX was -3.6% vs -24.5% for VICEX. Since the beginning of the year, advantage changes hands with VICEX -8.2% vs PAX -22.2%. The dichotomy observed with poorly diversified clusters is thus verified by the two diversified funds.
Sin stocks performed well lately for structural and psychological reasons. Their business is perennial because government regulations keep competitors at bay, and people keep drinking and smoking regardless of a tanking economy – maybe even more. In addition, ESG exclusion policies binding large institutional investors have created attractive entry points for smaller investors looking for pure value.
Figure 3: Yearly return of ESG stocks vs Sin stocks (June 2017 – June 2022)
(subjectively selected equities were used as industry proxy for the purpose of the analysis
Data show the US stocks saw their worst first half in 50 years amid stagflation and geopolitical tensions. This could mark a new paradigm, that of the New FAANG, where investors shift back from “ Facebook – Apple – Amazon – Netflix – Google ” (The New Economy) to “Fuels – Aerospace – Agriculture – Nuclear & Renewables – Gold & Minerals” (The Old Economy). It is too early to tell if the current bear market is a short-term blip or a structural shift, but we can only hope that the hunt for capital appreciation will be as treasured as the pursuit of the greater good. “When the last tree has been cut down, when the last river has been poisoned, when the last fish has been caught, only then will Man realise that money cannot be eaten.” (Anonymous).
Mathias Talmant
Junior Portfolio Manager
FARAD Investment Management S.A.