Investing with ESG (environmental, social and governance) principles has emerged as winning theme in 2020 but the significant inflows may have led to a bubble amongst some European ESG stocks, according to RWC Partners’ Graham Clapp.
Clapp, manager of the RWC European Equity fund, said there has been a “tidal wave” of inflows into European ESG stocks this year as investors have joined in on one of the winning trends of 2020. But these flows have created a disparity between share prices and the true potential returns of some companies.
Sustainability has been building momentum within the investment industry for a number of years and this trend has accelerated rapidly in 2020.
According to the Investment Association (IA), responsible funds saw a net retail inflow of £897m in August, taking the total of responsible investments funds under management to £36bn. In October last year, when the IA started publishing this data, responsible investment funds under management stood at £25bn.
Inflows into the space is important to note, according to Clapp, because a key characteristic of bubbles is investors jumping onto a strong trend and causing sharp moves in shares’ prices.
“When you see a trend of exponential moves in the value of an asset then clearly those are potential bubbles. And in a number of ESG related stocks you’ve seen that,” he added.
If this is the case, it means that the returns of certain European ESG stocks have surpassed the fundamental outlook for the stocks, which the manager worries is putting investors at risk of losses.
He said: “Clearly there’s a lot of focus about ESG in the stock market at the moment. Clearly it’s a trend which is throughout society and is going to drive demand for certain stocks, but in some cases the share prices have moved disproportionality compared to the potential benefit a move to ESG may make.”
“Many times when we’ve looked at the companies they have perhaps very good potential, but the share prices have moved well beyond reflecting that.”
This potential bubble is especially pertinent in stocks in the environmental theme of ESG.
“The E in ESG has a lot of momentum right now and there’s a huge sum of capital going into companies seen as winners in this space,” he said.
One of the companies Clapp believes has a mismatch between its earnings and its share price is Danish insulation company Rockwool.
The company produces sustainable insulation products made out of volcanic rock, which helps to improve energy efficiency.
Looking at the company’s price earnings ratio history, it has usually traded on about 20 times earnings. But this year it has increased to 30 times earnings.
Rockwool share price YTD
Source: Google Finance
Clapp said that he used to invest in the company and still speaks to them “quite regularly”.
Looking at Rockwool’s earnings estimates this year, he said like most companies it has been partially disrupted by the impacts of Covid-19.
“But the stock [share price] has pretty much doubled with no movement in the earnings estimates,” he added. “It’s gone from less than €200 a share to €400.”
Another example of this split in earnings expectations and share price is German company Tomra, which is best known for its reverse vending machines. These are deposit stations where rather than paying for a can of soft drink you can recycle your empty can, for example.
Going back through the company’s share price and returns history, Clapp said that the last time the company’s stocks were as highly valued as today was during the early 2000s when Germany was looking to pass regulation that supermarkets should provide onsite recycling facilities, fitting Tomra’s products perfectly.
When that interest was high the stocks traded at 200 Norwegian krone a share, Clapp said. But when enthusiasm for the theme wore off, the share price plummeted to 20 krone.
Tomra share price YTD
Source: Google Finance
“So a pretty significant downside potential when the enthusiasm [wanes],” Clapp said.
“And now more recently it’s been a big beneficiary of the renewed interest in that and also other machines. […] The stock basically traded on 15 times earnings for a decade between 2007-2017 and it’s now trading on 65 times earnings.
“This is good example of a company which has good prospects as a result of increased awareness of ESG factors in the economy and there will no doubt be strong demand for their product. But the point I would make is on 65 times earnings there’s a lot of potential already being reflected in the share price.”
Looking at the long term and Clapp said that it’s not a question of whether ESG and sustainability trends are going to remain in the market, but rather do these supposed ‘ESG winners’ have the same longevity in them.
“The trend in terms of what’s going on in the economy is persistent. There’s no doubt about that,” he said.
“It’s absolutely the case that the automotive industry is going to move to electric vehicles. The power generation industry is going to move to renewable energy. And until they come up with an alternative people are going to fly less because they’re aware of their carbon footprint. So those trends are long term and definitely going to go on.
“The questions is whether or not the share prices of some companies will not have that longevity because the potential that those businesses may have may already be fully reflected in the share price.”