One successful way to beat the stock market is to identify overlooked and undervalued opportunities instead of following the crowd. There is a great niche for investors to explore in what is called sustainable investing — which focuses on environmental, social and governance factors — if they are willing to take a long-term view.
Performance data tells the story. In 2018, sustainable funds outperformed benchmarks, with 63 percent landing in the top half of their categories, Morningstar found. Just 37 percent finished in the bottom half of their respective categories for the year.
There has been a lot of mispricing of stocks in this field where the security’s price doesn’t match the value of the underlying business due to investor sentiment. Old biases exist and many people feel you have to sacrifice returns to invest sustainably.
A major source of mispricing often tends to be behaviorial. In the modern world, we rely on our savings for survival, so when we’re investing, it triggers prehistoric instincts that were meant to protect our ancestors in the wild, but which aren’t particularly useful in the modern world. These behaviors may cause us to take too much risk, too little risk, or simply the wrong risks, all at the wrong times. Swaths of investors will tend to behave irrationally all at once, especially when the markets are volatile, and this creates opportunities for those who can remain clear headed.
Another cause of mispricing is an excessive short-term focus on company returns and business results including quarterly earnings and guidance. This has consequences. For example, herd behavior makes us want to change our stripes and chase whatever trends our peers are chasing, rather than sticking to a long-term thesis. And loss aversion can lead to panicked selling.
In reality, there is actually a “patience premium” that offers higher returns for long-term investing in stock markets because long-term investing is so hard to do. There’s less money in the markets following long-term ideas while, at the same time, the competition among short-term trading strategies is only increasing due to contemporary trends in the marketplace — such as high-frequency trading, and machine learning and AI strategies — which play on short-term information. Trading volume and turnover in ETFs and index funds is also worrisomely high. Investment sage, Jack Bogle, founder of index fund giant Vanguard Group, warned about the trend before his death last year.
There’s still a lot of debate among market participants about whether ESG or sustainable investment practices can add value to investors’ portfolios. The patience premium concept suggests that the mispricing of ESG ideas may be a positive contributor to long-term portfolios, partially because short- term investors will tend to overlook them.
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Imagine that Investor A knows that she’s just going to be holding a stock for the short-term, say a number of days. She may not really care about how the company is managing environmental or social issues, and completely ignore them in her estimation of the stock’s fair price. This investor is more likely to focus on near-term price momentum or simply the next quarterly earnings news. But if Investor B knows that she’s going to be holding a stock for a number of years, at some point it makes sense for her to start to ask about how the company is preparing for the environmental and social realities of the future, and to ensure that it is well-governed.
While investing in the future may cause a near-term drag on company earnings, these investments will be rewarded in the long-run. This is why we believe that companies making progress towards sustainability is an important part of being able to earn the patience premium.
Today, information about how companies are managing their environmental, social and governance profiles is increasingly available. A rising number of companies are including this information in their annual disclosures, and ESG ratings can be found on an increasing number of websites like Yahoo Finance and Morningstar along with traditional financial data.
“Fluency” is the name for a behavioral bias that causes us to value things more highly if they are easier to mentally process, and to undervalue things that are complex or uncomfortable. It is challenging to think about the hurdles that companies must cross to thrive in a sustainable future, but investors should always cheer when we identify ideas that others are systematically undervaluing, because we can hope to gain by positioning ourselves on the other side.
The good news is that the sustainable investing field is ripe with mispricing opportunities that long-term investors can capitalize on.
Disclosure: NBCUniversal and Comcast Ventures are investors in Acorns.
— By Nili Gilbert, co-founder and portfolio manager, Matarin Capital Management. Matarin recently partnered with S&P Dow Jones Indices to launch the Matarin Global Long-Term Index which tracks 145 sustainable stocks excluding those in the fossil fuels and tobacco industries.
Ms. Gilbert is a frequent contributor to CNBC. You can watch her report on this topic today on “Halftime Report.”