This article was originally published on oakmark.com by Alex Fitch.
One month ago, defense companies and oil producers were considered some of the least socially admirable businesses on the planet. ESG research firms, like Morningstar Sustainalytics, rated even the most responsible defense and oil companies “above average” ESG risks, and most fared much worse than that. Institutions, such as the Harvard endowment and the Ford Foundation, announced plans to divest from fossil fuels in response to outside pressure, and many other investment firms with ESG credentials promised to avoid investments in either industry. All told, ESG considerations effectively amounted to a broad-based withholding of capital from defense and oil companies.
Fast forward one month and Russia’s invasion of Ukraine has many market participants rethinking their ESG criteria. Swedish bank SEB removed its ban on defense stocks for several of its ESG funds. Citigroup published research arguing for broad-based inclusion of defense companies in ESG mandates. And the European Union is expected to categorize defense companies as socially desirable businesses in its upcoming social taxonomy (i.e., its guidelines for socially beneficial investment). A similar re-evaluation is underway in oil, where dependence on Russian exports is driving renewed calls for energy independence and greater U.S. and European investment in both renewables and hydrocarbons. Suddenly, the defense and oil industries can access pools of funding that were off limits just one month ago.
It’s worth asking: what did these investors learn over the last month to justify such dramatic change? It doesn’t take much imagination to envision the products of defense companies being used for both good and evil, depending on the circumstances. And it doesn’t take much foresight to realize oil will be essential to society for years to come, even as we rapidly invest in renewables. Moreover, the output of these businesses cannot shift anywhere near as quickly as the viewpoints of these investors. It takes years to research, develop and manufacture advanced weapons systems. It takes even longer to replace the energy exports of a major producer like Russia. So while the companies’ sudden access to funding may influence output years down the road, it is unlikely to help resolve the crises of today.
The trouble is most investors do not have long enough time horizons to actually see ESG considerations flow through to business results. As a result, many of these investors make do with shortcuts, force-fitting businesses into “good” and “bad” ESG buckets and simply divesting the “bad.” Divestment, though, is a blunt tool with potentially severe consequences, and binary ESG buckets betray the nuanced impacts these businesses actually have on society.
The reality is all business investments come with trade-offs. Defense companies are beneficial when they protect the innocent and harmful when they enable the guilty. Fossil fuels are harmful to the environment and critical to the functioning of current society. Rather than gloss over this complexity, we believe the role of the ESG-conscious investor should be to balance trade-offs and make decisions that drive the best possible outcomes over the long term. This means recognizing oil production will remain essential to society over the medium term and that environmental costs should eventually lead to declining demand. Both of these conflicting factors must be incorporated into the pricing of oil and gas investments today. When oil companies can be purchased at prices that compensate for these considerations, even ESG-conscious investors should be willing to invest.
We have long taken this more thoughtful approach. As long-term value investors, we make investment decisions through the lens of a long-term business owner. ESG considerations, like all factors that influence business value, are an important component of our research process. After all, a company cannot short-change its stakeholders or the environment for long without a bill coming due to owners like ourselves. As Bill Nygren explained in his third quarter commentary of 2021, with a long enough time horizon there is no difference between actions in the best interest of stakeholders and actions in the best interests of shareholders; what maximizes value for one typically maximizes value for the other.
Our long-term approach is what Bill referred to as an “and” solution – one that effectively addresses the interests of both shareholders and stakeholders. By recognizing that environmental costs will eventually cut into oil demand and correspondingly reducing our business value estimates, we are raising the bar for oil investment. It follows that we also tend to see more value in firms like ConocoPhillips and EOG Resources, which are planning for a less oil-intensive future and have production in lower emissions areas, such as the shale fields of the U.S. Importantly, we are exerting this influence without resorting to all-or-nothing divestment decisions that risk harming other stakeholders, like the consumers who rely on oil to meet energy needs today. Finally, we make these investments with a long time horizon and all-encompassing focus on business value, which makes us, in our view, a stabilizing force for corporate decision-makers who are so often whipsawed by changing market fads and trends. Altogether, it is no wonder we believe that long-term value investing is the most effective form of ESG investing.