how behavioural finance

How behavioural finance analysis can help unearth hidden sustainability potential

Tom Horsey, Equity Portfolio Manager
2023-04-30
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I think the accelerating momentum towards a more sustainable, net-zero carbon economy entails significant opportunities for long-term equity investors. However, uncovering these investment ideas can pose challenges, given the complexities associated with this structural change and the impact of shorter-term market sentiment.

Companies that appear at the forefront of the transition may already benefit from strong investor support, potentially leading to excessive valuations. Conversely, companies with significant scope to improve their contribution to the transition over the long run may be undervalued and underacknowledged. Often these companies face near-term challenges or operate in out-of-favour sectors, but they may offer attractive financial and sustainability potential over the longer term — in particular, where they can adapt their products and services to support the transition towards a sustainable economy.

This gap between the market perception of a company and its fundamentals has been researched extensively through the discipline of behavioural finance. Authors such as American economist Fischer Black — who famously showed that investors trade on noise rather than information1 — have highlighted the limits of the efficient market hypothesis. Behavioural finance, in my view, can also play a crucial role in cutting through that noise in the context of sustainability. Specifically, it can help to identify promising investment candidates and to assess current sustainability leaders for under-appreciated risks.

A key role for behavioural finance

As a team, we think about behavioural finance as sentiment analysis. if sentiment towards a company is poor, the share price tends to be low, which increases the scope for surprises on the upside. If sentiment is very positive, all the good news may be already priced in, but the downside risk isn’t. Consequently, we think there is more risk in fully priced stocks than in those where the sentiment is negative, but we believe the underlying business has the potential to improve over the next few years. Some of the main behavioural biases we assess are outlined below.

Figure 1
how-behavioural-finance-analysis-can-help-unearth-hidden-sustainability-potential-fig1

Our approach to applying sentiment analysis to sustainable opportunities

We believe sentiment analysis can be used in three ways:

1. Find underappreciated long-term winners where the market is fading these tailwinds too quickly.

The stock market tends to be focused on the shorter term, anchored to old growth rates and less efficient at discounting inflections in long-term growth rates. However, the long-lasting tailwinds we see in these companies can show higher growth potential over the longer term. Conversely, where our analysis shows that a stock’s growth rate is fading faster than the market expects, we would seek to avoid it.

A good example of anchoring would be a company which is a key enabler of electrification of buildings, transport and industry. Its low- and medium-voltage electrical products and software play a big role in the upgrading of buildings and electrical grids. A number of its solutions could improve energy efficiency by up to 50% and reduce energy costs by 30%, but this potential is currently not factored into the company valuation, because of anchoring to past legacy issues.

2. Identify companies that are promising for the long term but hampered by short-term cyclical concerns.

Short-term cyclical concerns may cloud a positive long-term picture when it comes to not only fundamentals but also decarbonisation and wider sustainability potential. From a behavioural perspective, loss aversion often leads investors to avoid cyclically challenged companies. This bias can lead to re-rating opportunities when the short-term cyclical environment improves, and the long-term tailwinds become apparent.

An example of loss-aversion bias would be a shipping equipment company which has developed marine engines that can run on green fuel. It has suffered from the downturn in the marine cycle, but as we approach the trough of the cycle it is starting to benefit from the shipping industry’s structural need to reduce carbon emissions. The company’s fundamentals are intact, with a solid balance sheet, and the valuation is attractive. However, the upside potential in the company — both from a sustainability and a financial perspective — remains broadly underacknowledged by the market due to these shorter-term concerns.

3. Manage risk

Investors tend to flock to stocks that may appear to be strong financial and sustainability winners. Yet this “safety of the crowd” bias may mask fundamental flaws in the positive investment case that supports current valuations and third-party ratings.

An example of safety of the crowd bias could be some of the wind turbine companies where the compelling sustainability case has led to a premium rating for the stocks which may mask any fundamental issues. In some cases, stocks have underperformed as a result of a growing dissociation between weakening fundamentals and a persistently strong sustainability case. We would avoid such stocks, given the risk they pose to clients’ portfolios.

Figure 2
how-behavioural-finance-analysis-can-help-unearth-hidden-sustainability-potential-fig2

I believe that taking sentiment analysis and combining it with rigorous fundamental, ESG and climate analysis (as illustrated in Figure 2) helps generate differentiated insights into companies’ true sustainability and return trajectories. In turn, these can translate into portfolios that, in my view, offer significant long-term return and sustainability potential as well as downside mitigation.

Within the sustainability component, we also see a critical role for ongoing engagement. A robust, research-based engagement dialogue with the board and other relevant stakeholders can help build an investment case further by encouraging and collaborating with the company to accelerate its sustainable transformation and strengthen its wider ESG practices. This includes encouraging the adoption and implementation of a science-based net-zero target2, which, if the engagement is successful, can unlock meaningful value over time.

What type of portfolio does this lead to?

In practice, taking this approach tends to translate into a well-defined portfolio based on the combination of fundamental, behavioural and sustainable perspectives discussed above. The portfolio is likely to be diversified by region, market capitalisation and industry (ranging from agriculture to construction and health care), with companies having implicit or explicit net-zero targets that can be strengthened and monitored through engagement. Many of these sectors have substantial environmental footprints and therefore tend to be increasingly discounted by the markets. Yet they also offer significant scope for developing solutions ranging from more sustainable food to greener building materials and less carbon-intensive medical services.

Bottom line

Over time, the structural transition towards sustainability will leave no company untouched. A major challenge, it also represents an opportunity for companies that have inherently strong fundamentals and are able and willing to adjust their products and services to help enable a sustainable world. I believe that markets are generally slow to recognise that potential, particularly where companies are out of favour for cyclical reasons and may be more challenged from a sustainability perspective. I think behavioural finance, and specifically sentiment analysis, can help identify these hidden sustainable progress stories ahead of the pack and manage under-appreciated risks among current sustainability leaders. This requires deep due diligence and the ability to conduct research-based engagement, as well as patience and stamina in the face of volatility. But I think the results can be highly rewarding from both a financial and a sustainability perspective.

1Source: “Advances in Behavioral Finance”, edited by Richard H. Thaler (Russell Sage Foundation New York, 1993). | 2Science-based targets provide a clearly defined pathway for companies to reduce greenhouse gas (GHG) emissions, helping to prevent the worst impacts of climate change and to future-proof business growth. Source: sciencebasedtargets.org

Our approach to sustainable investing

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