Despite recent challenges, we think the long-term outlook for socially responsible investing (SRI) remains robust.
The past twelve months have been tough for those investing in socially responsible strategies. Energy insecurity, high inflation, and the shifting energy market environment have weighed on the performance of SRI funds and portfolios.
Despite these headwinds, we feel that the structural drivers behind SRI remain in place. For the long-term investor willing to invest for at least three to five years, the trend towards environmentally and socially responsible investing remains an opportunity
What is socially responsible investing (SRI)?
Socially responsible investing means focusing on companies that do business in a fair and progressive way, while avoiding those involved in controversial practices. There are many reasons why people choose SRI portfolios – some like that they align with their values, while others see them as an opportunity to invest in companies that are better positioned to manage the risks that come from environmental, social and governance factors.
There are several ways of investing responsibly. ESG – the recognition and consideration of (environmental, social, and corporate governance factors – has become a foundational pillar of investment analysis, and not just for SRI funds.
ESG is critical in informing an investors’ views of long-term risks and opportunities. It marries non-financial information (which can include metrics like carbon emissions, board diversity, or human rights) with traditional financial techniques to better inform investment decision-making. It provides an additional lens through which to judge how sustainable and competitive business models will be over the long term, and seeks to identify who is best placed to prosper in a world of societal and environmental shifts.
At Nutmeg, we’re proud that socially responsible investing is a core part of our offering. We score all Nutmeg portfolios against a range of ESG factors too, so you can see the impact your investments are having whichever style you choose.
Why was 2022 so challenging for socially responsible investing?
The underlying drivers behind responsible investing didn’t go anywhere in 2022, but it was a disappointing year for ESG-focused investment strategies.
Many major ESG indices (those that exclude or underweight certain companies and economic sectors based on the activities they undertake) underperformed wider stock markets after several years of strong returns.
One critical driver of this underperformance was the revival in fortunes of the energy and commodities sectors that took place after the Russian invasion of Ukraine. Russia’s dominant role in commodities supply chains was exposed by economic sanctions levied in the wake of the invasion last February, and as a result, 2022 was characterised by large dislocations in core energy and commodities markets.
At the same time, economies around the world were in ‘reopening’ mode – a steady loosening of Covid restrictions and normalisation of activity across much of the world.
Energy and commodities producers benefitted from this environment. The first half of 2022 was characterised by an acceleration in some commodity prices, notably crude oil, natural gas, and many agricultural and food commodities. The near removal of Russian oil supply from western supply chains coincided with years of underinvestment in oil supply capacity against the backdrop of climate change and shifting policy initiatives, forcing prices higher.
This was a challenging development for many ESG-focused investment strategies that are naturally underweight (meaning they hold less than the benchmark) or exclude companies involved in fossil fuels, mining, or commodities extraction, given their negative impact on the environment. The energy sector was a key source of positive performance for some stock markets in 2022, and those markets with inherently higher exposure to the sector fared better than peers – for example, the UK’s FTSE 100 and the Canadian equities market.
In fact, in the example of the FTSE 100 index, energy and commodities-related companies such as BP, Shell, Rio Tinto, and Glencore were among the top performing stocks, while the energy sector contributed the vast majority of the index’s positive return in 2022.
Will the energy sector continue to outperform in 2023?
While energy companies should continue to fare well in 2023, it is unlikely that their profits will be quite as exceptional as last year. Prices have stabilised, and the extreme volatility that drove energy markets, such as natural gas, last year has cooled.
Over the medium-term, demand for crude oil and natural gas is expected to rise as China’s economy continues to reopen, and come winter, Europe will once again seek to bolster its energy reserves.
The energy sector continues to look attractive from a valuation perspective. It has the lowest forward price-to-earnings ratio of global industrial sectors, and half that of the wider global equity index.
Price-to-earnings, or p/e ratio, is a widely used valuation metric that measures a company’s current share price relative to its earnings-per-share. It helps analysts understand whether a company’s stock price is over or undervalued and where it sits relative to other companies in the same industry or benchmark, like the S&P 500. Forward p/e ratio uses future earnings guidance rather than current data, and a low forward p/e ratio suggests that analysts are expecting earnings to increase.
Strong earnings support this metric, but despite outperformance and large gains in the past 12 months, the energy sector still compares favourably to peers. Another attractive characteristic near-term is the free cash flow generated by energy majors, offering the potential for higher dividends and further share buybacks, which both contribute to total returns.
In the near term, the continued resilience of the energy sector is likely to be a headwind for ESG indices. But – as BP has itself pointed out – the direction of travel hasn’t changed. The energy transition is still a global imperative. Last year emphasised the need for it to take place in a secure, affordable, and sustainable way, while also accelerating the transition towards renewables, as countries seek to prioritise the pace at which they develop their own energy sources and self-sufficiency.
Is now a good time to invest sustainably and responsibly?
After a reversal in fortunes for ESG investment strategies in 2022, does this mean the future is dimmed for ESG? We do not believe so.
The structural drivers towards a more socially responsible economy are still very much at play. The climate agenda is high priority for leaders around the world. More and more companies and investment funds are incorporating measures or programs that use ESG metrics, and the demand for socially responsible investing solutions is set to increase.
Furthermore, ESG is intended as a holistic framework for the consideration of non-financial factors in investment decision making. It is more than just simply investing in a greener or more sustainable way. It includes important considerations, such as gender representation on boards, human rights and labour standards, and general corporate behaviour. It is intended to help investors determine how long-term structural changes, such as climate and policy change, will alter competitive dynamics and ultimately help us determine which companies we want to shape our global economy.
It has a different type of sustainability at its heart than many immediately recognise – the sustainability of profits, risk taking and operational models in a fast-changing global economy.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance.