Money Life: Bill Davis on ESG investing

This interview has been edited for clarity.

Chuck Jaffe: Welcome to the Money Life Market Call, where we talk with experienced money managers about their job, what they look for that determines their buys and sells, what they see happening broadly on the market, and how they’re putting it all together. Joining me today is Bill Davis, portfolio manager at Stance Capital. The last time he was here we talked about the Stance Equity ESG Large-Cap Core ETF, ticker STNC. The fund has been rebranded and today operates as the Hennessy Stance ESG fund. If you want to learn more about the firm and the fund – and it’s really important when we talk about ESG investing that you understand the principles behind it – go to stancecap.com. 

Bill Davis, it’s great to have you back on Money Life.

Bill Davis: Chuck, great to be here.

CJ: Now, as I said, we need to know the ESG principles that go behind it, but we also need to know methodology because buys, sells and holds are worthless till we have all that information. So lay it out for us. What is the basic investment style, and what’s the ESG style that you lay over it?

BD: First of all, our investment style is to identify companies within the S&P 500. So we’re focused on U.S. large caps that are statistically likely to outperform on a total return and an alpha basis over the upcoming three months. We’re using AI and machine learning—we always have been—in order to identify the companies from a fundamental standpoint that we like.

You mentioned ESG; I think it’s the most misunderstood thing in investing these days, but the idea behind what we’re doing is simply looking for companies who relative to their industry group peers are doing a better job of mitigating some off-balance-sheet risks. So what’s an example of that? 

If we were talking about a company that used a lot of water as an example, and all of a sudden there’s a scarcity of water in areas where they’re actually drawing a lot of water, or let’s say they are creating a lot of wastewater that’s creating pollution in rivers and things like that, those things represent risks to performance. So the way we look at ESG is, we wanna be avoiding companies creating unnecessary risk for investors.

It’s kind of that simple, Chuck. All we do is merge names we like from a fundamental standpoint with names we like from a sort of off-balance-sheet, material-risk factor standpoint, and in order to invest in a company we need to hold the view that they are good in both regards.

CJ: ESG has been taking a bit of a beating in the media largely because the term is, on the one hand, meaningful, and on the other hand lacks meaning and specificity. Sometimes I talk to an ESG manager and they say ‘These are our values’ and their values might be ethical, moral, religious, what have you. Other times it’s ‘No, we’re just applying what we think is good governance technique,’ and do good while we do good by investing in you. How much does that confusion make you worry that somebody who wants to be an ESG investor is maybe looking in the wrong places or not getting what they want in any ESG fund? I mean, I’m sure you want a certain type of ESG investor to come to you and there’s another type where you go, ‘Yeah, we’re not your fund,’ right?

BD: Yeah, I think that’s important. As you say, there are no rules in this, nobody can define exactly what it is. I mean, look, all it really was intended to be, was just data. And people could use it however they wanted to use it. I think where it got a little confusing is that there are different degrees of authenticity. There are ESG funds that own coal stocks, there are ESG funds that are full of energy, you know, conventional fossil fuel companies.

And that’s all fine, right? It’s all in the eye of the beholder. So ultimately I think it’s up to an investor to take the time to understand how the portfolio manager is thinking about these things and whether that aligns with their own worldview. I will tell you this though, Chuck, I think most ESG investors are in it to get aligned with some set of values that they currently hold. In our particular case, we’re in it in order to manage risk and to have a smoother ride for investors over a long period of time.

And we think that ESG done properly, for people who care to use it, is essentially a free option for investors. In other words, the companies we think are good from an ESG standpoint, we don’t have any sort of an expectation that [ESG] is going to, in and of itself, generate alpha for us. I think that the other things that we do in portfolio construction, fundamental analysis and risk optimization, that’s where we generate performance. The ESG is really just to get investors companies that they’re comfortable investing in.

CJ: In other words, the ESG side never overrides the investment side. You’re not buying something based on the fact that it passed an ESG screen. And at the same time, if the fundamentals are all there, you’re just making sure that you only look at those companies that have the right kinds of influences. And it’s an interesting side of things in a world with the kind of politics we’ve got right now, where I’m frequently asking money managers ‘Are you worried that politics would be a wild card?’ Well, I would imagine that with most ESG companies, you eliminate a lot of those. Whether you can drill or not drill, doesn’t affect you if your environmental screens are gonna eliminate big oil, right?

BD: That’s right. I would also say that media has a real role in this because when there’s a lot of click-bait nature to things I’ve read. I’ve been on some podcasts and done some interviews recently where people have said, ‘Oh, we hear that there’s massive exodus from the ESG space to the point of $2.8 billion in 2023.’ Well, what they don’t tell you is that $2.1 billion of that was a BlackRock fund that basically changed its mandate. And so in fact, the exodus from ESG is about the same as the exodus from equities in general during 2023, when a lot of money simply moved to the sidelines or moved into treasuries or money market funds. So yeah, the signal-to-noise ratio is very important to understand in this space. But at the end of the day, what we’re trying to do is simply invest in companies that are less likely to blow up on clients.

CJ: So let’s talk about a company or two that’s a good exemplar for the methodology, and maybe a company where the ESG research helps you make sure that, yeah, it’s not gonna blow up for crossing the line. In other words, maybe it’s the one that passes the screen, but it’s in one of those places where you’re like, ‘Yeah, you could see maybe this might be an industry that doesn’t always pass the screen.’

BD: A good example of that is industrials. If you take industrials as a sector, it can be dirty. A lot of ESG investors might avoid sectors that are a little dirtier. But the reality is, everything in the industrials and their various sub-sectors … it’s one of these catchall sectors that includes everything from airlines to cruise ships.

The reality is, these things aren’t going away as a result of the world decarbonizing. It’s just that there’s going to be winners and losers in all of these sectors. We happen to like industrials. By the way, we also happen to like health care. And we think that if you look at the macro environment right now, we just came out of a year—almost a year and a half—that has been pretty much dominated by the Magnificent Seven, which is very much big tech and comm services companies. It’s basically the seven largest, highest weighted companies in the S&P 500.

We think that trade is getting pretty tired, notwithstanding Nvidia’s beating their earnings or their estimates the other day. I think that right now we’re in a scenario where the spread between the equal weight S&P and the market cap weighted S&P – which is what most people are familiar with – the S&P 500, is the highest it’s been in over 20 years. And we think generally speaking, that is potentially scary and it’s unsustainable. And so one of the things that we see returning is greater breadth to the market, which necessarily means that companies in the bottom two thirds of the S&P 500, not just the top 10, but all of the S&P 500 are poised to actually outperform. And so if you look at sectors like healthcare and industrials, there’s a lot of companies that fit into that doing very, very different things.

A couple of names we like, Elevance Health as an example, a healthcare company, it’s up about 6% this year. That was through a couple of days ago. Another is Aon, which is essentially in the insurance sub-sector or subsegment of financials. That’s another name, both of those names we own in our portfolio and we like them a lot. And those are just kind of maybe a little bit off the beaten track from where a lot of other investors are looking.

CJ: What makes you sell? Presumably, while you wouldn’t expect somebody who’s got good ESG scores to suddenly change things dramatically, it could be that, but it’s more likely to be that the fundamentals have changed, right?

BD: That’s absolutely right. There have been occasions—the greatest example of all is probably Wells Fargo, which goes back a handful of years. Wells Fargo was in everybody’s ESG portfolio until it turned out that they were running a big fraud machine. Everybody jumped out of there, and a lot of people still haven’t gone back. But that’s pretty rare. Companies that tend to be good at governance tend to stay good at governance. But for, you know, the rare exception.

What does happen a lot is that all of a sudden, the fundamental picture changes. Something changes on the fundamental side. Again, since we need to hold both views simultaneously, if they don’t pass the fundamental screen, then they’re just not eligible to stay in the portfolio. So we rebalance quarterly and everything gets a fresh look every quarter.

To listen to the full interview, please visit Money Life with Chuck Jaffe.