Shunned by many university endowments and pension funds, coal is about as unfashionable as an investment can get.
Yet two coal producers were the best-performing stocks last year among St. Louis companies. Shares of Peabody Energy, on the verge of a second bankruptcy as recently as 2020, soared 162%, and Arch Resources delivered a return of more than 80%, including some large dividends.
There’s a lesson in those numbers for fans of sustainable investing, which often uses the initials ESG to denote a focus on environmental, social and governance issues. The lesson: You can’t always have your cake and eat it too.
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Of 11 sectors tracked in the benchmark Standard & Poor’s 500 index, energy was the only one with a positive return last year. That caused ESG funds, which tend to avoid or underweight fossil fuel companies, to have a bad year.
The Vanguard ESG US Stock exchange-traded fund, for example, had a negative return of 24%, compared with minus-18% for the market as a whole.
For several years, socially conscious investors had been able to claim a moral high ground while reaping above-average returns. The 2022 result is more in line with what both logic and economic theory would predict.
“If a large enough group of investors excludes certain stocks from their investable universe and favors other stocks, nothing happens to the companies’ earnings,” said Larry Swedroe, chief research officer at Clayton-based Buckingham Strategic Wealth. “But green stocks get high valuations, ‘brown’ stocks get lower valuations and higher valuations forecast lower returns.”
In part, the energy sector’s strong performance last year was caused by Russia’s invasion of Ukraine, which sent oil, coal and natural gas prices soaring.
The war wasn’t the whole story, however. Previous price spikes encouraged new production that eventually brought prices back down, but this time seems to be different.
“In the coal industry, you’d be out of your mind at this point to look at a new mine,” said William O’Grady, chief market strategist at Confluence Investment Management. “The price has gone up, but there has been no production response.”
Companies are reluctant to bet on a new oilfield or mine when both policymakers and the markets are telling them that fossil fuels are out of favor.
“There is no incentive to do long-term projects when there’s a danger of those assets being stranded,” O’Grady said. “Since there is no future, your goal is to reward your ownership as much as you can.”
O’Grady predicts that oil prices will stay elevated and perhaps even go higher. “Demand is not falling all that much and supply is going to be hard to come by,” he explained.
As for investors who have embraced the sustainability movement, they should expect to pay a price for their convictions.That’s not a bad thing; again, it’s just logic.
Research shows that companies with high ESG scores are less risky than other firms. They’re less likely to be hit with an environmental lawsuit, for instance. If you’re going to take less risk, however, you should expect a lower return.
That rule didn’t seem to apply when investors were piling into technology stocks, which tend to earn high ESG scores.
“Green valuations went through the roof, which means you’re making the future return smaller, but most people don’t understand that,” Swedroe said. “There’s a recency effect; they buy what’s been doing well.”
Tesla, a favorite of ESG investors, lost two-thirds of its value last year even as fossil fuel shares were soaring. The rules of investing logic may have been suspended for a few years, but they returned with a vengeance in 2022.