The case for investing in non-ESG stocks 

With more and more big funds shunning firms that don’t meet their ESG criteria, there may be handsome returns awaiting investors unafraid to rummage in the bargain bin


Industry cigarette factory line

As one might expect, the Church of England is a fastidious investor. To reflect its higher purpose, it needs an appropriately celestial strategy for the £9bn under its management. 

The Church declares: “We exclude from our direct investments companies involved in indiscriminate weaponry, conventional weaponry, pornography, tobacco, gambling, non-military firearms, high-interest-rate lending, human embryonic cloning, the extraction of thermal coal…” 

The list goes on. It’s also a no to businesses involved in “egregious controversies”, firms that have a damaging social impact and even those considered poor at reporting. All investees must meet its strict environmental, social and governance (ESG) criteria. 

The C of E’s ethical approach may be admirable and wholly fitting for an organisation of its nature, yet (squeamish readers may wish to turn the page now) it could be foolhardy from a financial standpoint. As more investment managers set high ESG bars, the stocks they shun for falling short begin to become bargains for those still prepared to touch them. For investors open to cigarettes, alcohol and guided missiles, there may be easy money to be made. 

The events of Q1 might prompt even the most pious of investors to rethink. Russia’s invasion of Ukraine at the end of February triggered a shift in global markets. Defence stocks soared, for instance. The share price of BAE Systems, maker of the Stormer armoured vehicles that the UK has sent to Ukraine, shot up on the day that Russian troops crossed the border. So did those of Italian defence conglomerate Leonardo and French giant Thales Group, maker of the Starstreak missile system that Ukraine is using to defend its airspace. 

I don’t think things are as black or white as we’ve been led to believe

And the widespread relaxation of Covid restrictions has released pent-up demand for booze and fags, as consumers flock back to pubs and bars. The share price of drinks giant Diageo slumped in the early months of the pandemic, but it has since roared back to record highs, while cigarette maker Philip Morris International is having a solid year.

So is there merit to an anti-ESG strategy – to reap where others won’t sow? As major asset managers such as BlackRock and Norway’s £1.1tn sovereign wealth fund avoid non-compliant stocks, logic suggests that stakes in profitable companies may be available at a knock-down price. 

There’s also the question of whether archbishops and other righteous investors are correct to exclude certain stocks. After all, the defence of Ukraine has been hailed across the democratic world as a noble cause. 

German defence company Rheinmetall is the maker of Leopard tanks and Marder armoured vehicles, both of which are badly needed by Ukrainian forces. In March, its CEO, Armin Papperger, told the FT: “Some months ago, people wanted to ban us; to say that this industry is a very bad industry… It’s a totally different world now.” 

When it comes down to pure returns, it’s hard to find convincing evidence that supports saints or sinners. The MSCI World ESG Leaders Index, which tracks the performance of ethically compliant large and medium-sized companies, narrowly beat the traditional MSCI World Index last year. The two indices have matched each other closely over the past five years. 

Yet recent research by financial services firm Refinitiv Lipper indicates that ESG performance has been dipping. Although the ESG companies it monitors outperformed over three- and five-year periods in the top-selling sectors, their returns have trailed about 8% behind those of their non-ESG equivalents over the past 12 months. 

Price lurches during wars and pandemics may offer false insights. Joe Smith, investment analyst at Equilibrium Investment Management, argues that you’d be foolish to base your allocation choices on volatile world events. 

“If you had looked two years ago at the case for the prices of oil and gas rising as they have done, you’d have needed to foresee a terrible conflict to deliver such returns,” he says. “It would have been a very speculative thing for you to have sat there and said: ‘I think there will be this conflict that will drive up prices.’”

In Smith’s view, it’s better to focus less on black-swan events, no matter how seismic, and take a longer-term view. The theory is that ESG stocks should prevail eventually. 

“Consider tobacco, for instance,” he says. “Sales are declining in the younger populations. And in older populations it is known to be harmful. It’s a product that kills its customers. There will come a point when the customer base won’t be there anymore.”

But the reliability of some processes by which firms are classed as ESG stocks has been called into question. Researchers at Columbia University and London School of Economics compared the records of US companies in 147 ESG fund portfolios with those of firms in 2,428 non-ESG portfolios. They discovered that the former group generally had worse compliance records with regulations protecting both labour rights and the environment.

Ratings agencies do reflect this uncertainty. Imperial Brands, maker of Gauloises cigarettes and Montecristo cigars, for instance, receives an A rating from MSCI for its work in helping farmers to diversify their income and constructing solar-powered water pumps in Malawi. And brewing giant AB InBev has won praise from ESG fund managers for setting a target for 20% of its income to be generated by low-alcohol and alcohol-free beer by 2025. 

“I don’t think things are as black or white as we’ve been led to believe,” says Dr Andrew White, senior fellow at the University of Oxford’s Saïd Business School. “Not all oil companies are the same, for instance. At BP, they are serious about their transition away from fossil fuels. Even investing in arms can look quite different today.”

St Thomas Aquinas, the mediaeval priest and philosopher, argued that war could be justified if it met certain conditions, writing: “It is necessary sometimes for a man to act otherwise for the common good, or for the good of those with whom he is fighting.” 

In light of recent events, perhaps even the arch-pacifists at the Church of England might want to rethink their ESG blacklist.