We examine the relationship between ESG scores and investment performance and observe that there is a significantly stronger relationship between investment performance and a company's potential for ESG improvement, as compared to the company's ESG score. Deep research and extensive engagement can help value investors capitalize on ESG controversy and access this potential source of alpha.

Introduction

One of the most intense areas of interest in the investment world today is how practitioners are integrating the consideration of environmental, social, and governance (ESG) issues into their investment processes. Some managers have taken a quantitative approach, incorporating an evolving set of tools to invest in companies with high ESG scores. While others, Pzena included, have focused on the integration of ESG issues into the investment process and working with companies, as active owners, to address those issues. An integrated approach appreciates the contribution ESG data providers have made to improving the availability and quality of data in the marketplace but does not use overall ESG scores to make investment decisions. From our perspective, an ESG score is simply one of many inputs to our investment process and by no means the arbiter of investment decisions. That is something that will always be the purview of our bottom-up, fundamentally-driven research team. Nevertheless, we are committed to furthering our understanding of the utility of ESG scores, particularly as it relates to positions or issues that clients have challenged us on. We, therefore, embarked on an intellectual exercise, making use of MSCI's ESG ratings to examine three questions.

• Are stocks with lower ESG scores cheaper?
• Is there a relationship between ESG scores and investment performance?
• Is there a relationship between ESG score improvement and investment performance?

Based on our analysis, initial indications suggest there is not a significant relationship between a company's ESG score and future investment performance, however, we observed a stronger relationship between ESG score improvement and future investment performance. Given the inherent limitations of data for these analyses, as discussed in Appendix A (at the end of this article), these observations, while interesting, should be considered an incremental contribution to furthering the knowledge base in this area, and directional at best.

Lower ESG-Rated Stocks May Be Marginally Cheaper

We started by testing the hypothesis that lower ESG rated stocks are cheaper than the overall universe. We used MSCI industry-adjusted ESG scores (IAS) to divide each universe into five quintiles with proportional sectoral representation. As such, each of the quintiles had the same number of companies from each sector to avoid any sectoral bias in ESG scores. As seen in Figures 1 and 2, the lowest ESG score quintile tends to be slightly cheaper than the overall universe. While the gap is not very large, it is noteworthy that this quintile had a lower price-to-book (P/B) valuation than the universe average in 21 of 27 quarters in the Global universe, and 25 of 27 quarters in the US universe. As such, it is probably reasonable to say that, in general, lower ESG-rated stocks appear to be slightly cheaper than the overall universe.

Relationship Between ESG Scores and Investment Performance

For this analysis, we focused on the relationship between IAS ESG scores and investment performance, as described in Appendix B, Methodology (at the end of this article). We divided the universe into five quintiles, each with the same proportionate sectoral representation based on IAS ESG scores, and we compared the three-year rolling total shareholder returns of each of the quintiles (equally weighted). A strong relationship should, ideally, exhibit three key characteristics. First, there should be a meaningful difference of measured return across quintiles; second, it should follow a monotonic trend across the quintiles (i.e., the highest ESG score improvement quintile outperforms the next improvement quintile, which outperforms the next, and so on), and last, the observed relationship should hold across both the Global and the US data sets. While both results (Figure 3) show that the lowest ESG scores tend to have weaker performance, the monotonic trend of declining performance with lower ESG scores is only visible in US universe.

There is no such relationship in the Global universe where the best return is from the fourth-worst ESG score quintile. Additionally, the return differential for the Global universe quintiles is much less accentuated than the US universe. On the basis of this analysis, the evidence does not demonstrate a strong and sustainable relationship between ESG scores and investment returns. Also remember that this period coincides with a strong push by asset managers to own higher ESG rated names, thus bidding them up, while excluding weaker-rated ESG names, leading to lower valuations, thereby creating a performance differential. While it is hard to parse that effect, strong investor preference for higher ESG-rated shares clearly implies that the relationship visible only in the US universe is also likely less strong than it appears, if it exists.

Relationship Between ESG Score Improvement and Investment Performance

We further focused on understanding the relationship of ESG score improvement to investment performance. For this analysis, we divided the universe into five quintiles, each with the same proportionate sectoral representation based on improvement in IAS ESG scores, and compared the three-year rolling total shareholder returns of each of the quintiles (equally weighted). As seen in Figure 4, there appears to be a significantly stronger relationship between ESG score improvement and total shareholder returns. On average, stocks with improved ESG scores tend to outperform stocks with lower improvement in their ESG scores. This relationship is equally strong across both universes and is monotonic.

Investment Implications

Given the study's limitations, it is unwise to draw strong conclusions, but it may be plausible to make certain inferences. This analysis elucidates that ESG score improvement has potentially a much stronger relationship to investment performance than a pure ESG score. That also makes sense as most ESG ratings are backward-looking and miss the direction of change. That means that weak ESG scores themselves are not negative. In fact, a weak ESG score could be a reason why the stock is cheap; and it may be a great investment opportunity if the company has solid ESG improvement potential, irrespective of its current rating. Investing in those stocks is a win-win because the community is better served when a company improves its ESG prudence, and investors benefit by way of strong shareholder returns. Clearly not every company will improve its ESG performance. Deep company-specific investment research is critical to identify the stocks that can be followed by extensive and continuous engagement with the company to help management in their transition to better ESG performance. Shareholder engagement helps investors determine which transition plans are sound (and which aren't). More importantly, it gives investors a voice to ensure that companies allocate capital efficiently to projects that make sense. For example, with the transition to a lower-carbon economy underway, starving economically critical businesses of capital because they are more carbon-intensive will only make the monumental task of the transition that much harder. Walking away, i.e., divesting from these companies, achieves nothing and may drive them to other less-accountable sources of capital than the public markets. Through engagement, market participants can select which energy players are putting capital to work more effectively and allocate investments accordingly.

ESG and Value Investing

A widely-held belief is that value stocks are weak on ESG and weak ESG stocks tend to underperform, implying that value investing and ESG prudence are in conflict, even mutually exclusive. This study opens up this view for debate, suggesting that value investors can capitalize on valuation dislocations due to ESG considerations by understanding the long-term impact of company-specific ESG improvement actions. A combination of deep research and extensive engagement are necessary for investors to access this potential source of alpha generation. In that respect, the company's ESG score likely matters less than the selection and monitoring of investments based on improvement potential. Our focus, therefore, is not on the absolute score, or even good versus bad ESG scores, but on whether we believe the company can recover its normalized earnings power over time. The combination of deep research and extensive engagement can help value investors like us capitalize on ESG controversy to achieve the objective of generating superior investment returns. We highlight this approach of engagement-led ESG improvement through the following two case studies.

CASE STUDY ONE

Enel S.p.A. - A Utility in Transition

The story of Enel, a diversified utility based in Rome, Italy, is one of a company forced to recover from self-inflicted wounds while navigating an evolving sector disrupted by the widespread adoption of green energy. These two headwinds created a classic value opportunity where the quality of the company's core business was obscured by poor results and fears of disruption. New management cut costs, implemented a culture of capital discipline, simplified the business, and invested prudently to better position the company for the changing landscape, creating the potential for a robust earnings recovery and a re-rating of the stock. Our conviction in Enel's turnaround was largely predicated on improvements in management's approach to environmental risks and corporate governance practices.

In terms of the environment, Enel had been shifting its focus toward businesses that stood to benefit in the new utility landscape: electricity distribution, renewables generation, and broader digitalization, such as smart meters. This came with a commitment to allocate 95% of its capital expenditure over multiple years to focus on these initiatives. Today, Enel is the largest non-government-owned renewable operator in the world, with over 49 GW of installed renewable energy capacity. Enel is continuing to expand its renewable offering, targeting 60 GW by 2022; at which point it will generate almost 60% of its total production from renewables. In tandem, Enel is phasing out coal generation by 2025-2027 (recently accelerated from 2030) and will completely decarbonize by 2050. Enel should also benefit from increased network investments, a necessary part of this energy transition that should enable Enel to earn solid regulated returns due to governments' desire for an upgraded, more efficient grid.

Governance improvements started with the appointment of a new CEO in 2014. He was leading Enel's growing green power division and was well suited to help the company navigate the disruption posed by renewables. He proceeded to transform Enel in numerous ways: increasing operating efficiency; streamlining the corporate structure; focusing capital spending on stable businesses; shifting away from traditional generation and commodity exposure; and improving capital allocation. He discarded major transformative acquisitions, instead focusing on select bolt-on deals, reduced debt, and invested in the business to address energy transition risk. Enel also increased its focus on returning capital to shareholders. It has increased its dividend at a double-digit rate since 2013 and committed to a 70% payout ratio going forward. Through these changes, Enel has transformed from an industry laggard for environmental and governance risks to an efficiently run industry leader with a stable business mix well-positioned for future growth. The company's turnaround (from 2016 to 2019) broadly mirrors the performance period we examined. Over this time Enel's stock experienced a 77% 3-year return, and the company was upgraded by MSCI from an A to AA ESG rating.

CASE STUDY TWO

Wilmar International Ltd. - Affecting Change in a Controversial Industry

Wilmar is a leading Asian agribusiness with operations in palm oil refining, oilseed crushing, and manufacturing of consumer products. The palm oil industry is notoriously controversial, garnering negative media attention for its role in rainforest deforestation and inadequate protection of labour rights in the supply chain. Driven largely by consumer pressure, large buyers of palm oil - specifically consumer goods companies such as Unilever and Nestle - have increasingly pushed their suppliers to shore up a sustainable palm oil supply chain. Wilmar is a classic example of where business success became inherently tied to improvement in ESG practices.

We identified several ESG issues around deforestation for palm plantations, child labour and human rights in the palm supply chain, supplier management, and sustainable palm oil production. We engaged with the senior management and the chief sustainability officer extensively to assess their commitment to addressing these sustainability and labour practice issues. As shareholders in Wilmar, we focused our engagement to fully evaluate the investment risks, as well as to ensure that the company understood the gravity of these issues and to emphasize management actions and investments to proactively address these issues.

Wilmar instituted a zero-tolerance 'no deforestation, no peat, no exploitation policy in 2013, but most notable is the work Wilmar undertook to significantly enhance its supply chain compliance and monitoring efforts. This culminated in the signing of a joint statement with consumer goods companies in December 2018 that established a clear zero-tolerance policy for all Wilmar suppliers - with any transgression resulting in immediate suspension of the supplier until a remediation plan is in effect. Wilmar was the first major player in the market to make this commitment to zero-tolerance, which undoubtedly positioned it favourably among its major customers.

In 2016, Amnesty International published an explosive report alleging widespread exploitative labour practices (including child labour) at the farms Wilmar purchases its raw material from, as well as at their own Wilmar-owned plantations. Amnesty International made a calculated move to highlight Wilmar because Wilmar's scale allows it to effect change throughout the value chain while trying to influence individual small farmers is less efficient. While child labour was not knowingly occurring at any Wilmar plantation, and many of the allegations were unfounded, negative reputational repercussions lingered for some time in the market. The claims in the 2016 report notwithstanding, Wilmar has made substantial improvements in its identification and management of labour rights issues. These efforts include education initiatives implemented at the planation level and publication of a human rights and women's charter framework.

In our engagements, we found the company and its founders to be focused on franchise longevity and very willing to proactively address these business risks. Wilmar has made steady progress which has accelerated over the last five years, achieving significant progress in both ESG ratings and profitability. The timeframe of these improvements broadly mirrors the performance period we examined (2015 to 2018) where Wilmar experienced a 41% total shareholder return and was simultaneously upgraded by MSCI from a BB to BBB ESG rating. Wilmar's sustainability efforts have improved enough such that company was listed for the first time on the well-respected Dow Jones Sustainability Index in 2020 and scored above the 90th percentile for indicators related to raw material sourcing, human rights, and labour practices.

APPENDICES

Appendix A: Study Limitations

There are several limitations of this analysis. Most importantly, the time period is too short to measure long term trends with meaningful significance. Additionally, this period is during one of the worst divergences in growth and value returns, potentially creating distortions in performance analysis. The analysis relies on MSCI's ESG ratings; while having continuously improved the rigor and coverage of its ratings, MSCI was still in the evolutionary phase in terms of depth and sophistication of the scoring mechanism. It is, however, the most comprehensive data set we have available for the duration of the study. Also, we used rolling three-year performance periods and, given the duration of our analysis, it weighs interim periods higher in the eventual calculations. Lastly, as with all correlations, a relationship between ESG factors and performance as demonstrated in the analysis does not imply causation in any way.

Appendix B: Methodology

The analysis is based on MSCI company ESG scores from January 1, 2014 - July 1, 2020, taken at the beginning of every quarter. We used MSCI's Industry Adjusted Scores (IAS) instead of absolute scores. IAS normalize the scores across industries thereby helping us avoid data bias as some industries have inherently lower scores versus others. To further eliminate any sectoral skews, all the analysis was performed on sector-neutral quintiles - i.e., we divided companies in each GICS sector into 5 equal quintiles to ensure proportionate sectoral representation in each quintile. That ensured that within each quintile, it has the same mix of number of names from each sector same as that of the universe. We performed our analysis on two universes - Global and US. Our Global universe included the top 2000 names globally by market cap and our US universe included the top 1000 names listed in US by market cap. We eliminated about 20% of the names in each of the universes due to lack of data. For each of the names in the universe, we collected MSCI's Industry Adjusted Scores (IAS) at the beginning of each quarter from January 1, 2014 to July 1, 2020. We used CapitalIQ to calculate total shareholder returns for each of the corresponding periods for our stock performance analysis. For each analysis, we used a simple average of total shareholder returns of all the companies in the respective quintiles for all the 3-year periods for the time frame of our study, January 1, 2014 - July 1, 2020. This implied 15 3-year time periods starting from January 1, 2014 to January 1, 2017 and last one being from July 1, 2017 to July 1, 2020. As we used a simple average, it effectively meant all the performance calculations are based on equal-weighting of the stocks in each quintile.

This document is intended solely for informational purposes. The views expressed reflect the current views of Pzena Investment Management ("PIM") as of the date hereof and are subject to change. PIM does not undertake to advise you of any changes in the views expressed herein. There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance is not indicative of future results. All investments involve risk, including risk of total loss. This document does not constitute a current or past recommendation, an offer, or solicitation of an offer to purchase any securities or provide investment advisory services and should not be construed as such. The information contained herein is general in nature and does not constitute legal, tax, or investment advice. PIM does not make any warranty, express or implied, as to the information's accuracy or completeness. Prospective investors are encouraged to consult their own professional advisers as to the implications of making an investment in any securities or investment advisory services. ¹Source: Cabinet Office of Japan, Federal Reserve Bank of St. Louis, Kenneth R. French, MSCI, Sanford C. Bernstein & Co., Pzena analysis. Data use 14 US recessions from 1929 - 2009 and eight Japan recessions from 1977 - 2012. The US universe is all NYSE, AMEX, and NASDAQ stocks defined by Kenneth R. French data library and excluding the smallest 30% of companies based on market capitalization to replicate our investable universe. The Japan universe is the MSCI Japan Index. Value is defined as the cheapest quintile of stocks on a price-to-book basis for each respective universe. All returns equally weighted in US dollars. Past performance is not indicative of future returns. 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Alignment with ESG principles is becoming imperative in investment management. A majority (86%) of Australians expect their super or other investments to be invested responsibly and ethically. In addition to the expectation of returns not being compromised, investors also expect these investments to have a real environmental, societal or governance impact, not just "ethics washing".

In a follow-up to our last blog on lessons from 2020, Andrew Baume and I discuss some of the challenges for investing when everything is so expensive.

Investors find it very difficult to feel enthusiastic about deploying capital in markets that are priced well above their historical norms and away from the investor's measure of value. Compounding this unease are periods where the outlook seems so uncertain. If anything, 2020 taught us that this is no reason not to deploy that capital.

It also told us that an explicit expense such as a manager fee is very persuasive compared to the more subtle question of paying for a manager with a value or risk adjusted return focus.

Keynes is often quoted as saying "markets can stay irrational longer than you can stay solvent", but the current asset inflation is by no means irrational.

It is the only possible response to liquidity injections designed to combat the most scary of diseases - deflation - at a time when the global savings pool is bigger than at any time in human history, not only by amount but also per capita in the Developed World.

In March 2020 the immediate response to a global shutdown was market action presuming significant slowing of world GDP with concurrent massive unemployment and dissaving. Governments and central banks who have discovered the joy of free money responded incredibly quickly, pulling asset prices off the floor. The German DAX had dropped 35% and the UK FTSE lost 30% by the time COVID shocks were fully priced. Ultimately GDP fell nearly 10% in the UK and Europe. Though prices have now recovered faster than economies with the DAX comfortably above Feb 2020 highs and the FTSE just below.

So, the fundamental analysis that has been the backbone of the investment process for a hundred or more years is giving us signals that the weight of money seems to completely ignore. The deluge of liquidity means that most assets are now extremely exposed to the risk-free interest rate which drives the dividend discount model of valuation. Despite this, 2020 shows us we need to remain invested, the option of waiting for a 'buying opportunity' is loaded against those allocated to zero rate cash.

Many allocators have been disappointed by the performance of their "liquid alternatives" allocations, partly because there had been a presumption that they would not behave in step with equities when there was a significant price pullback. This proved not always to be the case, some managers allowing the view they were un- or negatively correlated with equities in times of stress to persist even if not stating it explicitly.

In fact a symptom of the new low rates case is for the markets to tend towards a positive correlation (even towards 1) in both down and up markets. The sense that many "alpha" strategies were actually correlated with beta was borne out by performance.

Assets that were less liquid and tended not to be marked to market fared much better in March 2020 as new buyers vanished in the most liquid markets. Central banks managed the crisis via liquidity, bringing buyers back in to markets and evening out the performance gap between the liquid and less liquid. As the liquidity crisis was so short lived it is difficult to estimate how the less liquid asset classes would have performed under longer term redemption pressure.

Human nature is often seen in corporate behaviour as well. As people we often conflate familiarity with understanding, in fact it is much easier to act on our familiar triggers than to delve into the true nature of an event. Daniel Kahneman is a psychologist who won a Nobel Prize in Economics by recognizing this trait.

A couple of easy but potentially dangerous learnings from 2020 may be to remove liquid alternative sources of returns from portfolios and focus more on illiquid ones. Both courses of action are understandable responses but need to be taken in the context of all scenarios, not merely the one we have just witnessed.

So disappointment needs to be viewed in context. We all fall into the common trap of analysing the performance of each component of a portfolio when the outcome of all of the components working together was within expectations. Disappointment should be confined to when the overall portfolio performed outside expectations (given every portfolio has layers of risk, this expectation needs to be realistic). Secondly disappointment with a particular allocation needs to be seen in the prism of how the allocation was designed to behave and whether the execution failed the design. It is no good complaining about a liquid alternatives not being negatively correlated with equities when the underlying design did not include that characteristic for example.

One of the hot topics in Equity and to an extent Fixed Income investing is the cost benefit of indexing rather than active management. The design of that strategy is to outsource your return to the momentum of everyone else in the market. It will be interesting to see whether the mooted return of the value investor puts a spotlight on that design feature.

The next article will cover diversification as it relates to whole of cycle investing.

Recently I sat down with my colleague Andrew Baume to reflect on 2020 and what lessons can be drawn. As he says, with the dubious benefit of over 35 years in Financial Markets, "I have grown weary of commentators who do not accept that this time it is different." The fact that market prices move from one day to the next is evidence that not only this time, but every day in markets is different, otherwise, we could crystal ball gaze and live the simple life.

The era of "democratisation of information" may be a new phenomenon, but as any student of history will know, change is a constant. 

When Sir Thomas More walked across the iced-over Thames into the Tower of London he contemplated how cold London had become. In the early 1980s, Paul Volcker decided to massively manipulate the overnight cash rate and money supply. Mao Zedong was accused by Khrushchev of ruling via a "cult of personality". Mark Twain famously said history does not repeat itself, but it rhymes.

The past 12 months of investment markets have rhymed in an often clanging disharmony with elements of times past, but they are clearly also different. George Soros took a view against the Bank of England in 1992 that was a blueprint for the Reddit warriors to take on hedge fund shorted stocks as a cause célèbre. Soros was backed by deep research and a conviction that the level of the GBP was wrong, but it was might and a squeeze that won the day for him. GameStop was just might and weight of numbers, so soon reversed leading to massive losses for the warriors who bought at either of the tops (so far).

The COVID-19 asset pricing crisis of March 2020 was another driven more by weight of numbers than by deep research or analysis of the future case given the events playing out. Once the liquidity picture became clearer, and the stance of central banks doing "whatever it takes" (rhyming with Draghi) prices responded.

Investment textbooks teach that there is an "optimisation" process that over time will lead to smoother and ultimately better outcomes. Academic investing has a tendency to argue away the times when correlations break down, referring to the long term nature of the ideal investment portfolio. The danger of that approach is shown with the more common incidences of increased correlations between many markets over the last 20 years or so.

Managers have sometimes found it convenient to be seen as having negative correlations to other asset classes (usually equities) and found that in times of stress that is hard to sustain. Not only does that idea get more regularly tested than historically, by allowing that implication to be held the sector as a whole suffers crises in confidence. How we long for an investment that looks the same once the can is opened as the picture on the label. Optimisation when measured in hindsight can look anything but optimal.

Despite that, innovative methods of investing are an essential response to the constant change in conditions. One example of truly uncharted waters is a global middle class saving for their own retirement (rather than receiving a government or employer pension). According to the OECD, the global retirement pool is over US$49 trillion and growing. Once added to the bottomless pit of liquidity being provided by governments globally, it is little wonder markets are staying well bid and commentators call for another crash (they have predicted 27 of the last 3 pullbacks).

It is certainly not the first time investors feel impelled to buy assets that feel expensive. FOMO is real as asset prices stay frothy and cash rates are below inflation. Bond rates have already reflected the policy of massive stimulation, the capacity for them to provide relief in the event of an equity selloff has diminished compared to times past. Most asset valuations have benefitted from low discount rates, and assets like bonds that may have a veneer of negative correlation lose that relationship in stress. There is an ongoing need to be invested when being in cash is so penalising. 

In the midst of this, central banks tempt us with rhetoric that rates are not going anywhere for at least a couple of years. Investors can't rely on an optimisation strategy that worked when interest rates were higher. Diversification of sources of return that don't rely on low-interest rates is a difficult task, one that will improve portfolio outcomes particularly from a risk concentration standpoint. It was not just fixed interest that felt a shiver as US bond rates rose by 66% in the last two months.

There is no guarantee that any strategy is negatively correlated with any other during times of stress. Investors have to stay invested but perhaps the rhymes of history can be harnessed to build a more resilient dynamic asset allocation that reflects the way markets are behaving, not just reflecting expectations or hopes. Diversification through relatively static asset allocations needs "time in the market" to generate the academic outcome but can lead to wild rides in the interim. A 70/30 equity/others split works as the tide rises all boats, but clearly, the inverse is also true.

Diversification of return sources and an ability to dynamically reallocate has attractive characteristics because as Keynes said, "the market can remain irrational for longer than you can remain solvent". There is no option to be out of the market waiting for a time for assets to "cheapen."

Lastly, when markets move in ways that weren't expected, history is clear; more money is lost selling at the lows that made by timing the entry point. 2020's price action where the collapse and subsequent recovery of asset pricing on relatively low volume suggests participants are hearing the rhymes. 

"Needing" to sell assets in the dip was painful. Funds that had large amounts of illiquid assets had the light shined on them when an externality such as government allowing access to the hitherto always growing superannuation balance of millions of members tested liquidity policies. Illiquidity is not a bad thing at all as it usually comes with a premium and investors with long term horizons can bank that. Strong inflows had a dampening effect on the liquidity drain, but there is a lingering question of equity between the members who withdrew for super at a very small discount to pre-Covid pricing (and potentially reinvested into markets down 20-30%) and those who remained in the fund with even lower liquidity and an asset that might well not have been realisable at the holding price. Access to higher liquidity assets also allow funds to make bigger strategic rebalancing decisions.

Although timing the market is hard, there are big events where the need to do that is clear. Entities that seek to maintain fixed weight allocations also need to find flows to do that and top up the allocations for the sector that has fallen most. Some interesting thought bubbles for allocators to ponder.

In summary, lessons we can glean from knowing our history and looking for rhymes (not rules) are multiple, but some are straightforward:

• Crises are inevitable but their manifestation will often be unique,
• No matter how "expensive" market conditions may be, an investor has to deploy funds,
• Correlation and dispersion in practice can be quite different to the textbook,
• Abandoning alternative sources of return as the traditional ones get more and more expensive seems brave,
• The human element (irrational exuberance or negative bias) can weaken our investment outcome, but many have rejected quantitative over discretionary investing,
• Stabilising strategies are more reliable than tactical (over)trading, but Fixed Income is losing its ability to stabilise, and
• Investors often conflate familiarity with understanding - they can be much more at risk with a "vanilla" 70:30 allocation strategy than one that has dynamic and dispersed sources of return.

This is the first of several pieces that will explore these lessons of 2020 while recognising the environment of 2021. The outcome will rhyme with the past, but history will not repeat.

• The ANZ, NAB and WBC results for the March half-year demonstrated comfortable provisioning, strong balance sheets, improving margins, and prudent funding. What was missing was organic growth.
• The banks' loan write-downs in the next two years will be less than the provisions they made last year, but provision write-backs are no substitute for growth.
• We continue to believe that, although the banks will track Australia's post-coronavirus recovery, they will underperform the market in the longer term.

Last November we said that the big four banks were on the road to recovery, and recommended that investors hang onto the banks as a leveraged play on Australian growth in 2021. Over the last six months the banks' share prices rose by 35% or more: now the question is, can they keep on out-performing?

Australian investors have come around to the belief that our economy is on a smooth path to recovery, so they expect bank earnings to recover in line with the economy. Consensus forecasts imply that, after their FY21 rebound, bank earnings per share will grow by less than 10% in each of the next two years. Dividend payouts will not return to their pre-pandemic levels of 75%-plus, so dividend yields will grow very slowly from their FY21 levels of 4.5% to 5.0%.

The banks are simply not as profitable as they used to be, because of higher capital requirements and increased competition in key areas. A decade ago, 20% returns on equity were common; by contrast, in the next couple of years CBA will earn about 12% and ANZ, NAB and Westpac 9% to 10%.

The changed environment is reflected in the banks' dismal share price performance from 2015 to 2020 as seen in the graph below. CBA alone has just beaten its 2015 share price peak; the other three are still about 30% below their 2015 peaks. The "new normal" after COVID-19 will not be much better for the banks than the old normal before the pandemic.

Australian "Big Four" Banks share prices indexed to Base 100 = March 2015

Source: FACTSET

In the longer term, the banks still face the four strategic threats described on our 22 July 2019 paper (available on the Arminius website): higher standards, cryptocurrencies and payment systems, fintechs and neobanks, and ultra-low interest rates. The pandemic diverted attention from these threats, but the threats are still there.

We believe that the combined effects of these threats will erode the banks' growth rates over the next five years, with the result that their total returns will be about 1%pa below the 10.2%pa long-term return of the Australian share market.

The banks have already remediated almost all of their customers and updated their systems to cope with higher regulatory standards. Their CEOs have begun to lay out their post-pandemic strategies, and it is clear that they are based on very different visions of the future of banking.

We do not regard cryptocurrencies as a threat to the standard banking model, partly because acceptance is limited to the true believers, and partly because the regulators have barely started to supervise the sector. Payment systems, however, are undergoing dramatic changes which could change the banking model over the next five years. In particular, all of the major central banks are now looking at issuing their own digital currencies, and some of them may copy the Chinese model.

The pandemic killed off some of the weaker neobanks and fintechs, but the stronger players (e.g. Judo) have survived and are winning market share. Ultimately, their owners will probably succumb to the temptation to sell out to the big banks, but over the next few years they will nibble away at the incumbents' margins, in the same sort of process that we have seen in other disrupted sectors such as airlines and telecommunications.

Ultra-low interest rates are not a permanent feature of the Australian financial landscape, and the Reserve Bank's response to the pandemic included assistance to the banks. It is likely that the strength of the recovery, the jump in house prices, and the emerging inflationary pressures will encourage the Reserve Bank to begin raising official interest rates sooner than the market is expecting.

In addition, there is the challenge issued by the Reserve Bank of New Zealand. During the GFC, the Kiwi regulators could hardly fail to notice that the Australian banks operating in NZ made decisions to suit their Australian regulators and shareholders, without regard to their Kiwi stakeholders. The RBNZ has told the banks that it wants much higher capital ratios in their NZ businesses, ring-fenced so that Kiwi stakeholders come first. The Aussie banks must either comply, and see their Kiwi return on equity drop, or they must divest their NZ businesses.

Most importantly, the big four Australian banks are no longer cheap. In terms of price-earnings ratios and price-to-book ratios, they are more expensive than most banks in the developed world, even their much stronger US counterparts.

All data is in local currency terms. Blue data points are country level section averages, with the exception of Mkt Cap which is a sum total.

Source: FACTSET

They are also slightly expensive relative to their own history. Relative to the Australian market, however, they are still slightly cheap, and their strong capital positions leave room for share buybacks. Therefore we recommend that investors maintain their bank holdings, at least until the next set of results in November.

When the Australian Investment Council, the peak investment body for private asset managers, released the performance highlights for the most recent financial year it was shown yet again that Australian Private Equity outperformed listed markets over a 5, 10 and 20 year period by between 2.0% and 8.9% p.a. net of all fees:

These results are consistent with findings overseas and makes intuitive sense given investors should be rewarded with an "illiquidity premium" for investing in private assets.

But what is less understood is what drives these consistently superior returns.  We set out in this article to examine some of the key factors that contribute to Private Equity's outperformance.

GREATER OPPORTUNITY SET

Illion, in a recent report on SME business opportunities estimated that there are around 14,000 private companies in Australia which could be classed as small-medium (revenues of $20-150m).  This contrasts with the number of larger private businesses (~2,000) and the typical public fund universe of 200-300 securities.  It can even be argued that the real investable universe for public equity large cap managers is even smaller as many managers are restricted to primarily dealing in the top 30-50 securities given their mandate and liquidity constraints.

But how accessible are these private companies to PE managers?  In a report published in 2017 by PricewaterhouseCoopers, over two thirds of founders or family business owners indicated they will sell their business or pass it on to the next generation in the next five years providing ample acquisition opportunities for private equity managers.

The existence of a greater number of companies being competed for by a fewer number of purchasers leads to more opportunity to find "undiscovered gems" at prices that don't necessarily find equilibrium through normal market discovery processes.

Number of Australian private companies by sector activity and by size of revenues: 

Source: Illion | Services: Trade, Accommodation and Food Services, Transport, Postal and Warehousing, Information Media and Telecommunications, Financial and Insurance Services, Professional, Scientific and Technical Services, Administrative and Support Services, Public Administration and Safety, Education and Training, Health Care and Social Assistance, Arts and Recreation Services and Other Services. Industrials: Mining, Manufacturing, Electricity, Gas, Water and Waste Services and Construction.

LOWER ENTRY MULTIPLES

The entry multiples, that is the measure of the price paid for a business as a multiple of EBITDA, are lower for private businesses than they are for public ones.  This is a natural outcome from greater public company information availability combined with the fact that the price that purchasers are willing to pay being lower for private assets.

In turn, multiples paid for small to medium private businesses are on average lower than those paid for larger businesses due to those businesses being perceived as being more risky.  The table below shows that multiples for small-mid sized private businesses in Australia generally fall between 6-8x EBITDA whereas larger businesses fall into the 10-12x range.

The price that a purchaser pays for an investee company is critical in determining the return an investor achieves.

Multiples of completed Australian company transactions grouped by Enterprise Value

Source: Dealtracker 2020; Grant Thornton

VALUE CREATED THROUGH INTERVENTION

With larger listed businesses it is often the case that they are able to afford to employ the expertise to enable operations and strategy excellence to create efficiencies that enhance overall company performance.  This is rarely the case with private businesses and particularly with smaller businesses which are family or founder owned.

For family or founder owned companies and start-ups with less management capability, significant value can be created by leveraging the expertise provided by private equity firms. Company efficiencies are improved, growth is accelerated through customer expansion, M&A activity initiated, managing cash, reducing costs, attracting talent and improving IT systems.

Often these businesses see private equity as a valuable way of accessing industry experts who can assist with benchmarking, accessing new markets and generally providing expertise that is not easily accessible otherwise.

Adams Street Partners, a global private markets specialist,  quantified the sources from value creation in the US LBO Private Equity market from revenue growth being at 38% and multiple arbitrage (which is often a by-product of revenue growth) at 33% meaning the managers they studied brought meaningful value to private investments primarily through the enhancements they made to private businesses.

LESS RED TAPE

It can be argued that the focus of boards on corporate governance related to shareholder requirements and oversight can stifle entrepreneurial spirit.  Listed company boards spend large amounts of time concerned with control-related topics and shareholder reporting as opposed to matters concerning expanding the business.  Private equity managers are often able to strike a balance between governance and growth to deliver on their investment thesis and increase the value of their portfolio companies.​

There are a multitude of other reasons that private equity may result in better company performance that public ownership.  These include:

• Release of capital constraints: An injection of capital under private ownership may enable improvements and/or financing of growth opportunities that may have been limited where capital sourcing opportunities were inhibited through public ownership restrictions
• Patient capital.  Private equity managers can choose when to deploy capital based on opportunities available, economic conditions and price.  The evidence that timing when to invest can make meaningful differences to performance outcomes is evidenced by the fact that Private Equity funds that invested during and following significant economic downturns have significantly outperformed other vintage years.
• Lack of analyst coverage: For some smaller listed businesses, their lack of size means less company analyst coverage which can inhibit a companies ability to raise capital for growth opportunities.  This issue goes away with private ownership focussed on investing for growth.​

In conclusion: Private Equity has been shown to outperform public equity over long periods across numerous markets, for a number of reasons.  Institutional investors have known this for decades and have allocated meaningful amounts to the asset class.  Through Vantage Private Equity individual investors now have the opportunity to participate in these institutional, private opportunities and access the significant returns that the Private Equity asset class delivers.

• Not all areas of the market that are benefiting from the recent shift in market sentiment are good places to invest.
• A balanced view that includes assessment of value and quality in addition to sentiment points us to six sectors that are particularly attractive in this environment.

In recent weeks, market sentiment has undeniably shifted away from relatively expensive, high-risk, low-quality stocks. To illustrate the magnitude of this aggregate shift, it's helpful to compare our measures of sentiment with our assessments of value, quality, and risk.

The correlation between sentiment and value has shifted from negative to positive over the past two months; the already positive correlation between sentiment and quality has become higher over the same period. At the same time, the correlation between sentiment and high risk has plummeted. Figure 1 shows the extent to which investors recently have been turning their attention toward more reasonably valued, higher-quality, lower-risk stocks.

Figure 1

Correlation of Active Quantitative Equity's Proprietary Sentiment Scores with Proprietary Scores for Value, Quality, and Risk

That said, in our view not every area of the market with improving sentiment is a good place to invest, and not every segment with deteriorating sentiment should be avoided. Consumer Services and Real Estate both remain unattractive on our measures, despite their improvement in sentiment in recent months. In general, Consumer Services firms still represent very poor value (when taking quality considerations into account). And although many Real Estate companies continue to be of high quality, our signals - which quantitatively analyze the language used in earnings conference calls and in the explanatory notes of financial reports - are concerning.

The six market segments we most favor in this environment of shifting sentiment (in no particular order) are Health Care Equipment, Banks, Insurance, Technology Hardware, Autos, and Semiconductors. Our preferences are not always based on improvement in sentiment (see Figure 2). For example, although the broader Health Care sector has experienced heavy deterioration in market sentiment, we still like Health Care Equipment and Services, especially in the US. The language signals from Health Care Equipment and Services companies' conference call transcripts and financial reports are very strong, valuations are reasonable, and quality is high.

Figure 2

 AQE's Current Most-Favored and Least-Favored Sectors

Banks have benefited from improving sentiment in recent weeks. While we favor banks overall, that improvement in sentiment is not the sole source of that positive assessment. Drilling down to examine banks by region reveals some important distinctions. European banks have seen a much larger improvement in sentiment than their North American counterparts, but we view European banks as only neutral in attractiveness compared with cheaper North American banks.

The same multi-dimensional view informs our negative assessments as well. Sentiment toward real estate stocks across the developed world has improved a lot in recent weeks, but in Europe sentiment toward real estate stocks has actually gotten worse. Our language signals for European real estate names are also very poor.

Bottom Line

Sentiment has turned to favor attributes we like, including high quality and cheaper valuation. When choosing stocks, however, it's important to weigh all important attributes, including value, quality, and risk - as well as sentiment - in order to avoid simply riding the latest sentiment trends.

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