Letter number 142 of March 2022
- QUESTIONS & COMMENTS
The first part of this article has been published in the January issue, which is available here.
As in any market, if ESG issues are increasing, this is also because there is investor demand.
This is indeed the case. For example, in the first quarter of 2021, inflows to ESG equity funds (€120bn, up 18% on the previous quarter) exceeded those to traditional funds according to Morningstar. By 2020, 532 new ESG funds had been created, and more than 250 conventional funds had been converted into ESG funds by reorienting their investment policy. And in ESG bond funds, $54bn was invested in the first five months of 2021, compared to $68bn for the whole of 2020. As Mathilde Sauvé, Director of Management Development at La Banque Postale AM, explains: "The search for meaning and responsible investment was seen as incidental, but now it has become essential.". And Véronique Cherret of Aviva Investors adds: "There will be less and less room tomorrow for funds that do not have a real commitment to responsibility and a clear ESG process".
As another example, at the end of 2019, 12 major international investors through the Net Zero Asset Owner Alliance (NZAOA) initiative, had committed to their investment portfolios emitting no CO2 at all by 2050, in order to align with the COP 21 commitments. By June 2021, there were 42 signatories, representing €5,500bn in assets under management, including Allianz, Aviva, AXA, Calpers, Dai-ichi Life Insurance, Generali, Prudential, etc. A first step to 2025 is to reduce greenhouse gas emissions by 16-29% (depending on the starting point of the members). These targets will not be achieved by simply selling shares in oil companies to buy shares in wind turbine operators. This would create crashes in sectors that are still useful (who among us could suddenly do without oil and its many derivatives?), and would create gigantic bubbles in others, compared to which the green stocks bubble in late 2020 would be a fond memory.
They have to work on all the companies in their portfolio, and given the size of these investors, on practically all the listed companies, to help them or force them to embrace the energy transition. How do we explain that a small US investment fund, Engine No. 1, with a 0.02% stake if ExxonMobil, succeeded in May 2021 in federating around itself the majority of the US oil company's shareholders to elect as directors three people who were keen for ExxonMobil to initiate its energy transition, up against three partisans of the status quo supported by management, if not through a coalition of investors who are able to see a little further than the end of their noses? And on the day the results of the vote were known, ExxonMobil's share price rose by 3.6%, as investors thought that this would begin to bring the oil company out of the denial threatening its long-term survival.
These commitments are not unique to investors in listed companies, as evidenced by private equity investors, 85% of whom say they have already implemented, or plan to implement in the next year, concrete actions related to climate change; 83% of whom measure the carbon footprint of their investments; and 63% of whom have adopted a carbon neutrality strategy. Not to mention the 56% who have already refused an investment on ESG grounds.
Our overview of investors would be incomplete without the banks. Under the aegis of the UN, 43 of them committed in April 2021 to making their loan portfolios carbon neutral by 2050 by forming the Net Zero Banking Alliance. And by 2050, there are intermediate targets every 5 years. It is true that some NGOs had cleverly caught them by their Achilles heel, their love of rankings, by publishing this one:
With the added headline "JP Morgan Chase is destroying the climate". Not very subtle, but effective.
In this context, it is not surprising that ANZ, Barclays, BNP Paribas, Crédit Agricole, Credit Suisse, Société Générale and Unicredit are refusing to finance TotalEnergies' Ugandan project to build the world's longest heated pipeline (at 50°C) to transport viscous crude to be extracted from Lake Albert to the Indian Ocean, 1,443 km away. A senior banker at Natixis noted that: "It is clear that in the long term, issuers will have difficulty raising financing if they are not committed to the green or sustainable path, or at least they will have more difficulty finding new banks."
Especially since the European Central Bank and other banking regulators, considering that the energy transition poses risks to financial players and financial stability, are pushing banks to better integrate climate risks into their lending decisions. To this end, climate stress tests will be carried out in 2022 on their loan portfolios to measure their degree of resistance to the materialisation of this risk, as banking regulators have done regularly since 2008 to measure their resistance to an economic crisis. And it is likely that, in a few years (2023 to 2025), the regulatory capital requirements for banks in Europe will be modulated according to the degree to which their lending is green and sustainable. Some banks already do this in their management (the green weighting factor of Natixis).
Conclusion by the President of Deutsche Bank: "Banks risk losing their licenses if they fail to make green finance a priority."
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But measuring risks means quantifying them, because you can only manage what is measured. And in this teeming field, with a multitude of methodologies, figures, publications, gaps, and different perimeters, it is easy to get lost and to make comparisons is not easy, if not impossible, especially as initiatives are multiplying. For example, since 2021, Crédit Agricole has been giving an energy transition rating to 8,000 listed companies, which should be adapted and extended to SMEs and intermediate-sized enterprises in 2022. It complements traditional credit ratings in credit or investment files.
This proliferation is not illogical, given that the field is new, and even natural, given that standardisation initiatives have not yet been completed. But we're moving in that direction.
Accordingly, from March 2021, all investment funds domiciled in Europe must be classified into three categories:
so-called Article 6 funds, which do not follow an explicit sustainable strategy, representing about 78% of the funds;
so-called Article 8 funds, which promote environmental and social criteria, representing about 20% of the funds;
so-called Article 9 funds, which follow an explicit sustainable strategy, amounting to about 2% of the funds.
Of course, it's the fund managers that classify funds, and some may be tempted to misclassify funds as Article 8 that do not really have a sustainable strategy (greenwashing). There is a risk that financial product distribution platforms or asset management advisors will not list asset managers who only manage Article 6 funds. But this is a short-term choice, with commercial risks, because sooner or later controls will expose the deception, and the final investor is not always the village idiot.
Most companies with more than 500 employees, whether listed or not, are required to publish a non-financial performance statement. The content of this declaration will be reformed and should be harmonised at European level, probably on the occasion of the publication of the 2023 accounts, around the following principles:
a dual financial and environmental materiality identifying the risks that the environment poses to the company, but also those that the company poses to the environment;
common indicators to reliably compare the performance of companies in ESG areas covering the company, but also its supply and distribution;
information about the past, but also prospective information;
information structured on three levels: global, sectoral to better compare companies, and company-specific;
control of extra-financial information by specialised external parties (extra-financial auditors), which is already done in France but rarely elsewhere;
an extension to all companies with more than 250 employees;
with a probable transformation of EFRAG to give it a role as a standard-setter, at least European, for non-financial data, as a counterpart to the IASB for accounting standards.
It will then be much easier to formalise the conceptual framework that is envisaged, in which the required return on an asset may no longer depend solely on its market risk, as in the CAPM currently, but also on its ESG impact. Our bet is that by 2025, this could become a reality. For example, researchers at the BIS, by cross-referencing greenhouse gas emissions intensity with syndicated loan spreads, have found a carbon premium of up to 7 basis points for the highest carbon emitters.
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Will we achieve our targets for limiting global warming by 2050? We don't know. What we do know is that there is no way that we can achieve them without the active involvement of finance. And it seems to us that we can now say that this support has been definitively acquired, and that many tools and techniques are now in place for it to be massive, and for the pace to step up dramatically.
 H. Bioy, "ESG funds outpace traditional funds in terms of inflows", Moningstar.co.uk, 5 May 2021.
 Option Finance 7 June 2021, n° 1610, page 23.
 As above.
 PwC, Private Equity Responsible Investment, May 2021.
 In the Agéfi Hebdo of 22 April 2021.
 In an interview with the Financial Times on 20 May 2021.
 Under the European SFRD, Sustainable Finance Disclosure Regulation.
 European Financial Reporting Advisory Group, an international association that advises the European Commission on the adoption of IFRS.
 The pricing of carbon risk in syndicated loans: which risks are priced and why? BIS working papers No. 946, 1 June 2021.
Where are fears of sustained inflation? Certainly not in Switzerland, where even at 30 years to maturity, off our chart, interest rates on government bonds are barely positive (0.22%).
And elsewhere, it is not visible, at this stage, in the interest rate curves that are still as shallowly sloping.
With the collaboration of Simon Gueguen, lecturer-researcher at CY Cergy Paris University
Estimating the recurring part of a company's income is one of the most difficult tasks for financial analysts. The partitions proposed by the various accounting standards (French standards, US GAAP), but not proposed in IFRS, are not always sufficient to separate and isolate recurring and non-recurring items. However, this distinction is essential for making a judgement on the real situation of a company and, above all, for forecasting its future and making an assessment. A recent article shows, based on US data (in US GAAP), that non-recurring items are increasingly numerous and difficult to identify, so that it is possible to beat the market by basing your analysis on correctly adjusted earnings.
Rouen et al use data provided by New Constructs, a US provider of financial information and data. They point out that this organisation only provided the data and did not fund or supervise the study, which is useful because the results highlight the quality of the data. On this basis, they identify the frequency and amount of earnings items related to transitory shocks or ancillary and non-recurring activities. Adjusted items include: results of acquisitions or disposals, foreign exchange gains and losses, legal fees or restructuring costs. The study shows that the number of items to be adjusted has increased over the last twenty years. The average number of profit and loss lines involved increased from 6 to 8 between 1998 and 2017. The necessary adjustments relate to approximately 20% of net earnings. In addition, about half of the adjustments require gleaning information from tables other than the income statement itself.
The study also shows that these adjustments effectively produce more recurrent earnings than book earnings. Statistically, the persistence of adjusted earnings is 30% higher than book earnings. In other words, it better represents the company's earnings prospects (over a period of one to five years). However, some analysts are late in incorporating these adjustments, especially when they are gleaned from information outside the income statement. Rouen et al show that the total amount of adjustments calculated from their data is predictive of the adjustments made by analysts to estimated earnings 12 months after publication. Better still, these adjustments can form the basis of a winning strategy. By buying firms in the top decile of the adjustments (those whose earnings are most improved by the adjustments) and selling those in the bottom decile, Rouen et al obtain an annual outperformance of 8.2%.
The purpose of this article is not so much to propose a trading strategy as to show the importance of distinguishing between income statement lines according to whether they are recurring or not. As Rouen et al point out, these results show above all the importance of the work of financial analysts, particularly in their ability to identify relevant information that is predictive of future performance. They also note that the recent trend (increase in required adjustments) penalises less sophisticated investors, which should therefore be a concern for accounting standard setters.
 E. Rouen, E. So, C.C.Y. Wang, "Core earnings: New data and evidence", Journal of Financial Economics, 142, No. 3, December 2021, pp. 1068-1091.
Q&A : n assessing the solvency of a listed company, is it better to reason in terms of the ratio of net bank and financial debts to shareholders' equity, with shareholders' equity taken as book value or market value?
Let's just say that in the overused sense of solvency, i.e. the ability to repay debts in the ordinary course of business, the ratio of net debt to EBITDA has become the norm.
In the classic sense of solvency, the ability to repay debts in the event of liquidation, market value seems much more relevant than the book equity, because it reflects the current market view of the value of assets and debts (the difference between which makes up the value of shareholders' equity) whereas the book equity, which is established according to formal rules (no account is taken of unrealised capital gains, recognition of unrealised capital losses with delay) reflects a past that may be distant rather than a present that concerns us.
The fact that market value introduces volatility is not in itself a problem because a company whose solvency is in doubt will have a value of its equity that will fluctuate structurally a lot, since it is the result of a small difference between two large masses, one of which is more or less fixed (the value of the debt).
Regularly on the Vernimmen.com Facebook page we publish comments on financial news that we deem to be of interest, publish a question and its answer or quote of financial interest.
Here are some of our recent comments.
How do you dispose of a 20% stake in a Russian listed company?
This is a question that BP's financial teams are having to work hard on at the moment, for their group that owns 19.75% of Rosneft, Russia's second largest market capitalisation, as their leaders announced this move. It is likely that no Western group will want to buy, that no Russian group will want to or be able to buy, that no non-Western group will want to take the risk of buying, and at what price? No structured placement in the Russian market can take place (especially as the Moscow Stock Exchange is closed). As for a share buyback of Rosneft shares held by BP by Rosneft itself, which could be interesting from a financial point of view for its shareholders in the long term, the current situation does not allow them to see further than the very short term in all likelihood.
What remains might be the distribution of the Rosneft shares held by BP to its shareholders in the form of a special dividend, with the onus on them to make the best use of it. In 2014, LVMH sold its 23.2% stake in Hermès following the acquisition of the acquisition of this stake in its competitor that was considered anything but friendly by the majority shareholders of Hermès, which led to the agreement with LVMH. It had been an excellent deal for the shareholder of LVMH (price multiplied by 4 in 7 years). It could be different this time for other reasons.
Warren Buffett's 2022 annual letter to his shareholders
3 elements to remember, in our view:
1/ A suggestion to publish important news about a listed company on the Friday evening after the close of the stock market in order to allow investors to analyse it quietly during the weekend before reacting in full knowledge of the facts and to avoid a price surge followed by a fall, or the opposite, when after having acted to follow the movement following news published at 7.30 am, investors then start to think. This is obviously not always possible, as regulations require issuers to publish news that may impact on their share price without delay. And the analysts who had managed to save their Friday night/Saturday morning are not going to like it much.
2/ Berkshire Hathaway, well known for its financial holdings (5.6% of Apple, 9.2% of Coca-Cola, 19% of Amex, etc.), is less well known for its industrial activities (rail freight, renewable energy, etc.), even though it has become the largest American group in terms of fixed assets: $158bn.
3/ And finally, as every year, because pedagogy is the art of repetition, the power of compound interest, which means that with an IRR double that of the S&P 500 over 56 years (20.1% compared with 10.5%), a sum invested in Berkshire Hathaway shares since 1964 is worth 120 times more today than if it had been invested in the S&P 500, knowing that the latter is already worth 303 times the initial investment in 1964.
Porsche's IPO project, or the schizophrenia of investors
When a group feels permanently undervalued, it is a classic practice to think about listing its most successful subsidiary, which is not necessarily the most important one in terms of business volume. Examples include FiatChrysler Automobiles and Ferrari, or Vivendi and UMG.
On February 22, the Volkswagen group confirmed that it was thinking of listing 25% of the capital of Porsche AG, which it currently owns 100% and which represents 3% of its vehicles sold (0.3 million), 10 to 12% of its turnover (€32bn), 33% of its operating profit (€5.5bn) and around 45% (€102 bn according to BNP Paribas Exane) of the value of its assets.
On this announcement, Volkswagen's share price rose by 4.1%. That of its main shareholder (31% of shares and 53% of voting rights), which is Porsche SE, by 11.3%. And the next day, Porsche SE's share price rose by 4.6%, probably because the scheme calls for it to acquire a direct 5% stake in the carmaker during the IPO of Porsche AG, even if it means selling Volkswagen shares to finance this investment.
The fact that investors, like modern Saint Thomas, need to see the listing of Porsche AG to confirm its value is already a surprise for the second largest German stock market capitalization (€110 bn), which is not a priori a company under the radar of analysts and major investors.
Moreover, how will value be created for Volkswagen's shareholders when shares in the group's nugget are sold to third parties, unless they are sold at a significantly overvalued price, which is unlikely in what will be one of the largest IPO processes in Europe?
Can you imagine LVMH taking Louis Vuitton public? And the LVMH share price jumping by 4% on this announcement?
Finally, once Porsche AG listed, the discount of Volkswagen's share price to the sum of its assets minus its net debts will be even more obvious, calling for either an outright demerger (like AXA and Equitable, Atos and Worldline), or a buy-out of Porsche AG's minority shareholders (like Orange and Wanadoo for example).
The pressure will be all the stronger as there will be three levels of listing for assets that are not very dissimilar: Porsche SE, Volkswagen, Porsche AG.
It is therefore not surprising that academic research has shown that the creation of value in a demerger is real when one goes to the end of the process without stopping, as in this project, at a partial IPO. If the spin-off of Ferrari was such a success, it is precisely because the spin-off was complete and that Ferrari succeeded in positioning itself as an ultra-luxury value (average sales price of €0.4m compared to €0.1m for Porsche, production volume 30 times lower) with a luxury P/E (currently 40 times).
In this particular case, the unsatisfactory governance of the Volkswagen group - the founding family holds 15% of the shares, but 53% of the voting rights, the supervisory board is de facto controlled by an alliance with the employees, either of the family or of the State of Lower Saxony - makes this development unlikely.
In short, too much or too little.