Weekly Edition #65

In this edition:

Tesla is an electric car company (if you didn’t already know). They have revolutionized the car industry and the electric car industry specifically. He has probably done more to advance the electric car revolution than anyone else. Sure, electric vehicles have their faults, and they are not perfect, but he kickstarted the current wave of EVs we see today. On the other hand, companies such as Exxon Mobil, ConocoPhillips, EOG Resources, etc. are involved in oil and gas exploration, which is very environmentally unfriendly. ESG investing tries to tilt portfolios towards companies that are friendly with the environment, have good social policies and strong governance. Based on what we described above you would assume that Tesla would score highly on ESG, and Exxon and the others would score poorly on ESG. After all, Tesla is an electric car company, and the others are oil & gas drillers.

Many investors in order to invest in ESG stocks use ETFs that claim to be ESG. Generally, these ETFs track indices that do the ESG scoring and weighting for them. Well one of the largest indexing companies, S&P Dow Jones Indices, just kicked out Tesla from their ESG index. And the companies we mentioned above are all in the index (there are more oil and gas companies than those, but the list would be too long to list). This is why we always say that you need to truly understand what you’re investing in. If you bought an ETF tracking this index in hopes of divesting from oil and gas and investing in companies actually helping the environment, then this is not it. Don’t just go by the headlines, actually understand what you’re investing in before you do it.  

A couple of months ago, El Salvador approved a law to legalize Bitcoin as legal tender and Nayib Bukele, the president, decided to use the country’s money to buy a bunch of Bitcoin. In fact, they are in the process of selling an international bond and use part of the proceeds to “invest” in Bitcoin. These purchases were made at prices much higher than what Bitcoin is now, in fact they have lost around $29 million. El Salvador’s Bitcoin experiment seems to be failing, pretty much nobody uses it to pay for anything, they are down big in their trading, and the bond still hasn’t been issued. How would you feel if you president gambled away your country’s money in pure speculation?

 
 
 

A big problem with cryptocurrencies is the cult like mindset that surrounds them. The hype is so large that people truly believe it will be the future and oftentimes invest their life savings into them. They throw out the whole concept of diversification out the window. The reasoning is that many people have become ridiculously wealthy in crypto, so many people see it as a one-way lottery ticket to riches. They don’t think about the downside which in crypto is very real. The latest blowup of UST is a perfect example. Some “investors” believed in the project and poured their life’s savings into it. Only to watch it blow up and lose everything.

When markets are calm and going up, investors start to get complacent. One place this complacency shows up is in the credit markets. Usually when companies issue bonds, investors will include certain covenants that the companies must follow. These covenants can be related to what the company can and cannot do, certain financial ratios, limits on what assets they can sell, how senior are the bonds and to what they can seize in case of default, amongst other things. Companies typically don’t just issue one bond, as business grows companies need money, so they issue several tranches of different bonds. Oftentimes the bonds have covenants to protect creditors from other creditors. So, if you buy bond backed by some of the company’s assets, you don’t want the company to then issue another bond backed by those same assets.

 
 
 

Recently there have been several instances of certain creditors voting to amend bond covenants in their favor. What happens is oftentimes creditors will offer companies cheaper debt in exchange for an amendment to their current bond holdings in their favor. There have been cases where the company moves assets to a subsidiary or some sort of sister company so that some creditors don’t have a claim on these assets. Other cases have been where investors offer better financing terms in exchange of a selective default on certain bonds (in this case investors have CDS protection which pays out if companies default on certain bonds). Like we said before, this becomes possible after many years of stable markets since investors become complacent and lend money to companies with little protections. The worst part of this is that it tends to happen only when a company is in trouble and having problems servicing their debt.

The world of cryptocurrency is endlessly complex. Few people truly understand how many of these currencies work, what they’re for and what are the risks. The recent collapse in the stablecoin Terra proves our point. Many claimed it was the future of decentralized finance and we’ve heard stories of people investing their entire life’s savings into the coin. The problem with this is that unless you are a programmer and have the time to truly understand each project, you have no idea what is actually going on. Therefore, the risk of investing in these projects is extremely high and investing a significant portion of your net worth is frankly irresponsible.

 
 
 

Many of these projects are simply launched to separate investors from their hard-earned money. Back in 2017, there were a lot of projects launched with no specific purpose (or with a stated purpose but with no real future). We remember looking at projects which made no sense such as DentaCoin which would be used to pay for dentist appointments (why you can’t just use dollars and need a crypto is beyond us). Anyways, a lot of projects were launched in an effort to make the backers rich by scamming “investors” out of their money. Now a lot of them are being investigated by authorities for being Ponzi schemes. Like we’ve said many times before, be careful when you “invest” in cryptocurrencies since many of them are probably scams.

There are two main premises with ESG investing. One is that if you divest from “bad” ESG companies that will drive their cost of capital higher and they will have a harder time financing their projects (this ignores that higher cost of capital means higher expected returns for other investors, but we digress). Therefore, if you want to stop companies from doing environmentally harmful projects, then sell their stock and if enough people do that then they might stop doing these projects. We don’t agree with this logic but it’s what is being sold to investors in ESG funds. The other reasoning behind ESG is that climate risks pose a threat to companies, so companies that are more environmentally friendly will be exposed less to these types of climate risks and should do better when these climate risks materialize. We’ve been more neutral on this argument; sure, it makes sense. But if markets were efficient this would already be priced into the stock, and it should be reflected in relative pricing between ESG and non-ESG companies.

 
A new report from Dimensional Fund Advisors (a $679 billion asset manager) shows that there is essentially no link between emission metric and a company’s future profitability or expected returns. This proves our logic that if ESG metrics had any predictive power on future returns or risks, this information would already be priced into stock prices. Therefore, just looking at ESG metrics would give you no new information on what stocks should do going forward.
Thanks for reading!
 

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