Crucial Takeaways From Berkshire Hathaway’s 2022 Earnings And Buffett’s Annual Letter
Berkshire Hathaway’s (BRK/A, BRK/B) fourth-quarter earnings release also includes the annual letter from Warren Buffett as part of the annual report. The yearly letter continued the theme from last year as a type of owner’s handbook for Berkshire shareholders. Buffett noted that he and Charlie Munger do two main things at Berkshire. First, invest in operating businesses, usually by owning 100%. This review will focus on the performance of these operating businesses controlled by Berkshire Hathaway BRK.B . Second, buy non-controlling stakes in publicly traded stocks. An analysis of Berkshire’s publicly traded holdings is here. Buffett also noted that shareholders should focus on Berkshire’s operating earnings rather than the volatile GAAP results. He also took particular aim at those blindly deriding corporate stock repurchases. He unequivocally stated, “Gains from value-accretive repurchases, it should be emphasized, benefit all owners – in every respect.”
Berkshire Hathaway reported a gain of almost $18.2 billion in the fourth quarter versus a profit of over $39.6 billion in the same quarter of 2021. This gain broke the string of bottom-line losses thanks to the fourth-quarter rebound in the stock market since results are heavily impacted by gains or losses from the investment portfolio, with unrealized losses from their portfolio included in earnings. Operating earnings, which remove the distortion from market changes and better reflect the firm’s earnings power, fell by 8% for the quarter versus 2021. The 2022 calendar year operating earnings rose 12% over the same period in 2021. Providing an illustration of the value from share repurchases, per-share operating income for 2022 increased by 15% versus 2021.
Because the Covid-19 pandemic negatively impacted most businesses, including Berkshire, beginning in early 2020, comparing current results to pre-pandemic 2019 results is helpful. Operating earnings for the calendar year 2022 are 28% above 2019. Operating earnings increased across all primary business segments except insurance underwriting, which was well below 2019 levels. Thanks to share repurchases, operating earnings per share for 2022 were a whopping 43% above 2019.
A further look into the different operating segments for the fourth quarter of 2022 shows generally weaker results across the segments versus 2021. Interest income and Berkshire Hathaway Energy were the stronger segments in the fourth quarter. Notably, the operating income for all segments, except the Other category, was better relative to the pre-pandemic levels of 2019.
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The operating segments for all of 2022 show better results than 2021, except for insurance underwriting and the railroad. Operating income for all segments, except insurance underwriting, was better for 2022 relative to the pre-pandemic levels of 2019.
Insurance: 2022 investment income was 35% higher than in 2021, primarily due to higher interest income from short-term investments. Investment income was previously depressed by ultra-low interest rates implemented in response to Covid, but the Federal Reserve raised rates aggressively in 2022 to fight inflation. Investment income should continue to see improvement as the Federal Reserve seems likely to remain in hiking mode through at least most of this year. Underwriting results were poor for 2022, but the real culprit was GEICO, with significant underwriting losses. Berkshire Hathaway Primary Group and Berkshire Hathaway Reinsurance Group had underwriting gains for 2022. GEICO continues to suffer from more frequent auto claims and rising claims severity due in part to the higher valuation of used vehicles. According to the Mannheim index, used vehicle prices have fallen from their peak, but prices are still 42% above the level at the end of 2019. GEICO expects to generate an underwriting profit in 2023 since it received approval to raise premium rates due to the increased claim costs.
The two most essential concepts in insurance investing are “float” and underwriting profit. In simple terms, float is created for insurance companies because insurance premiums are paid before any claims are made by the insured. Insurance companies can invest the float, sometimes for years, before insurance losses are reimbursed. Berkshire has a history, unlike many insurance companies, of earning an underwriting profit, meaning that their float costs them nothing and makes them money in addition to allowing them to earn a profit off of investing the float. An underwriting profit means the insurance premium exceeds all insurance claims and expenses. Despite Berkshire’s underwriting loss for 2022, it posted underwriting profits for calendar years 2021, 2020, and 2019. Berkshire’s float was higher at approximately $164 billion versus the $147 billion level on December 31, 2021, and above the $138 billion on December 31, 2020. In general, the value of float increases as yields rise. Float per share has increased to $112,066 from $98,960, also aided by share repurchases. Berkshire completed its purchase of Allegheny in October 2022, which increased float in the fourth quarter.
Railroad: Berkshire owns one of the largest railroads in North America, the Burlington Northern Santa Fe (BNSF) railroad, operating in the U.S. and Canada. Net operating earnings fell 1% versus 2021 but were 8% over pre-covid 2019. 2022 revenue was higher due to higher pricing and a fuel surcharge driven by higher fuel prices, but volume declines and higher operating costs hurt the bottom line.
Utilities and Energy: Berkshire owns 92% of Berkshire Hathaway Energy Company (BHE) which generally provides steady and growing earnings, as one would expect from what primarily consists of regulated utilities and pipeline companies. The utilities were boosted by higher customer usage and customer growth, partially offset by increased costs. The pipelines benefited from “higher regulated storage and service revenues.” Overall, BHE posted 12% higher operating earnings in 2022 relative to 2021 and 37% above 2019. Interestingly, this group also operates Berkshire Hathaway HomeServices (BHHS), the largest residential real estate brokerage firm in the country. The slowdown in housing activity is evident in the results, with 2022 net earnings 74% below 2021. The 2022 BHHS earnings suffered from lower mortgage and refinance activity thanks to higher interest rates and a decline in closed brokerage transactions.
Manufacturing, Service and Retailing: This segment consists of many diverse businesses, so this analysis will focus on a few significant themes when looking at this segment. Berkshire’s aerospace exposure remains substantial despite selling its publicly traded airline holdings earlier in 2020. Berkshire previously took a $10 billion impairment charge on the Precision Castparts PCP (PCC) business due to its exposure to the COVID-disrupted aerospace industry. PCC’s pre-tax earnings rose slightly in 2022 relative to 2021, primarily due to improved demand for aerospace products. The rebound in domestic air travel and the restart of Boeing 787 production in the third quarter has boosted the outlook for this business, which continues to be hampered by increased costs and supply chain issues. Management continues to note that future growth is predicated on increasing production since the company has suffered from worker shortages and supply chain disruptions. Berkshire’s FlightSafety and NetJets continued to see a rebound, with training hours up 11% and customer flight hours rising 9% in 2022 versus 2021.
Housing-related businesses like Clayton Homes, Shaw, Johns Manville, Acme Building Products, Benjamin Moore, and MiTek posted sharply higher earnings relative to 2021, a 40.7% increase in quarterly pre-tax profits versus 2021. Berkshire noted that higher prices and volumes offset cost pressures. Despite the good news for the year, management indicated that “comparative revenues and earnings in the near term will likely decline from current levels” due to the impact of higher interest rates on new home construction.
The most significant portion of the retailing segment is Berkshire Hathaway Automotive (BHA), owning over 80 auto dealerships. BHA had 18.4% higher earnings in 2022, driven by higher vehicle gross profit margins. These vehicle margins peaked in the first half of 2022 and declined in the second half. Berkshire noted that 2022 apparel and footwear earnings plunged 68% relative to 2021 due to lower sales and higher inventories. Management said it was “taking measures to right-size our operations for the long-term and reduce inventory to more appropriate levels.” In addition, 2022 earnings were lower for Pampered Chef, See’s Candies, and their furniture retailers, including Nebraska Furniture Mart. This weakness in some of the retailing exposed businesses is not a surprise, given similar results of declining demand and higher inventory levels from others in the industry. Berkshire added a global toy company, Jazwares, with the acquisition of Allegheny in October 2022.
Berkshire’s McLane unit had 17.8% higher profits in 2022 versus 2021. McLane is a wholesale distributor to retailers and restaurants. The increase in earnings was primarily due to “slightly higher gross margin rates.” Still, supply chain constraints, labor shortages, truck driver shortages, and higher inventory costs hurt the business last year. Berkshire had been pessimistic about McLane in 2022 but removed any forecast for 2023.
Other: The segment had a significant profit for 2022 primarily due to foreign currency gains and an increase in equity method earnings at Kraft Heinz (KHC), Pilot, and the inclusion of Occidental Petroleum OXY in the fourth quarter of 2022. This segment includes companies’ profits that must be accounted for under the equity method due to the size of ownership and influence on management. The after-tax equity method earnings have Berkshire’s proportionate share of profits attributable to its investments in Kraft Heinz (KHC), Pilot, Berkadia, Electric Transmission of Texas, and Iroquois Gas Transmission Systems. The equity method earnings include Occidental Petroleum (OXY) beginning in the fourth quarter of 2022. Berkshire now owns 21.4% of the outstanding shares of Occidental. More about the possible reasons for the Occidental investment is here.
Pilot is the largest operator of travel centers in North America, under the names Pilot and Flying J. In January 2023, Berkshire acquired an additional 41.4% ownership of Pilot for roughly $8.2 billion. As a result of the Berkshire’s ownership increasing to 80% of the entity, it will be shown as part of the consolidated financials for the operating companies in the future.
The foreign currency exchange rate gains were generated from bonds issued by Berkshire Hathaway and denominated in British Pounds, euros, and Japanese Yen. These foreign currency liabilities are not a concern as Berkshire has significant assets and earnings denominated in these foreign currencies. Investment losses from non-U.S. dollar investments generally offset these gains.
Berkshire bought back a little over $2.6 billion of its stock in the fourth quarter. Until an announcement in mid-2018, Berkshire had only made repurchases when the stock traded at less than 1.2 times the price-to-book (P/B) ratio. While that constraint is now relaxed, it is still a good indicator of the general range when aggressive repurchases will likely be seen. Berkshire’s P/B ratio was between 1.3 and almost 1.5 times during the quarter, so one might have thought the purchase amount would have been lower. Berkshire only intends to repurchase shares when the “repurchase price is below Berkshire’s intrinsic value, conservatively determined.” The P/B ratio remains a reasonable proxy for gauging Berkshire’s intrinsic value. Still, Warren Buffett and Charlie Munger’s judgment about its intrinsic value versus other available uses of capital can differ from that simple price-to-book measure.
In addition, Berkshire made other purchases but was a net seller of publicly traded stocks in the fourth quarter. Berkshire bought $1.7 billion of stocks while selling $16.3 billion for a net decreased investment of $14.6 billion in publicly traded equities. The details can be found in the 13F, which is reviewed here.
Summary: Quarterly results are generally not meaningful for Berkshire since it is managed with a focus on increasing long-term value and not meeting quarterly hurdles. This ability to take advantage of time arbitrage has served the company and shareholders well over the years. The goal in looking at the results is to see if the segments are generally operating as expected and consider the capital allocation decisions made by Warren Buffett and Charlie Munger.
Operating earnings for the fourth quarter of 2022 fell by 8% over 2021 but are 52% above pre-pandemic 2019 levels. The 2022 calendar year operating earnings growth was impressive at 12% and 28% above 2021 and 2019, respectively. In recent years, a significant capital allocation decision was made to increase share repurchases. This activity signals that Buffett and Munger believe Berkshire Hathaway’s price is below their intrinsic value estimate. If they are correct (and there is no reason to doubt them), the purchases are a value-creator for the remaining shareholders. Operating earnings per share for the 2022 calendar year were 15% above 2022 and 43% above 2019, with the additional benefit from share repurchases. The increase in repurchases in the fourth quarter was interesting, given the higher valuation of Berkshire. Still, it might have something to do with the inability of the duo to find some other opportunities with a more attractive risk versus reward for investing capital. In addition, a 1% U.S. excise tax on share buybacks became effective at the end of 2022, so the additional purchases might have been timed to avoid taxation.
The underwriting loss for the insurance businesses in 2022 is disappointing. GEICO, one of Berkshire’s crown jewels, continues to be challenged by the impact of the pandemic. Still, it is encouraging that the premium increases are in the pipeline, and management believes GEICO will revert to its typical underwriting profits in 2023. Other better news for 2022 was that the investment income from the insurance business continued to rebound sharply as the Federal Reserve aggressively raised short-term interest rates. Cost pressures from rising inflation caused non-insurance profit margins in 2022 to decline below 2021 levels, but margins remained higher than in pre-pandemic 2019.
Berkshire’s stock price handily outpaced the S&P 500 in the fourth quarter, soaring by 15.3% versus a total return of 7.6% from the S&P 500. For 2022, Berkshire’s price is +4.0%, while the S&P 500 had a total return of -18.1%. Cash levels were above last quarter. Berkshire retains a fortress balance sheet with cash and equivalents of over $128 billion, providing flexibility to take advantage of opportunities, including repurchasing its stock. Berkshire has stated that there would be no stock repurchases if it would cause cash levels to fall below $30 billion.
Berkshire’s third quarter 10Q filing noted that they “do not expect a material impact on our consolidated financial statements” from the passage of the Inflation Reduction Act of 2022. The inflation reduction act becomes effective for tax years beginning in 2023 and includes a 15% corporate minimum tax, tax credits for clean energy, and a 1% tax on stock repurchases. Berkshire’s effective income tax rate was 27.9% in 2022.
Despite the advanced age of its two top leaders, shareholders should take comfort in knowing that the firm continues to be managed to survive and emerge stronger from any economic or market downturn. Berkshire’s businesses are performing well, aside from woes at GEICO and some slowing due to macroeconomic headwinds. According to FactSet, S&P 500 earnings per share grew 3.9% in 2022 which is significantly less than Berkshire’s 15% growth in operating earnings per share. Management warned that some businesses, particularly the retailing and housing related business, have seen some softness. Berkshire retains its Fort Knox balance sheet and a diversified mix of businesses, which allows the unique ability to take advantage of significant opportunities when disruptions or crises provide them.
Don’t Make A Mess Out Of The Texas Citizens Participation Act
The Texas legislature is considering a proposed amendment to the Texas Citizens Participation Act (TCPA), which is the Texas Anti-SLAPP law and roughly the equivalent to the Uniform Public Participation Act (UPEPA) which is in the process of being adopted nationwide. Because the proposed amendment has the potential to create more problems than it solves, and in fact may create a mess of things, some analysis is in order.
The TCPA is found at Texas Civil Practice and Remedies Code § 27.001, et seq. The TCPA basically provides that if one party files an action some sort of action which infringes upon certain constitutional rights of another party, that second party (movant) may file a motion to dismiss the action of the first party (respondent) in certain circumstances.
I will not go into the entire operation of the TCPA, but will instead here focus upon only the part that is relevant to the proposed amendment.
If the movant’s motion to dismiss is unsuccessful, then the movant may appeal under § 27.008 of the TCPA and the corresponding § 51.014(a)(12) that provides for an interlocutory appeal of a trial court’s denial of a motion to dismiss. Very importantly, § 51.014(b) provides that while this appeal is ongoing, all other proceedings at the trial court are stayed pending the appeal.
The stay pending the resolution of the appeal is necessary to avoid potential wasted effort by the trial court and the litigants. Otherwise, if the litigation were to proceed before the trial court while the appeal was ongoing, but the appeal later reversed the denial of the TCPA motion, everything that the trial court and the litigants would have done in the interim would be totally wasted activity.
Of course, the respondent who defeated the motion to dismiss wants to get on with their case, but the truth is that the stay pending appeal is probably not going to be very long anyhow, because § 27.008(b) provides that “[a]n appellate court shall expedite an appeal or other writ, whether interlocutory or not, from a trial court order on a motion to dismiss a legal action under Section 27.003 or from a trial court’s failure to rule on that motion in the time prescribed by Section 27.005.” So, if there is a delay in the litigation, it should be only a short one and thus there is no need for a relief from the stay.
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The bottom line is that there is nothing wrong with this stay during appeal as it currently exists in the statutes. It doesn’t need fixing. Nevertheless, in SB896/HB2781 the Texas legislature is considering tinkering with § 51.014 to limit the application of the stay pending appeal to three circumstances:
First, where the motion to dismiss failed because it was untimely under § 27.003(b);
Second, where the motion to dismiss not only failed, but was also deemed to be either frivolous or assert solely for the purposes of delay, per § 27.009(b); or
Third, where the motion to dismiss was denied because an exemption to the authorization of the motion existed (such as commercial speech, wrongful death claims, insurance disputes, evictions, etc. ― Texas has a bunch of such exemptions) under § 27.010(a).
The reason for this tinkering is implicit: If the TCPA motion to dismiss does not seem like a close call, there is no reason to delay the litigation while the movant (who lost the motion to dismiss) prosecutes what is likely a fruitless appeal.
Except that there is.
The hard truth is that trial courts frequently get things wrong. So frequently, in fact, that states such as Texas have full-time appellate courts with numerous districts to review purported errors by the trial courts. Particularly where the state courts are asked to consider matters with constitutional implications ― issues which, unlike the federal courts, they rarely deal with ― the state courts have a tendency to err. Plus, once a trial court has made one misjudgment, the effect is usually to snowball and result in other bad rulings that follow, such as sanctioning a party who was right in the first place.
Thus, long ago it was determined that it did not make any sense for litigation at the trial court level to go on at the same time that there was an appeal pending, for the reason that if the appeal ends in a reversal then whatever the courts and the parties were doing up to that point in the trial court becomes a giant pile of wasted judicial resources and efforts. This is the very reason why § 51.014(b) stays activity at the trial court level for interlocutory appeals. Such is even more important in the Anti-SLAPP context, such as with the TCPA, where one of the primary purposes of such statutes in the first place is to conserve the judicial resources of the courts and the parties — and particularly the party against whom abusive litigation has been brought.
However, the single counterargument against allowing the litigation to go forward during the appeal as in the proposed Texas amendment is this: The appeal is not going to last very long anyway, because of the mandate of § 27.008(b) that the appellate court must resolve a TCPA appeal expeditiously. Because the appeal period will be short, there is really no compelling reason to risk wasting judicial resources and the parties’ resources in the meantime. The proposed amendment to the TCPA is a solution in search of a problem.
It also must be considered that what the Texas amendment really attempts to do is to negate what amounts to a frivolous appeal by a party that has lost its TCPA motion. However, there is already a remedy for that, which is that the Texas Court of Appeals may itself award monetary sanctions for a frivolous appeal. Thus, if a party files a bogus appeal of the denial of their TCPA motion, the Court of Appeals may award appropriate monetary sanctions, not just against the party who brought the appeal but also against the counsel who filed that appeal. This is a significant deterrent to the bringing of such appeals.
But let us consider what might be done in these circumstances if somebody really just wanted to do something for the sake of doing something. It would not be the proposed Texas amendment. Instead, the appropriate solution would be to allow the Court of Appeals the discretion to lift the stay under § 51.014(b) upon the request of a party or upon its own initiative in the described circumstances.
What happens with all appellate courts, including the Texas Court of Appeals, is that the particular panel makes a decision on the outcome of the appeal pretty quickly. The delay in the Court of Appeals issuing its ruling is that it takes time to write the opinion to support the ruling. If the Court of Appeals knows that it is going to rule to deny the appeal, then the Court of Appeals at that time could lift the stay at the trial court level in anticipation of their future formal decision denying the appeal.
The problem of the stay pending appeal is not a trial court issue, and should not be resolved by changing what goes on with the trial court, but instead is an appellate issue that should properly be resolved (if at all) by allowing the Court of Appeals the option of terminating the stay. One thing is certain: The proposed amendment to the TCPA that automatically terminates the stay is not the way to deal with this issue ― if, indeed, an issue actually exists at all.
What Are The 2nd Quarter Teflon Sectors?
The FOMC decision last week fulfilled most expectations, but it was the details that hit stocks Wednesday afternoon. The conflicting comments between Fed Chair Powell and Fed Secretary Yellen on bank guarantees spooked the market as the futures dropped 70 points in the last hour.
It was not surprising that the concerns over the banking system continued last week after last weekend’s emergency buyout of Credit Suisse. The pressure on Deutsche Bank (DB) increased Friday as the US shares were down 5.5% in reaction to their credit default swaps (CDS) hitting a four-year high on Thursday.
For the month DB is down almost 25% as the German Chancellor Olaf Scholz came out with supportive comments on Friday. Most banking analysts do not appear to be worried as Stuart Graham and Leona Li, analysts at global financial research firm Autonomous, said that “Deutsche is in robust shape.” Also, DB has turned in 10 straight quarters of profits.
What was surprising for most was the stock market’s ability to rally on Friday as most of the major averages did close the week higher. Once again the Nasdaq 100 led the way up 2% to push its year-to-date gain to 16.7%. The S&P 500 ($SPX) and Dow Jones Industrial Average ($INDU) had smaller gains of 1.4% and 1.2% respectively. The disparity on a YTD basis has widened further as $INDU is down 2.7%.
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The iShares Russell 2000 had a volatile week but closed up 0.7% while the Dow Jones Utility Average was the weakest, down 1.4%. It is now down 5.9% YTD as it is the weakest performer. For the week the NYSE advance/decline ratio was positive as 1808 issues were advancing with 1385 declining.
As of Friday’s close, the Invesco QQQ Trust (QQQ) was up 1.97% in March as it closed just above the 20-month EMA at $305.24. The next monthly resistance is the August high at $334.42. The multiple-month highs from early in 2022, line a, are in the $370 area. The March low at $285.19 is now an important support level to watch.
The Nasdaq 100 Advance/Decline line is a bit higher this month but still below its WMA as it has been since August 2022. A move above the WMA does not look likely this month. The weekly A/D line (not shown) is fractionally above its WMA as is the daily A/D line.
The monthly relative performance (RS) has moved above its WMA for the first time since late 2022. This is a sign that the QQQ is leading the SPY higher as we move into April. In late January the weekly RS signaled that QQQ was leading the market higher.
The outperformance of growth stocks was not the consensus view at the start of the year or in February. Now the question is whether the growth stocks will continue to move higher despite the strong recessionary fears.
So far in March, the iShares 1000 Growth ETF (IWF) is up 3.5% while the iShares 1000 Value ETF (IWD) is ETF is down 4.3%. The ratio of IWF/IWD formed a V-shaped bottom at the start of the year and moved back above its 20-week EMA in late January.
The downtrend (line a) was broken two weeks and the resistance at line b has also now been overcome. The August peak at 1.631 is the next barrier for the ratio. The ratio is well above its 20-week EMA so it is a bit extended on the upside. The MACD-His did form a slightly positive divergence at the late 2022 lows, line c, and is still rising strongly with no divergences yet.
The monthly analysis of the iShares 1000 Growth ETF (IWF) shows that it closed on Friday just below the 20-month EMA at $237.87. The February high was $242.87 while the monthly starc+ band is at $290.06. The long-term support from 2020, line a, was tested in October.
The monthly RS has just moved above its WMA suggesting that IWF can continue to lead the SPY over the next quarter. The volume has declined over the past two months and the OBV is still slightly below its WMA. The weekly indicators (not shown) are positive.
Of the eleven sectors, there are just two where the monthly RS is rising and it is above its 20-month WMA. The Technology Sector Select (XLK) is up 7.1% so far in March and is currently trading above the February high. The high from August at $150.72, line a, is the next barrier.
The monthly RS has moved further above its WMA in March consistent with a market leader. The volume increased a bit in March and the OBV has moved above its WMA for the first time since April. The weekly indicators (not shown) are positive as the RS is well above its WMA.
The Communications Services Sector (XLC) is up 6.2% in March with the next resistance at $60.24. On a move above this level, the monthly starc+ band is at $67.60. The March low at $51.37 should be good support.
The monthly RS has just moved above its WMA indicating that XLC is leading the SPY. The RS dropped below its WMA in October 2022, one month after the high. The volume has been strong this week and the OBV has moved above its WMA and the resistance at line c, which is a good sign. The weekly studies (not shown) are positive with last week’s close.
Crude oil reversed on Friday to close back below $70. In last week’s review I shared my concerns over this sector as it could hold the major averages back. Sharply lower crude oil prices also could add pressure on some of the regional banks which is not what they need.
In conclusion, the analysis of the Growth/Value ratio and the monthly RS analysis suggests that growth stocks and EFFs should be favored on any pullback. The technical evidence indicates they should be Teflon-like in the next quarter and hold up better than the value stocks.
The Calculus Behind The ESG Battle Between The White House And Capitol Hill
When President Biden used his first veto (less than 60 days after his party no longer controlled both houses of Congress), the media reported on the event with much fanfare. That it had to do with a very narrow subject didn’t matter. But was all the chest pumping justified? Could it be that the issue was already moot even before Congress passed the joint resolution that inspired the veto?
On Wednesday, March 1, 2023, the Senate voted 50-46 to overturn the Department of Labor’s new Fiduciary Rule. This new Rule was to replace a similar Rule promulgated by the DOL under the Trump administration. At issue was the application of ESG criteria by ERISA fiduciaries to retirement plan investments.
What does ESG stand for?
“ESG stands for environmental, social, and governance,” says Andrew Poreda, VP and ESG senior research analyst at Sage Advisory Services in Austin, Texas. “ESG factors are non-financial (yet important) factors that are critical to the success of a corporation or entity.”
The concept isn’t entirely new. A similar philosophy called “Socially Responsible Investing” (“SRI”) emerged as a favorite among activists in the 1980s. It primarily targeted institutional investments in South Africa.
Going further back, religious organizations have practiced this form of exclusionary investing for quite some time. For example, it’s not unusual to see portfolios for church groups prohibit investments in “sin” stocks (alcohol, tobacco, and gambling) or stocks in the defense industry.
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Why is ESG important?
If ESG is just an SRI rose by another name, why has it suddenly become the center of such controversy? In short, it’s because it’s a little hard to define, and when it’s defined, it seems to run contrary to fiduciary practices.
Lawrence (Larry) Starr, of Cornerstone Retirement, Inc./Qualified Plan Consultants in West Springfield, Massachusetts, says, “There is no way to mandate something that is so poorly defined and differs widely in application from company to company and from investor to investor.”
As one of those investors, however, it’s critical you understand how other investors view ESG for the same reason it’s important for value investors to understand how growth investors think and vice versa.
“ESG is data that can provide a more complete picture of how a company operates beyond financial analysis alone,” says Bud Sturmak, the head of impact investing and a partner at Perigon Wealth Management in New York City. “ESG analysis helps to better understand a company’s overall stability, its opportunity to create shareholder value, and its exposure to critical business risks. ESG data can help inform sound investment decisions and allow you to tailor your portfolio to reflect your personal values.”
What is the main focus of ESG?
Starr says the primary reason ESG exists is “to provide ‘socially conscious’ investors with guidance as to a company’s attention to these (not well-defined) subjects.”
Again, if you look at things from the point of view of proponents, ESG, no matter how ill-defined up close, has a sincere intention when looking at it from the 30,000-foot level.
“The main purpose of ESG investing is to reward good corporate citizenship and encourage companies to act responsibly by allocating capital to companies that share the investor’s values,” says Rob Reilly, a member of the finance faculty at the Providence College School of Business and an investment consultant at North Atlantic Investment Partners in Boston. “Environmental criteria consider how a company deals with environmental risks and natural resource management, including corporate policies addressing climate change. Social criteria evaluate how a company manages relationships with customers, suppliers, employees, and the communities where they operate. Governance deals with a company’s leadership, board of director diversity, internal controls, executive pay, audits, and shareholder rights.”
This broad objective can have multiple tactics. How do these varying approaches impact the definition of ESG?
“This depends on one’s perspective,” says Matthew Eickman, national retirement practice leader at Qualified Plan Advisors in Omaha. “At a binary level, it’s either to invest in companies in an effort to support or advance social and environmental agendas, or it’s to invest in companies whose commitment to environmental, social, and/or governance issues situates the companies to perform well in the future.”
This confusion can lead some to question the real aim of ESG.
“It is a Machiavellian and subversive attempt by ESG woke proponents to seize and control how boards of directors in America run their company on ESG goals rather than profit and loss goals,” says Terry Morgan, President of OK401k in Oklahoma City.
What did the President and Congress hope to achieve by their actions?
Given the passion ESG generates on both sides, is it any surprise that it has become a political hot potato? And when something becomes a political hot potato, you need to guard against hyperbole.
“First, it should be noted that there is a disconnect between what the bill does and what some politicians are claiming it does,” says Poreda. “The intent of Congress’s joint resolution appears to be aimed at preventing retirement plans from investing in strategies that are aimed at pushing political and ideological agenda (e.g., ESG strategies are seen as being aligned with climate activism and ‘woke’ agendas).”
Indeed, it could be that both proponents and opponents of ESG may not have read the fine print of either the Trump or Biden Rules.
In a post published in the Harvard Law School Forum, Max M. Schanzenbach (Northwestern Pritzker School of Law), and Robert H. Sitkoff (Harvard Law School) wrote, “Much of the confusion that the 2022 Biden Rule endorses ESG investing, and that the 2020 Trump Rule opposed it, traces to the original proposals for those rules. The Biden Proposal favored ESG factors by deeming them ‘often’ required by fiduciary duty. The Trump Proposal disfavored ESG factors by subjecting them to enhanced fiduciary scrutiny. However, following the notice-and-comment period, the Department significantly revised those proposals before finalization. Neither final rule singled out ESG investing for favored or disfavored treatment. The final Trump Rule did not use the term ‘ESG.’ The regulatory text of the final Biden Rule refers once to ESG investing, but only to state that ESG factors ‘may’ be ‘relevant to a risk and return analysis,’ depending ‘on the individual facts and circumstances.’ This statement is true for all investment factors, ESG or otherwise.”
Certainly, political leaders possess the legal literacy to discern this similarity. Why, then, did we have all the fireworks surrounding the Joint Resolution?
“Unfortunately, this issue has become politicized and certain politicians believed these factors were being taken into account to achieve political rather than financial goals,” says Robert Lowe, a partner (through his professional corporation) of Mitchell Silberberg & Knupp LLP in Los Angeles.
Clearly, there is no consensus on the meaning of ESG. Perhaps, given there are multiple ideas concerning the definition of “ESG,” it’s only natural that the reasons behind the various maneuverings might also be divergent.
“Different supporters of the vetoed proposal had different intents,” says Albert Feuer of the Law Offices of Albert Feuer in Forest Hills, New York. “Many supporters believe risk return analysis should be subordinated to ESG factors that are not called ESG factors, such as investing in United States fossil fuel ventures to preserve jobs in those ventures even if they have poor risk-return profiles. These same supporters criticize ESG advocates of the divestment fossil fuel investments, which the regulation prohibits absent a showing that these investments will be replaced by those with a better risk-return profile. Other supporters have little confidence in financial analysts and free markets. They believe ESG factors are inherently bad and thus fiduciaries should be prohibited from considering them absent compelling evidence that in a particular situation, such factors would improve the risk-return profile of an investment.”
Marcia S. Wagner, Esq., president/founder of The Wagner Law Group in Boston, Massachusetts, in a Forbes.com interview, said that President Biden faced pressure from his own party. Starr agrees. He says Biden had no choice but “to bow to his far-left constituency, especially since he just approved major drilling for oil in Alaska. This gives him a countervailing argument to show he hasn’t abandoned his ‘progressive’ policies completely.”
In the end, you could have easily predicted the actions by all actors in the dance between the joint resolution and the veto.
“This was a foregone conclusion,” says Eickman. “Biden knew he couldn’t appear weak on this, even if he may not view the DOL regulation as having nearly the impact as Congress had suggested with its votes.”
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