Ep724: Mark Neuman – Constrained Capital and ESG Orphans

Andrew Stotz 00:02
Hello fellow risk takers and welcome to my worst investment ever stories of loss to keep you winning in our community. We know that to win in investing, you must take risk, but to win big, you've got to reduce it. Ladies and gentlemen, I'm on a mission to help 1 million people reduce risk in their lives to join me and go to my worst investment ever.com Right now, fellow risk takers this is your worst podcast host Andrew Stotz, from a Stotz Academy, and I'm here with featured guests, Mark Neuman, Mark, are you ready to join the mission?

00:36
Yeah, let's do it.

Andrew Stotz 00:38
We're going to do something different. I want to introduce you to the audience first, and then I'm going to ask you your first question. So let me do that. Mark Newman is CO CIO and founder of constraint capital. He is like myself, a CFA charter holder. He's creator of the ESG orphans index. He's a 30 year Wall Street veteran, former goat former global equity derivatives trader with Merrill Lynch, Susquehanna Jones trading, Bay crest partners. He's a former event driven hedge fund partner, his recent investment project. Well, ladies and gentlemen, he has spent 1000 hours of deep dive into all things ESG over the past six years. And his goal is to deliver truth in ESG to protect and help investors make informed decisions with measurable results when understanding risk and your reward. So let's, why don't we start off Mark, just tell us about the unique value that you are bringing to this wonderful world.

Mark Neuman 01:41
So I've always been a student of the markets, and I've really found my passion in digging in and finding, getting to the bottom of a story, and helping investors and myself to, you know, understand situations and really get a good get my arms around risk and reward. And I pride myself on making sure that those people I come into contact with and talk about in investments. Understand, at least the way I see it, you know, it's not always going to be the right view. But it's always going to be clear and straightforward. And no, no, no, no, pulling no punches.

Andrew Stotz 02:19
I was thinking about the heart of an analyst. You know, I always tell students in my valuation masterclass that, the minute I sat down as a job as an analyst in 1993, I just knew this was for me. And the beauty of the financial markets is that it could possibly be the last place in the world where dumb ideas get destroyed. You know, someone out there who has a dumb idea about you know, something in life, you know, they, they may think, okay, my idea is that I can fly. Go ahead and try it, and you'll find out. But the point is that many people exist with dumb ideas. And there's, people are now allowing that to persist. And the stock market is where you can go in and you bring your dumb idea, and someone else takes your money away from you. And so I just think when I listened to you talk, and we talked a little bit before this, you know, I hear the heart of an analyst digging deep into a topic.

Mark Neuman 03:28
Yeah, I mean, I've always, like I said, prided myself in doing the deep dive and turning over the rocks. And you know, there are some folks who sort of want to find an outcome or result before they dig into something. And so they'll see things in a certain way or in a certain light, based on what I'd call a little bit of bias going in, where I always just sort of, what's my gut reaction? What's my instinct? And does this change, help, or distract from my thesis on the idea, and that sort of, you know, my idea behind the ESG orphans, and sort of my approach to ESG was based on you know, I just, I started realizing that it was pervasive and becoming a real, you know, the driving force the theme in the markets and I think over the last decade, it's taken seat one, the front seat, the lead seat, if you will, on things driving, driving the investment markets these days.

Andrew Stotz 04:31
So I have a message to all the listeners and viewers I'm gonna, you know, give it very important, Warning, warning, independent and objective thinking about to occur. Okay, now we can talk because under CFA code of ethics, we are actually required to think independently and objectively In fact, I'll be teaching my EF my ethics in finance course today at university where it Teach the CFA curriculum on ethics. And one of the key key things is to be independent and objective. So ladies and gentlemen, the one thing about independent objective is that it is often discomforting.

Mark Neuman 05:13
Yeah, it's the critical thinking is key. And like you said, Andrew, it does, it does sometimes make some people squirm because they don't want to hear the sort of harsh reality of things as they exist in real life in real time, real life.

Andrew Stotz 05:29
And so in this case, what I've decided is that we just don't have enough time to go to your story and ESG. So I think we're going to spend another time talking about your story, but for today, first thing I'd like to do is for you to explain what is constrained capital and ESG orphans, what are you doing, not your business?

Mark Neuman 05:49
Okay, so, constraints on capital is a pattern that exists in the market based on policy based on investment themes and philosophies. And most recently, ESG has been the biggest example of constraints on capital. And I want to just take a little step back. And, you know, I came across the idea of constraints. In finance, reading a paper by a guy called Cliff Asness of AQR. He wrote a piece in May of 2017. Virtue is its own reward, one man's floors and other man's ceiling. And he talked about constraints on capital, causing misallocation and malinvestment. In general, starving certain industries, and flooding other industries. Based on you know, let's call them less than scientific reasoning, so to speak. So for example, in ESG, we saw that constraints were heavily implemented on fossil fuels, nuclear energy, weapons, the other those are the newer what I call woke, shame stocks, if you will. And then the other three sectors are the old sin stocks, alcohol, tobacco, and gambling. Basically ESG said those are bad for EA or the s or the GE, whatever it might be. And then on the other side, the sort of malinvestment, misallocation of capital, they chose certain winners that were apparently good in ESG. Now we can dig into the ESG rating systems and, and the inconsistency of it all, which is part of my research, but you know, technology, for example, so a lot of inflow that was Miss allocation of capital, on the other side of constraints or constraints in a sort of different way, where, say, for just, for example, real quick, Amazon is ranked very high and isn't in 80%, of ESG funds, but it has a huge carbon footprint, it's not friendly to the unions, and working conditions aren't that great. So it's a great company, perhaps, but it's not ESG. So in the end, those constraints, push capital to one place, starve capital to another place, and my orphans, my ESG orphans index was those six sectors, fossil fuel, nuclear energy, weapons, alcohol, tobacco, and gambling that were routinely excluded. I was the only consistency in all of my research that I found in ESG. I looked at the funds, I looked at what they did philosophies, methodology methodologies, and the only thing consistent was what they all excluded, which was this basket of orphans, the ESG orphans index that I created. And so

Andrew Stotz 08:30
are you. You created this because you just said, Hey, guys, there's just something going on in the market. And for some reason, these guys are being cut off, and therefore, as they're being cut off from capital, the value of these stocks falls, and then they're in a great investment opportunity, or is this an anti ESG? Fund? I mean, or ETF, or what what, what is it?

Mark Neuman 08:55
Well, it's an index now. It's an index. And so first of all, the one of the themes that Cliff Asness talked about was higher expected return securities, the idea of the sort of scarlet letter stuff for someone to own a stock that they could get ostracized for that they could get made fun of, or shamed, if you will, there has to be a higher expected return for them to want to hold that. So that's the idea of these exclusions. These ones were all the capital flowed in over the past decade, to all those sectors excluding mine, right, excluding the orc, the index. So for example, in the last decade up through 2021, let's call it the Infotech. space in the s&p 500. It grew from 18% weighting to 36. And the energy sector shrunk from about 10, nine 10% down to two and a half in November of 2021. So I just looked at it from end All those, let's just call them energy. So energy sector, industrials, sort of with the the weapons, we can call it aerospace but let's and then Alcohol Tobacco you know are sort of like a staple sort of but those all shrunk over the past decade because of these flows and ESG contributed, whereas info tech, the the apples of the world and the healthcare space really blew up and bloomed. And so I looked at it as you know, when you see the guy at the circus tying the balloons, he makes a poodle on one hand is the little pet and then the body and looked at all the ESG orphans, the exclusions as that little head, and the all the other stocks, Apple, Google, Microsoft app, Amazon big tech allocations in these ESG funds as the big body. And so my indication was over a longer period of time, we're gonna see a reversion. In addition, those sectors, fossil fuel weapons, they became so cheap on a relative basis. So the index itself screens as nice dividends, great cash flow, relatively very cheap. And part of the exclusions where my thought is as that pendulum shifts, and ESG gets called out, which it has recently some and it's starting to, you're going to see reversal flows and flows are going to go back to those names that were excluded. And that's part of the theme and thesis behind the ESG orphans index.

Andrew Stotz 11:32
And one question that pops out of my head, is it I would like to think that capital has been taken away from defense contractors, but I mean, is that the case that that sector has underperformed? I mean, I when I think about all my ESG friends out there, and I say, you know, like, if you stopped allocating money to defense contractors today, they would not be able to do business to some extent, or invest, and therefore you could stop the war and the war was, you know, that's going on right now in Ukraine, is the ultimate destruction of human life, which is the S wouldn't you want that?

Mark Neuman 12:16
Right. So that's a great point, Andrew, the idea that these weapons are a deterrent right to despots around the world, you would hope. But interestingly, weapons have been on the orphans, the exclusions, and that's not ESG. So many who are ESG full throated supporters are supporting the Ukraine. But they can't even technically invest in those companies that are getting the hundreds of billions of dollars. Look, unfortunately, the reality is when we give 100 billion to the Ukraine, they're not buying McDonald's and Coca Cola. They're buying weapons. So that's the irony of the the weapons aspect of ESG. Because everyone wants deterrence. We don't want. You know, we don't want Vladimir Putin running crazy. But the ESG investors can't even buy the beneficiaries of those weapons purchases. And now you would ask the question, I wanted to take a quarter step back, you asked about the anti ESG nature. So its anti ESG factor. Yes, sir. As an investor, this factor has become a massive bubble, but as it personally, I grow my own vegetables. I grow my own herbs. My son spent time in Peru planting trees in indigenous villages last summer. So I'm an outdoorsman, and in my house, we haven't had plastic bottles for a decade. Swell bottles, hydro flasks, that's how we roll. Yeah, exactly. Glass bottles much better. So you know, for me, everyone's like, Oh, you're anti ESG No, no, I'm anti the ESG bubble as an investor as a CFA charterholders saying this has gotten too crazy. There's major value in a lot of these companies that have been discarded look, in the end. I think we need future energy, different plants. I agree. But we can't take some quantum leap and abandon fossil fuels and just say, Oh, we're gonna get by on the wind and batteries tomorrow. That's just people are going to starve. People are gonna freeze. People are gonna die if we go that extreme. So the idea of, oh, no more gas, no more gasoline. Well, everything. I'm looking at your bookshelf and all these things behind it. All these things have petroleum and they do. So we need to find a replacement. I agree. But starving Exxon Mobil instead of leaning on ExxonMobil to lead up to renewable to lead the charge. Ironically, Chevron is one of the biggest renewable participants and we're shutting Chevron because they're fossil fuel. We're going to you. You can't get to the future of energy without present energy. That's one of my underlying sort of thoughts.

Andrew Stotz 15:05
Okay. You know, as we talked earlier before we went on, and I think it's common for most people to say, I agree with, you know, the goals of environments, so social, and governance. You know, it's just that, you know, I disagree in the methods and all that, but I've come to a new opinion, which is, I disagree. No, I disagree. I disagree. Because you can't even tell me, what is the goal of the E? You can't even tell me what is the goal of s. And if the ESG cheerleaders are not protesting in the street to stop the destruction of human life, in Ukraine, previously in Yemen, and in many other places around the world? Which, of course, led by us in most cases, if you're not out protesting the destruction of life, then what are you doing? What is your ass? make everybody happy at work? Or, you know, have a certain number of males or females? Or is it what? So I've gotten to a point now, where my starting point is, I disagree?

Mark Neuman 16:23
Yeah, there's a lot of, you know, Andrew, you and I come from a critical thinking perspective. And, you know, we look at things from our backgrounds and our style of approach, what is measurable, right, and I would say, in the E, S, and G trifecta, the E, aspect, to me is sort of the most measurable, right, you can actually measure carbon and carbon, carbon in the, you know, I work with some farms down here in Atlanta, Georgia, and you can you can measure the soil, and you can measure the carbon amounts, and this nitrogen and the sequestration and the use of water, and the runoff, the cleanliness of the runoff into the into the water base, and so to speak. So you can actually measure that. And those are the kinds of things where you can point and say, I installed this, I use this new natural fertilizer and reduce water consumption and sequestered carbon, that's measurable. But when we talk about the social interview, and I could think about six different social things, and your top six are not going to be my top six, and there are no universal measure of goodness, you and I sit in a certain spot, we say, Oh, I got to recycle, which we can we probably have the luxury to afford it. Let's assume someone in the third world did they have the ability and the time to separate their plastics, they're worried about feeding their kids, they can't be like, Oh, plastic bottles are my most important thing that's environmental, but still, in terms of social and governmental issues. In governance, there's no universal measure. And there's we can you and I can have an opinion, oh, we need major diversity across all aspects of our business. Maybe we do, maybe we don't, some people might say I want the smartest people, and who are going to contribute wants diversity, but I need someone who can, you know, do high high end math, let's say that's the first record. So in terms of measuring the goodness, that's an impossibility, and in terms of sort of knowing that it impacts a company is even harder. I mean, being an analyst, it's hard to say that, Oh, they had 23 More people who were from seven different backgrounds that added to our bottom line. That's a supposition. That's not really like a quantifiable measure. So as you know, I agree in the theories of ESG, what they stand for, they don't agree in the practices and how they're measured, and how people are sort of putting feelings, feelings about facts on some level. And I think that's a troubling aspect of ESG. For me,

Andrew Stotz 19:04
the other thing that I can't really figure out how to resolve is I really think that the ESG folks have co opted, the G, which is governance. And governance is all about a pretty simple thing, agency theory, where an investor is putting money into a company without really any ability to know what's going on in that company. And therefore, they need some structures in place to make sure that their interests are being represented as best as possible. And that is just a simple shareholder capitalism structure in place, just like we have a stock market, there's a structure for trading. And the governance structure is something that I think is, you know, an important thing for shareholder capitalism. And so one of my questions is, like, do we even do ESG? a disservice ourselves when we're talking about it? By allowing it to co-opt the G with the E and S.

Mark Neuman 20:04
So that's a great one. And let me just, I'm gonna give an example here. So, Silicon Valley Bank, it's a bank, they had no risk manager for eight months prior to their collapse. Okay, so when I look at the, the tripod, E S and G of s VB Silicon Valley Bank, which by the way, had a medium ESG risk, before it collapsed, a medium, the three the three pillars ESG a bank without a Risk Officer, that's a zero in G, that is an absolute zero. So to me, that ESG stool, you don't sit in that one, there's no G two legged stool, what the medium risk, and what they said they were doing well, we're supporting climate change, and we're this and we're that everyone was like, Oh, what an amazing story. Everyone piled into that. And then they got torched. Right? Because there was no, there was no G. So there was that misleading nature of, you know, the rating system. And I think what we've seen, and I'll give you another GE example of governance within the company, okay, I used to it use Hershey's as an example. Okay. Hershey's is on an ESG push of sustainability. And they say, you know, what, we need sustainable chocolate. So they have to go deeper into the cocoa producing areas, find the sugar that has those very strict sustainability aspects of they gotta go deeper turnover, more rocks that cost more money. Now, as a consumer, do I go into the CVS or the local drugstore and say, I want a sustainable chocolate bar? Maybe I do, maybe I don't. For me, I don't go that granular and say, I need a sustainable chocolate bar. I don't need a lot of chocolate. But anyway, so has the ESG push raised costs, yep, it has spurred Hershey's, they have to go deeper and have Hershey's asked the shareholders and said, Hey, by the way, we're going to pursue this, it's going to cost us more. And they also have to say, we're not even sure that it changes the consumption of our product. So in the end, that's where shareholders and stakeholders are involved. And they're basically subject to what Hershey's is being peer pressured into doing. Maybe the CEO does say I want to do ESG, sustainable chocolate, maybe he does, maybe the bank says, You've got to lower your ESG profile and get the negative score, or else you're not getting a good loan, so then they have to improve their ESG score. Again, they didn't really ask the shareholders and the cost of everything went up. And its margins compress. And it's hard to say that sales go up because of the sustainability. So there's a bit of capture there, there's a bit of conflict. And I think that's part of the trouble too, is that, you know, Larry Fink, original ESG, proponent, right? We're gonna force behaviors at BlackRock? Well, they surely are forcing behaviors. And I'm not sure it's for the benefit of everyone. And I think a guy like Larry think he cares if I had to rank the four things, Aum power fees, and ESG. I know which one's the fourth, I don't know about the other three, but I know ESG is last on that list of four. And so it's captured, it's conflicted. And it's a big force that we're that we're in the midst of.

Andrew Stotz 23:44
One of the sad things about this is that we don't have too much time left, but I want to touch on a couple of things. You know, when I said that I disagree with ESG. And I just disagree. I start from a point that I'm going to ask people to define things and when I ask people to define things, then you find that the definitions are not there. And so I I no longer take E and S Environment and Society on face value I now my my natural reaction is not I don't I don't that the starting point is you must define now that other thing is some people think oh, Andrew, if you don't believe in these things, what's going to happen to the world? You know, companies are going to you know, spew out all this, you know, gas and all that. Well, my one of my points in my 26 reasons why I'm anti ESG is ESG weakens, weakens democracy. Because what it does is people for some, you know, if you remember when we were young mark, no, no respectable liberal, would say that the capitalists are going to Save us. And yet here, we think that the capitalists through their allocation of capital and through their companies are going to bring us to a better future. Whereas what we really need to be doing is, you know, putting pressure on our governments that are elected officials that we can also elect out if we disagree with their implementation of what they're doing. And what I'm saying is that ESG, the ESG movement is pulling people away from holding a government accountable to say, if we want less pollution in our city as an example, we have to hold our government officials accountable. What are your thoughts on that?

Mark Neuman 25:41
So unfortunately, we've seen in the US a real weakening of the provisions of governance from the government and investing, it's become very corporately, in corporate governance intertwined, in terms of how decisions are made, how they're handed down, and who is pulling what strings. And unfortunately, that's muddied the investment landscape, I call it the investment, landscape distortion. And to be honest, this really, to me on some level culminated with the, you know, last handful of years of the end of the bond market, bull market, if you will, in other words, as rates went to zero, the cost of taking risks went to zero. I mean, if money is free, you can do all these things and pursue these measures. And there's no real cost. And you can see that in 2022. Last year, well, late 2021. But early 2022, the cost of capital was like, you know, two, the two year yield on January one of 2022 was around 75 basis points, there's really low. And so there was no real cost of and Fed Funds was low too. And so you could hire extra people, you could go out and hire a chief sustainability officer. And the government sort of was pushing this idea, along with the Larry Fink's of the world. We need diversity, we need to protect the environment, climate change is coming. And because money was so free flowing, there was all this distortion going on, oh, we need to hire some more people. Okay, we got free money, we could do that. Right? What happened in 2022, interest rates spiked dramatically in 12 months. And at the end of 22, you saw all these tech companies that had over hired, they laid off all these people, right? Because all of a sudden, wait, money was free, and now it's not and we hired all these people in our p&l is suffering, the government encouraged us to expand this message. And then Wow, p&l actually matters rates are higher costs are higher, like it's expensive to make an error. So I think that we've seen this sort of, I don't know, I'll call it a technocracy technocratic sort of environment now, where, you know, a company like Facebook, or meta, excuse me, they're doing some of the government's heavy lifting. And they're also if they're doing that they have to comply with diversity and all these different things to make sure they continue to stay in the good graces of the government. So to me, that, as I said, the blurring of the lines, has captured a lot of people. And I think now, we have the regulator's industry as a huge integrates a booming business. the fees collected in ESG, you know, are in the billions now, we have more people we have the growth industry is ESG hires. That's what it's been. And it's been a bit government aided and played by the government rules and you'll be treated favorably. That's sort of what we've witnessed.

Andrew Stotz 29:08
I just want to highlight one last thing from my side. And then I'm gonna give you the last word to kind of wrap up. But one of the things that I like to think about is voluntary behavior. And that we want to provide an opportunity for voluntary behavior. And if Hershey's wants to voluntarily decide which it didn't, the only reason why Hershey's did this is because he got pressures of capital, but of Hershey's wanted to voluntarily say, we're building a sustainable supply chain with these features, because we believe in this, do it you know, so I'm all for it. And I think that there is an argument that it could be a great selling point, it could be a great actual corporate strategy that people could buy into there. But what I also have come to the opinion of recently is that the best way that we can handle this is we can say, if your decisions, your investment decisions or your company are based upon stakeholder capitalism, not shareholder capitalism, you need to clearly state that in your company bylaws. And I challenge any company who's voluntarily changed, you know, focused on the ESG type of stuff, or sustainability. I challenge them today, to change your bylaws, to put in your bylaws that we are putting stakeholder capitalism, above shareholder capitalism. And therefore we get to some truth about what you are doing. But I'm kind of an extreme is now after talking to you, Mark, I've now I realized, I'm going to give you the last word, and I want you to tell us about what we can find at or ESG, orphans.com, and constrained capital, you know, ETF. So let me turn it over to you as a final wrap up.

Mark Neuman 31:09
Well, this this actually is where it takes a little bit of a turn, Andrew, I've my ESG orphans index is I created, it's been it's still trades, it's been around the the ESG, orphans, ETF itself actually lived lived actually a short life. And I'm sorry to say that, but as a businessman, and a trader and an investor, you know, I still have a pretty young family and this and that I created that ETF to mirror the index. And just when interest rates are now 5%, the equity risk premium is, you know, it's not as much there and when the video is trading at whatever, 35 times, and it's up, whatever 200%, or whatever it is, this year, it's hard to compete. And so for me, you know, it was a great idea. And it is a great idea. And I still hold these stocks myself personally, but the ESG orphan ETF itself, I just shut it down, because it's a very ETF business is very saturated, very competitive. And it's just a tough business, a tough racket, the I've now been doing a lot of ESG consulting, working with companies to helping them understand the risks. And when, you know, when they look at a company and say, Is this company really doing ESG? Well, if certain people have classified it as an ESG, medium risk or low risk or whatever, I want to kick the tires, I want to turn it over. I want to speak to people because I've spoken to people and I asked you know, I've spoken with corporate execs, and I've said, What's the story? Well, I'm filling out a Due Diligence Questionnaire, because they're asking me specific things, and I gotta check these boxes. Are they saying good? Or are they doing good? You know, and that is the big thing I've realized, because, you know, when people buy something based on an analyst risk, well, have they done their own due diligence? Have they dug into what that really means? So I've spent a lot of time recently doing consulting work around ESG. And actually, one of the amazing things I've connected with some farmers down here, and as I mentioned, the real ESG measurable, I'm working with some organic farms down here that are doing regenerative sustainable farming, no pesticides, no, no, no antibiotics kind of stuff. And we've done soil tests. And we've looked six months ago, where were they? Where are they now and the use of what's called new new fertilizer called biochar, which is an organic fertilizer that improves soil quality and water runoff. So those are things where I'm putting my expertise to work in helping people understand and really improve real ESG measurable, and not some pie in the sky, say good versus versus doing good, because, you know, I'll give you one example. I know we're running out of time. But last year, Exxon Mobil's rating improved relative to Tesla, and people were up in arms and they didn't understand but what happened was Exxon Mobil offloaded public parcels, to private equity, less scrupulous private equity, let's say definitely less under under the radar if, you know under the radar, so that the energy equation didn't change. But what happened was Exxon offloaded some parcels and said, yes, we've reduced our oil and gas and their ESG rating went up. But in the reality, the net equation in the society didn't change. So that's the kind of stuff where I'm trying to help investors, when they look at something and say, Oh, this guy's doing ESG they raid Hi. I say, you know, how do you kick the tires? Like, remember the SBB example? Yep. Is there a risk manager Well, that's a pretty simple question. So I'm trying, that's what I've been doing constrained capital is still a thing. And it's still what I, you know, live under, so to speak. But, you know, I really enjoyed what I'm doing. And my passion is sort of making sure people understand risk and reward and are not misled by any SG saying, everybody wins, nobody loses it's costless. And we're all benefiting. That just sounds too good to be true for me. And my truth in ESG, is where that analysis comes from?

Andrew Stotz 35:32
Well, to just wrap this up, I would say that to the listeners and the viewers out there, make a difference in this world. But do it in a way that makes a real difference. Not in a way that's checking off boxes and all that and what you're talking about and what I'm talking about. I don't want to be moralized. You know, people coming at me with all of their opinions about what I should do. I follow the laws. And also I look for innovations to improve things. And so that's kind of the message that I get from you, and I'm gonna wrap it up there fellow risk takers. That was another great discussion on an interesting topic. I think there's a lot more to discuss on this topic, and I dare to discuss it. So this is your worst podcast hosts, Andrew Stotz St. Mark, thanks for your time, and I'll see everybody on the upside.