Do Yourself A Favor…

This edition of the newsletter talks about the tension between ethics and economics and how most companies get it wrong, but some get it right. Subscribe to this newsletter for weekly actionable insights, as well as advance VIP access to events and courses. Subscribe here. OK, on with the show.

What happened at Open AI last week was a stark illustration of a fundamental law of finance:  economics wins almost every fight against ethics. 

This is why the non-profit board of Open AI was forced out of the company they ostensibly oversaw. The economic benefits of continuity were much stronger than any concern over risk.

This is why a few hundred millions of lobbying dollars in the US keeps the American healthcare system a dysfunctional, trillion-dollar cesspool.

But there is another financial law that is equally true and serves as a countermeasure: environmental, social and governance factors, when they are materially significant, are almost always underestimated and mispriced. Businesses and investors mistakenly assume they are meaningless gripes from hippy activists, when they are actually huge disruptive shifts.

This is why Tesla was able to change the game in the auto industry so that winning means electrification. The world was used to meaningless charitable attempts at electric cars like GM’s pathetic electric car, the EV1, whose only real purpose was to be photographed for a CSR report. 

When I analyzed banks during the subprime mortgage crisis most investors dismissed accusations of predatory lending as overblown and alarmist. But real wages in America had stagnated for 12 straight years while household credit had increased by 72%. I argued that the surge in subprime mortgages wasn’t just an ethical lapse of predatory lending by banks, it was a trillion-dollar thermo-nuclear bomb. I’ll never forget a meeting with Citigroup when I asked them about their multi-billion-dollar exposure to subprime mortgages and they offered me a glossy pamphlet about their $40 million micro-finance fund in Africa. I was talking about a multi-billion-dollar mispriced risk that would nearly destroy the bank. They were talking about a charitable donation. 

One of the tragedies of ESG is that no one can distinguish the analysts from the activists. 

Inside the ESG industry there has always been a civil war between the analysts and the activists, the punks and the hippies. Between those who care about materiality and those concerned with impact. 

The analysts believe that ESG is a lens to discover mispriced and actionable investment signals before anyone else does. Their goal is to track the quiet storms that wreak havoc when they make landfall. I was firmly in this camp when I was still in the game. I loved uncovering weird data like tracking every mine and steel plant and mapping it to geological data about water scarcity, so that we can anticipate which mines would have to halt production because they run out of water. Or how municipal bans on fracking would affect output in oil and gas companies. Or by identifying boards which had conflicts of interest and wouldn’t hold management accountable if they misbehaved. You don’t need to be a tree hugger to see that this information is essential. The data is valuable for the eco/ethical-agnostic. 

The activists want to highlight environmental and social malfeasance by companies and encourage investors to invest elsewhere. I couldn’t stand the activists. I thought they were sanctimonious. They issue ethical judgments about companies that were often totally divorced from the actual businesses of the companies they cover. Their sense of right and wrong was subjective. They fixated on controversies that are often freak, outlier events. And, many of the activist agencies’ CEOs paid themselves obscene sums while their workers were paid below the poverty line.

The tragedy of ESG is that the activists and analysts are all covered under the same ESG brand. It’s impossible for the world to tell the difference.

But underneath the noise and the controversy is a fundmanetal question that every company and every investor needs to answer: What environmental, social, and governance factors will impact earnings, risk, and reputation?

This is how ethics and environmentalism becomes aligned with earnings. This is the fundamental question that OPEN AI’s new board needs to wrestle with. 

DO YOURSELF A FAVOR

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