Will Bad Companies Fail? Want To Bet?

Activists cheered when Peabody Energy, the world's largest coal company, declared bankruptcy last week.  These activists have been lobbying endowments and pension funds to shift their holdings away from fossil fuel companies. They want the funds to take a stand against big polluters and dirty deals. They might not be aware that when Peabody went down, at least one social venture fund also made a profit.

Over the last two years, energy stocks like Peabody have taken a beating.  The price of a share of Exxon declined 17 percent while the S&P 500 index rose 10 percent, for example. So, if you sold stock in an energy company in 2014 and bought something else, you probably did well by doing good.

Sustainvest Asset Management takes this strategy a step further. Its owner, Dale Wannen (who is also a contributor to TriplePundit), has opened a hedge fund that does two things. Like many other funds, it invests in companies that rank highly on measures of environmental, social and governance (ESG) policies. But it also bets against companies with low ESG scores.

"A lot of socially responsible investors are fairly savvy," Wannen says. "So, if you're divesting from bad companies and you believe they're going to fail, why not go further? Why not short them?"

Wannen and other hedge fund managers "short" stocks by selling shares they have borrowed. They believe that the price of the shares will fall. When they bet correctly, they buy the shares back at the lower price, return them to the owner, and pocket the difference. This is the opposite of normal investing (known in the trade as "going long"), which centers around buying a stock because you believe it will increase in value.

Wannen's Sustainavest Fund invests 80 percent long and 20 percent short. He looks at a company's economic prospects based on traditional measures, such the ratio of stock price to earnings. Then he looks at how it performs on social audits from CDP (formerly the Carbon Disclosure Project), ISS (Institutional Shareholder Services) and other agencies. Companies that do well in both sorts are contenders for the long list. Those that do poorly on both lists might get shorted.

To make his final choices, Wannen reads widely, thinks things over and connects the dots. A good social responsibility report is a must, he says, and that's one reason why the fund goes long on Estee Lauder, Starbucks and Microsoft.

The shorting decisions can be more complicated. It's easy to understand why Wannen bet against Peabody Energy (even though the company also has a slick social responsibility report). But why is he shorting Conn's, a Texas department store chain?

"I asked myself: Who will be negatively affected if oil prices stay below $40 a barrel for the next few years? Conn's came up numerous times," Wannen says. "It also looked like they might have problems meeting their short-term earnings targets. And they don't even have a responsibility report. It seemed like they aren't thinking that way. So I shorted them at the beginning of March, and it was a good call. They had a horrible month."

Wannen tested the strategy privately, using his own money for 20 months before opening the fund to investors in January. His returns in 2016 are beating the S&P index, but he says that returns alone are not the main reason for a hedge fund.

Hedge funds are not for small fry. Wannen asks for a minimum investment of $250,000. "A good hedging strategy reduces the volatility in a larger investment portfolio," Wannen says. "It means that when the market goes down, you don't lose as much." Measures of risk-adjusted return, such as the Sharpe and Sortino ratios, are a better indicator of a hedge fund's quality than is unadjusted return, he says. In 2016, Wannen says, his fund's Sharpe ratio is twice as high as the S&P's.

"I'm passionate about socially responsible investing," he says. "This is all I've done for 12 years. So one reason I opened this fund is to push people's buttons. Do you really believe that companies like Monsanto cannot succeed? All right then, let's get into it! Let's short 'em!"

Image credit: Flickr/Paul Sableman