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Perspective

The race of our lives revisited
Human beings have a history of responding well only to more immediate and tangible threats

Jeremy Grantham

There’s a cheerful professor at Harvard, Dr. Steven Pinker, who’s come out with a couple of books saying how wonderful things are. On the data he uses, he’s absolutely accurate. Yes, we do live longer. Yes, we have fewer wars, fewer murders, and fewer this and fewer that. But what it doesn’t account for is sustainability and toxicity: that we’re using up our resources and threatening our biosphere. It’s a bit like the guy who falls off the top of the Empire State Building, and as he passes each floor on the way down he is heard to say, “So far, so good.” “14 inches of soil, life expectancy increases, so far so good.” “12 inches of soil, 8 inches, 4 inches, so far so good.” “80% of our sperm count, 50%, so far so good.” “80% of our flying insects, 50%, 25%, so far so good.” We’re simply not accounting for the real underlying damage. Without that accounting, things can indeed be construed as looking pretty good. It’s seductive. Right up to the edge of the cliff most of the numbers look better and better and just a few look worse and worse. But how super critical those few worse numbers are. 

The greatest deficiency of capitalism is its complete inability to deal with any of these things that we are talking about even though it can handle the millions of more mundane factors that go into producing a workable economy, far better than planned economies. Let me tell you my story once again of the devil and the farmer. The devil goes to a Midwestern farmer and he says, “OK, if you sign this contract and give me your soul, I will triple your profits, your meager profits that have always been a struggle for you. And I will do it for 100 years for you and your descendants.” The farmer is desperate, so he signs. The profits are tripled and all is well. 

Now footnote 21 of the contract — there are always footnotes with the devil — says the farmer will lose 1% of his soil every year. Because that’s what farmers are all losing anyway, big deal. So he signs, and 100 years later there’s no soil at all left for his great-great-grandchildren. He has given up soil as well as his soul. Exhibit 32 shows what happened. The expected value of the deal with the devil was $5.5 million. The no-deal farmer up the road who stuck it out the hard way had a present value of only $2 million. 

As I’ve noted before, at least when the starving crowds arrive from Chicago, the farmer dies rich. As currently configured, every MBA ever produced would sign that contract, or fail the course. That is capitalism. Ask Milton Friedman once again. A corporation’s responsibility is to maximize profits, not to waste money attempting to guess how to save our soil. There’s simply no machinery in today’s world, which has gone all Milton Friedman on us, to get this job done: to reach a sustainable agriculture system, and a stable temperature that we can live with — ideally close to the one we have enjoyed for the last few thousand years. 

Part VI: Investing and the environment 

Exhibit 33 is our portfolio at GMO of climate change opportunities, which has been around for a year. What we’re trying to do is understand, a little ahead of the market, these powerful and complicated new crosswinds as we decarbonize. I hope we are helped in this task by the deliberate propaganda that has been aimed at downplaying the current speed and long-term importance of climate change. Unsurprisingly, the portfolio has lots of clean energy stocks, copper (which is 5 times more heavily used by electric cars than conventional cars), masses of energy efficiency opportunities, and around 20% in agriculture. I can say that I have a very high-confidence belief that these industries collectively will have higher top-line revenue growth than the balance of the economy.

Part VII: The alleged perils of divestment 

It should be pretty clear from this discussion that if you’re messing around with oil stocks, you’re taking the serious risk of ending up with stranded assets, and if you’re messing with chemical companies of the toxic kind, you are taking some risks also. Oil companies are being sued everywhere because they’ve been caught red-handed. They were writing for peer-reviewed journals in the late 1970s, proving that carbon dioxide was dangerous and that the ocean levels would rise. They took advantage of their knowledge: they took it into account to drill in the Arctic and to site their refineries. And they have misrepresented the damage they knew their products would cause. They are vulnerable and face many legal battles as we speak. Yet investment committees, the most conservative groups on the planet as we know — I have spoken to perhaps 3,000 or so of them — maintain that if they divest from oil it will ruin their performance. And that in any case, ethics, à la Friedman, should not come into it. If they accept any constraint at all, they feel, it will ruin their performance. I’m sympathetic up to a point: you don’t want everyone with a bee in his bonnet to come marching in. But this issue — climate change — is the mother and father of all exceptions. It is about our survival. Exhibit 34 shows what we did to test this long-held divestment hypothesis. We took out each of the 10 major groups in the market for 30 years, leaving only 9 of the 10 groups in each portfolio, and what we found was that it didn’t make any difference. The entire range from best to worst was only 50 basis points. The return you get without Energy is highlighted — you make 3 bps more without Energy. Look at the graph. Taken together, other than IT in the 2000 bubble, they look like a single series. Even the 2000 deviation settled back as if the bubble had never occurred. 

After I first showed this exhibit I had a suspicion that we had picked a lucky time period. My conscience nagged me for a while. So, we went back in history, first to 1957, and then with some considerable effort all the way back to 1925, as shown in Exhibit 35. Look at 1925: the range between missing the best group and the worst has soared from plus or minus 50 basis points to plus or minus 56 basis points. When you divest from oil or chemicals, the starting assumption must be that it will cost you a few tiny basis points of deviation, and it’s just as likely to be positive deviation as negative. These are the facts — not the hearsay of investment committees that have managed to maintain an erroneous, but perhaps convenient, consistency over decades on this issue. 

There are two quick points to be made before we leave this exhibit. The first is on the power of compounding. In the 92 years since 1925 the S&P 500 would have turned a single dollar — not allowing for inflation and taxes — into $22,911! Not bad is it? (Without Energy you would have had 4.3% less, or $21,984.) The second point is to admire how well the market mechanism did this particular job. I have always made a lot of fuss at how incompetent the market mechanism has been in dealing with bubbles, allowing through momentum and career risk for crazy overvaluations followed by dangerous collapses. But here the market has been amazingly efficient at pegging the long-term prospects of these 10 major groups. It has taken away any possible free lunches from buying, say, appealing high-growth technology and selling dopey utilities by pricing technology higher and utilities lower to compensate. Impressive. Who knew? Not me anyway. 

Now we can put a more accurate price on divestment and ethics. For example, if you were to consider it unethical to own these oil companies whose scientists wrote, as mentioned, about the serious dangers of climate change in the 1970s only to have management later ignore it all and fund deniers and obfuscators, you can believe the cost of your ethics is about +/- 20 basis points! 

There is, however, one more economic argument in favor of divestment: that the Energy sector will be the first example of much more significant mispricing than any sector in the past due to oil companies not bending with the economic winds but fighting them all the way. And why would the market not do its usual remarkable job of forecasting this? Because this is the first time in history, I believe, where a significant chunk of the US investment community does not believe in the most important factor that will affect this sector — climate change. Why? Because we have had a 30-year, well-funded program to make the problem of climate change seem vague, distant, and problematic, the end result of which 35 is that we have a Republican Party wherein 60% of the people don’t believe a word of the facts I have showed you. Some of them, presumably, are in the stock market. How many of these deniers does it take to distort the price? How can this not affect the market’s probabilities of carbon taxes, energy regulations, and other important factors? There certainly should be more mispricing than normal and that might just allow for unexpected long-term underperformance of Energy (and perhaps some chemicals). Certainly the governor of the Bank of England, Mark Carney, has been telling everyone that they are bitterly underestimating the future troubles facing the oil industry and I agree. 

(The short-term prospect for oil, however, is a very different story and there exists a probability, in my opinion, of a near-term squeeze on oil prices before the electric cars kick in fully.) 

Part VIII: What should investors do about climate change? 

Let me finish this with some recommendations. What I’m hoping you will do, first of all, is vote for green politicians. I don’t care what party they belong to. It might surprise you to learn that all the great environmental law of the past 100 years came from Republicans. Second, lobby your investment firms to be a bit greener and encourage them to lean on their portfolio companies to do the same. Push them hard. Cash in some of your career risk units. You will at least be able to look your children in the eye. You may even feel better. And your firms may be able to attract more of the best kind of young recruits who are beginning to care very much more about these issues than we older folk collectively do. 

We’re racing to protect more than our portfolios from stranded assets and other climate change impact. That I believe is easy enough. But for those portfolio managers who happen to be human, we have a much more important job. We’re racing to protect not just our portfolios, not just our grandchildren, but our species. So get to it.

This is an excerpt from Jeremy Grantham’s August 2018 column. The views of Jeremy Grantham expressed through the period ending August 2018, are subject to change. Copyright © 2018 GMO LLC. All rights reserved.

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