I’ve always liked this quote from the movie The Incredibles and finally have a work-related context in which to use it. From an environmental, social, and governance (ESG) investment standpoint, its logical extension is: “When everyone’s super, no one will be. And valuations of similar companies should converge.”
What this means is that, as ESG issues become more mainstream across industries, the “uniqueness” that differentiates individual companies may begin to dim over time, which could result in more uniformity among companies in the eyes of shareholders, customers, and others.
Less differentiation, more “sameness”?
With less differentiation among companies, the argument for valuing one company versus another on different valuation metrics (e.g., price/sales ratio versus price/earnings ratio) or levels (e.g., high price/earnings versus low price/earnings) becomes more difficult to justify.
Most companies are keenly aware of growing consumer and political demands for greater prioritization of ESG factors and, not surprisingly, are responding by adapting their business strategies accordingly. As this adaptation occurs, any big ESG valuation premiums or discounts that existed before may gradually converge toward the median. It’s also likely that the list of companies that are considered ESG-friendly will expand with time, potentially offering up significantly more choices for investment portfolios with an ESG focus or mandate. This may further reduce the premium multiples currently given to some companies.
The auto industry as a case study
This discussion is obviously more relevant for some companies and sectors than others. The automobile industry is a prime example, in part because it has long been widely seen as an ESG “offender” due to the massive carbon emissions produced by all the cars we drive. Simply put, the basic idea is that most auto companies recognize the inexorable trend toward environmentally friendly car engines and are taking steps to adapt so as to not be left behind by their rivals. This could lead to many traditional auto makers looking more like pure electric-vehicle (EV) auto companies (and more like one another) over time.
The auto industry has historically been a competitive, fragmented business with high capital expenditures, short product lives, and low profit margins and multiples. I’m not sure the ongoing move to EVs will change that profile very much. The vast majority of autos are sold by companies that manufacture both internal-combustion engines (ICEs) and battery electric vehicle (BEV)/plug-in hybrid electric vehicle (PHEV) engines. Most companies are already selling BEVs, or soon will be, and have plans to ratchet up that exposure. These companies will eventually derive the lion’s share of their sales from BEVs/PHEVs in Europe. Admittedly, that’s still a number of years down the road, but as the line of sight gets clearer, it seems reasonable to expect that the equity valuations will start to converge.
Meanwhile, the number of EVs made by the traditional original equipment manufacturers (OEMs) will likely be rising too. One would think that as EV ownership grows, it will become harder to charge consumers a premium for one because the product will be less unique. Hence, the auto industry should remain competitive for everyone, including the legacy OEMs as well as new entrants. Currently, pure EV OEMs trade at significantly higher multiples based on sales or profits. These relative multiples may converge as legacy OEMs increase their EV exposure to 50% or higher and become more similar than different versus pure EV OEMs.