Sunday, December 10, 2023

The Difference Makers: Key Person(s) Valuation

    Can one person make a difference to the value of a business? Of course, and with small businesses, especially those built around personal services (a doctor or plumber’s practice), it is part of the valuation process, where the key person is valued or at least priced and incorporated into valuation. While that effect tends to fade as businesses get larger, the tumult at Open AI, where the board dismissed Sam Altman as CEO, and then faced with an enterprise-wide meltdown, as capital providers and employees threatened to quit, illustrates that even at larger entities, a person or a few people can make a value difference. In fact, at Tesla, a company that I have valued at regular intervals over the last decade, the question of what Elon Musk adds or detracts from value has become more significant over time, rather than fading. Finally, Charlie Munger's passing at the age of ninety-nine brought to a close one of the most storied key person teams of all time at Berkshire Hathaway, and generations of investors who had attached a premium to the company because of that team's presence mourned.

Key Person: Who, what and why?
    While it is often assumed that key people, at least from a value perspective, are at the top of the organization, usually founders and top management, we will begin this section by expanding the key person definition to include anyone in an organization, and sometimes even outside it. We will then follow up with a framework for thinking about how key people can affect the value of a business, with practical suggestions on valuing and pricing key people. We will end with a discussion of how enterprises try, with mixed effects, to build protections against the loss of key personnel.

Who is a key person?
    In the Open AI, Tesla and Berkshire Hathaway cases, it is persons at the top of the organization that have been identified as key value drivers, but the key people in an organization can be at every level, with differing value effects. 
  • It starts of course with founders who create organizations and lead them through their early years, partly because they represent their companies to the rest of the world, but more because they mold these companies, at least in their formative years. It is worth noting that while some reach legendary status, sharing their names with the organization (like Ford and HP), others are unceremoniously pushed aside, because they were viewed, rightly or wrongly, as unfit to lead their own creations. 
  • Staying at the top, CEOs for companies often become entwined with their companies, especially as their tenure lengthens. From Alfred Sloan at General Motors to Jack Welch at General Electric to Steve Jobs at Apple, there is a history of CEOs being tagged as superstars (and indispensable to the organizations that they head), in successful companies. By the same token, as with founders, the failures of businesses often rub off on the people heading them, fairly or unfairly.
  • As you move down the organization, there can be key players in almost every aspect of business, with scientists at pharmaceutical companies who come up with pathbreaking discoveries that become the basis for blockbuster drugs or design specialists like Jon Ive at Apple, whose styling for Apple’s devices was viewed as a critical component of the company's success.  The skills they bring can be unique, or at least very difficult to replace, making them indispensable to the organization's success.
  • In businesses driven by selling, a master-salesperson or dealmaker can become a central driver of its value, bringing in a clientele that is more attached to the sales personnel than they are to the organization providing the product or service. In businesses like banking, consulting or the law, rainmakers can represent a significant portion of value, and their departure can be not just damaging but catastrophic.
  • In people-oriented businesses, especially in service, a manager or employee that cultivates strong relationships with customers, suppliers and other employees, can be a key person, with the loss of that person leading to not just lost sales, as clients flee, but create ripple effects across the organization.
  • In some businesses, the key person may not work for the organization but contribute a significant amount to its value as a spokesperson or product brander. In sports and entertainment, for instance, business can gain value from having a celebrity representing them in a paid or unpaid capacity. In my valuation of Birkenstock for their IPO, just a few weeks ago, I noted the value added to the company by Kate Moss or Steve Jobs wearing their sandals. Over the decades, a significant part of Nike’s value has been gained and sometimes lost from the celebrities who have attached their names to its shoes.
In short, the key person or people in an organization can range the spectrum, with the only thing in common being a “significant effect” on value or price.

Key Person(s): Value effects
    Given my obsession with value, it should come as no surprise that my discussion of key people begins by looking at the many ways that they can affect value. As I identify the multiple key person value drives, note that not all key people affect all value drivers, and the value effects can also vary not only widely across key people, but for the same key person, across time. At the risk of being labeled as a one-trick pony, I will use my intrinsic value framework, and by extension, the It Proposition, where if it does not affect cash flow or risk, it cannot affect value, to lay out the different effects a key person can have on value:

For personnel at the top, and I include founders and CEOs, the effect on value comes from setting the business narrative, i.e., the story that animates the numbers (revenue growth, profit margins, capital intensity and risk) that drives value., and that effect, as I have noted in my earlier discussions of narrative and numbers, can be all encompassing. The effects of people lower down in the organization tend to be more focused on one or two inputs, rather than across the board, but that does not preclude the effect from being substantial. A salesperson who accounts for half the sales of a business and most of its new customers will influence value, through revenues and revenue growth, whereas an operations manager who is a supply chain wizard can have a large impact on profit margins.  As someone who teaches corporate finance, I have always tried to pass on the message, especially to those who are headed to finance jobs at companies or investment banks, that of all of the players in an organization, finance people are among the most replaceable, and thus least likely to be key people. It is perhaps the reason that you are less likely to see a company’s value implode even when a well-regarded CFO leaves, though there are exceptions, especially with distressed or declining companies, where financial legerdemain can make the difference between survival and failure.
    With this framework, valuing a key person or persons becomes a simple exercise, albeit one that may require complex assumption. To estimate key person value, there are three general approaches:
1. Key person valuation:  You value the company twice, once with the key persons included, with all that they bring to it’s cash flows and value, and then again, without those key persons, reflecting the changes that will occur to value inputs:
Value of key person(s) = Value of business with key person - Value of business without key person
A key person whose effect on a business is identifiable and isolated to one of the dimensions of value will be easier to value than one whose effects are disparate and difficult to isolate. Thus, valuing a key salesperson is easier than valuing a key CEO, since the former's effects are only on sales and can be traced to that person's efforts, whereas the effect of a CEO can be on every dimension of value and difficult to separate from the efforts of others in the organization.
2. Replacement Cost: In some cases, the value of a key person can be computed by estimating the cost of replacing that person. Thus, key people with specific and replicable skills, such as skilled scientists or engineers, may be easier to value than key people, with fuzzier skill sets, such as strong connections and people skills. However, finding replacements for people with unique or blended skills can be more difficult, since they may not exist.
3. Insurance cost: Finally, there are some key people in an organization who can be insured, where insurance companies, in return for premium payments, will pay out an amount to compensate for the losses of these key people. For companies that buy insurance, the key person value then become monetized as a cost, reducing the value of these companies when the key person is present, while increasing its value, when it loses that person.
    The key person valuation approach, while general, can not only yield different values for key people, but also generate a value effect that is negative for a key person whose influence has become malignant.  The framework can also help explain how the value of a key person can evolve over time, from a significant positive at one stage of an organization to neutral later or even a large negative, explaining why some key people get pushed out of organizations, including those that they may have founded. 

Key Person(s): Pricing effects
    It is true that markets are pricing mechanisms, not instruments for reflecting value, at least in the short term, and it should come as no surprise then that the effects of a key person are captured in pricing premiums or discounts, sometime arbitrary, and sometimes based upon data. In this section, I will start with the practices used by appraisers to try to adjust the pricing of businesses for the presence or potential loss of a key person and then move on to how markets react to the loss of key personnel at publicly traded companies.
    In appraisal practice, the effect of the potential loss of an owner, founder or other key person in a business that you are acquiring is usually captured with a key person discount, where you price the business first, based upon its existing financials, and then reduce that pricing by 15%, 20% or more to reflect the absence of the key person. Shannon Pratt, in his widely used work on valuing private companies, suggested a key person discount of between 10%-25%, though he left the number almost entirely to appraiser discretion. In addition, the nature of private company appraisal, where valuations are done for tax or legal purposes, has also meant that the acceptable levels of discount for key people have been determined more by courts, in their rulings on these valuations, than by first principles.
    In public companies, the market reaction to the loss of key personnel can be an indication of how much investors priced the presence of those personnel. Empirically, the research in this area is deepest on CEO departures, with the market reaction to those departures broken down by cause into Acts of God (death), firing or retirement. 
  1. CEO Deaths: In the HBO hit series, Succession, the death of Logan Roy, the imperious CEO of the company causes the stock price of Waystar Royco, his family-controlled company, to drop precipitously. While that was fiction, and perhaps exaggerated for dramatic effect, there is research that looks at the market reaction to the deaths of CEOs of publicly traded companies, albeit with mixed results. A study of CEO deaths at 240 publicly traded companies between 1950 and 2009 finds that in almost half of all of these cases, the stock price increases on the death of a CEO, and unsurprisingly, the reactions tended to be positive with under-performing CEOs and negative with highly regarded ones. Interestingly, this study also finds that the impact of CEOs, both positive and negative, was greater in the later time periods, than in earlier periods. A different study documented that the stock price reaction to CEO deaths was greater for longer-tenured CEOs in badly performing firms, strengthening the negative value effect argument.
  2. CEO (forced) replacements: CEOs are most likely to be replaced in companies, where their policies are at odds with those that their shareholders desire, but given the powers of incumbency, change may require the presence of a large and vocal shareholder (activist), pushing for change. To the extent that shareholders have good reasons to be disgruntled, the companies can be viewed as case studies for key-person negative value, where the top manager is reducing value with his or her actions. Research on what happens to stock prices and company performance after forced replacements largely confirm this hypothesis, with stock prices rising on the firing, and improved performance following, under a new CEO.
  3. CEO retirements: If CEO deaths represent unexpected losses of key people, and CEO dismissals represent the subset of firms where CEOs are more likely to be value-reducing key people, it stands to reason that CEO retirements should be more of a mixed bag. Research backs up this hypothesis, with the average stock price reaction to voluntary CEO departures being close to zero, with a mildly negative reaction to age-related departures. It is worth noting that market reactions tend to be much more positive, when CEOs are replaced by outsiders than by someone from within the firm, suggesting that shareholders see value in changing the way these businesses are run.
The positive reaction, at least on average, to CEO firing is understandable since CEOs usually get replaced by boards only after extended periods of poor performance at companies or personal scandal, and investors are pricing in the expectation that change is likely to be positive. The positive reaction to some CEO deaths is macabre, but it does reflect the reality that they are more likely to occur in organizations that are badly in need of fresh insights. 
    There are a few case studies that look at how the market reacts to a company signing or losing a key celebrity spokesperson or product endorser, especially when that loss is unexpected. Thus, when Tiger Woods, who operated as a spokesperson or product endorser for five companies (Accenture, Nike, Gillette, Electronic Arts and Gatorade), had personal troubles that were made public, these five companies collectively lost 2-3% of their market value (about $5-12 billion). That should come as little surprise, since Tiger Wood's product endorsements, prior to this incident, had added significant value to these companies, with one study noting that Nike generated a 10% increase in profits in its golf ball division, after the endorsement.  In an earlier episode, Nike also lost billions in market capitalizations, when Michael Jordan, an NBA superstar whose name-branded footwear (Air Jordan) had become a game changer for Nike, unexpectedly announced in 1993, that he would be retiring from basketball, to play baseball. Finally, and this is perhaps a reach at this point, the biggest story coming out of the National Football League (NFL) this year has been the Taylor Swift-Travis Kielce romance, which in addition to creating tabloid headlines, has also increased NFL ratings, especially among women. Is it possible that the person who adds the most value to the NFL this year is not Patrick Mahomes (its highest profile quarterback) or Roger Goodell (its commissioner), but a pop star? Time will tell, but it is not an implausible claim.

Managing Key Person Value
A business that has significant positive value exposure to a key person can try to mitigate that risk, albeit with limits. The actions taken can vary depending on the key person involved, with more effective protections against losses that are easily identifiable.
  1. Insurance: Smaller businesses that are dependent on a person or persons for a significant portion of their revenues and profits can buy insurance against losing them, with the insurance premia reflecting the expected value loss. To the extent that the insurance actuaries who assess the premiums are good at their jobs, companies buying key person insurance even out their earnings, trading lower earnings (because of the premiums paid) in periods when the key person is still present for higher earnings, when they are absent. It is also true that key person insurance is easier to price and buy, when the effects of a key person are separable and identifiable, as is the case of a master salesperson with a track record, than when the effects are diffuse, as is the case for a star CEO who sets narrative.
  2. No-compete clauses: One of the concerns that businesses have with key people is not just the loss of value from their departure, but that these key people can take client lists, trade secrets or product ideas to a competitor. It is for this reason that companies put in no-compete clauses into employment contracts, but the degree of protection will depend on what the key person takes with them, when they leave. No-compete clauses can prevent a key person from taking a client list or soliciting clients at a direct competitor, but will offer little protection when the skills that the person possesses are more diffuse.
  3. Overlapping tenure: As we noted earlier, it is routine, when pricing smaller, personal service businesses to attach a significant discount to the pricing of those businesses, on the expectation that a portion of the client base is loyal to the old owner, not the business. Since this reduces the sales proceeds to the old owner, there is an incentive to reduce the key person discount, and one practice that may help is for the old owner to stay on in an official or unofficial capacity, even after the business has been sold, to smooth the transition.
  4. Team building: To the extent that key people can build teams that reflect and magnify their skills, they are reducing their key person value to the business. That team building includes hiring the “right’ people and not just offering them on-the-job training and guidance, but also the autonomy to make decisions on their own. In short, key people who refuse to delegate authority and insist on micro-management will not build teams that can do what they do.
  5. Succession planning: For key people at the top of organizations, the importance of succession planning is preached widely, but practiced infrequently. A good succession plan starts of course by finding the person with the qualities that you believe are necessary to replicate what the key person does, but being willing to share knowledge and power, ahead of the transfer of power.
As you can see, some of the actions that reduce key people value must come from those key people, and that may seem odd. After all, why would anyone want to make themselves less valuable to an organization? The truth is that from the organization's perspective, the most valuable key people find ways to make themselves more dispensable and less valuable over time by finding successors and building teams who can replicate what they can do. That may be at odds with the key person's interests, leading to a trade off a lower value added from being key people for a much higher value for the organization, and if they own a large enough stake in the latter, can end with being better off financially at the end. I have been open about my loyalty to Apple over the decades, but even as an Apple loyalists, I admire Bill Gates for building a management team that he trusted enough, at Microsoft, to step down as CEO in 2000, and while I cringe at Jeff Bezos becoming tabloid fodder, he too has built a company, in Amazon, that will outlast him. 

Determinants of Key Person Value

    If key person value varies across businesses and across time, it is worth examining the forces that determine that value effect, looking for both management and investment lessons. In particular, key people will tend to matter more at smaller enterprises than at larger ones, more at younger firms than at mature businesses, more at businesses that are driven by micro factors than one driven by macro forces and more at firms with shifting and transitory moats than firms with long-standing competitive advantages.

Company size
    In general, the value of a key person or persons should decrease as an organization increases in size. The value added by a superstar trader will be greater if he or she works at a ten-person trading group than if they work at a large investment bank. There are clearly exceptions to this rule, with Tesla being the most visible example, but at the largest companies, with hundreds or even thousands of employees, and multiple products and clients, it becomes more and more difficult for a single person or even a group of people to make a significant difference. 

Stage in Corporate Life Cycle
    I have written about how companies, like human beings, are born, mature, age and die, and have used the corporate life cycle as a framework to talk about corporate financial and investment choices. I also believe it provides insight into the key person value discussion:
As you can see, early in the life cycle, where the corporate narrative drives value, a single person, usually a founder, can make or break the business, with his or her capacity to set narrative and inspire loyalty (from employees and investors). As a business ages, CEOs matter less, as the business takes form, and scales up, and less of its value comes from  future growth. At mature companies, CEOs often are custodians of value in assets in place, playing defense against competitors, and while they have value, their potential for value-added becomes smaller.  At a company facing decline, the value of a key person at the top ticks up again, partly in the hope that this person can resurrect the company and partly because a CEO for a declining company who doubles down on bad growth choices can destroy value over short periods. The research provides support, with evidence that CEO deaths at young companies more likely to evoke large negative stock price reactions. 
    This life-cycle driven view of the value of to management may provide some perspective into the key person effects at both Open AI and Tesla.
  • At OpenAI, for better or worse, it is Sam Altman who has been the face of the company, laying out the narrative for the future of AI, and Open AI remains a young company, notwithstanding its large estimated value. While the board of directors felt that Altman was on a dangerous path, the capital providers, which included not only venture capitalists, but Microsoft as a joint-venture investor, were clearly swayed not in agreement, and Open AI’s employees were loyal to him. In short, once Open AI decided to open the door to eventually being not just a money-making business, but one worth $80 billion or more, Altman became the key person at the company, as Open AI’s board discovered very quickly, and to its dismay.
  • With Tesla, the story is more complicated, but this company has always revolved around Elon Musk. As a young company, where investors and legacy auto companies viewed it as foolhardy in its pursuit of electric cars, Musk's vision and drive was indispensable to its growth and success. As Tesla has brought the rest of the auto business around to its narrative, and become not just a successful company, but one worth a trillion dollars or more at its peak, Musk has remained the center of the story, in good and bad ways. His vision continues to animate the company’s thinking on everything from the Cybertruck to robo-taxis, but his capacity for distraction has also sometimes hijacked that narrative. Thus, the debate of whether Musk, as a key person, is adding or detracting from Tesla’s value has been joined, and while I remain convinced that he remains a net positive, since I cannot imagine Tesla without him, there are many who disagree with me. At the same time, Musk is mortal and it remains an open question whether he is willing to make himself dispensable, by not only building a management teams that can run the company without him, but also a successor that he is willing to share power and the limelight.
In general, the life cycle framework explains why good venture capitalists often spend so much time assessing founder qualities and why public market investors, especially those who focus on mature companies, can base their investments on just financial track records.

Micro versus Macro
    There are some companies where value comes more from company-specific decisions on products/services to offer, markets to enter and pricing decisions, and others, where the value comes more from macro variables. A media company, like Disney, where movie or television offerings constantly have to adjust to reflect changing demand and in response to competition, would be an example of the former, whereas an oil company, where it is the oil price that is the key determinant of revenues and earnings, would be an example of the latter.
    In general, you are far more likely to find key people, who can add or take away from value at the former (micro companies) than at the latter (macro companies). Consider the heated arguments that you are hearing about Bob Iger and his return to the CEO position at Disney, with Nelson Peltz in the mix, arguing for change. While some of the forces affecting Disney are across entertainment companies, as I noted in this post, I also argued that whether Disney ends up as one of the winners in this space will depend on management decisions on which businesses to growth, which ones to shrink or spin off and how they are run. With Royal Dutch, it is true that canny management can add to oil reserves, by buying them when oil prices are low, but for the most part, much of what happens to it is impervious to who runs the company. 

Business Moats
    Business moats refer to competitive advantages that companies have over their competitors that allow them to not just grow and be profitable, but to create value by earning well above their cost of capital. That said, moats can range the spectrum, both in terms of sources (cheap raw material, brand names, patents) as well as sustainability (some last for decades and others are transitory). Some moats are inherited by management, and others are earned, and some are high maintenance and others require little care.
    In general, there will be less key person value at companies with inherited moats that are sustainable and need little care, and more key person value at companies where moats need to be recreated and maintained. To illustrate, consider two companies at opposite ends of the spectrum. At one end, Aramco, one of the most valuable companies in the world, derives almost all of its value from its control of the Saudi oil sands, allowing it to extract oil at a traction of the cost faced by other oil companies, and it is unlikely that there is any person or group of people in the organizational that could affect its value very much. At the other end, an entertainment software company like Take-Two Interactive is only as good as its latest game or product, and success can be fleeting. It should come as no surprise that there are far more key people, both value-adders and value-destroyers, in these businesses than in most others. 

    The notion that a key person or persons can add or detract from the value of an organization is neither surprising nor unexpected, but having a structured framework for examining the value effects can yield interesting implications.

Aging of key person(s)
    There are many reasons that key persons leave companies, and while companies can try to stave them off by taking actions to protect key people, there is one reason - aging and death - which are inexorable and inevitable. As key people, especially at the top of an organization age, investors should start factoring in not just their eventual departures, but a decline in effectiveness, as they get older. Speaking of key people in large companies, Berkshire Hathaway has a had a special status, an insurance company with the best portfolio managers in the world in Warren Buffett and Charlie Munger. Well before Munger's passing, Buffett and Munger had bowed to advancing age and had  passed the baton on to Ted Weschler and Todd Combs. While Buffett undoubtedly still has a say in investment choices, it is also clear that he has a far lesser role than he used ro, which may explain Berkshire's bet on a company like Snowflake, a company that has a snowball's chance in hell of getting through a Buffett-Munger investment screening.
    Are markets building in the recognition that Berkshire Hathaway's future will be in the hands of someone other than the two legendary leaders? I think so, and one way to see how markets have adjusted expectations is by comparing the price to book ratio that Berkshire Hathaway trades at relative to a typical insurance company:

In the last decade, as you can see, Berkshire Hathaway's price to book has drifted down, and relative to insurance companies in the aggregate, the Buffett-Munger premium has largely dissipated, suggesting that while Combs and Weschler are well-regarded stock pickers, they cannot replace Buffett and Munger. That may explain why Berkshire's stock price was unaffected by Munger's passing.

Industry Structure
    As we shift away from a twentieth century economy, where manufacturing and financial service companies dominated, to one where technology and service companies are atop the largest company list, we are also moving into a period where value will come as much from key people in the organization as it does from physical assets. It follows that companies will invest more in human capital to preserve their value, and here, as in much of the new economy, accounting is missing the boat. While there have been attempts to increase corporate disclosure about human capital, the impetus seems to be coming more from diversity advocates than from value appraisers. If human capital is to be treated as a source of value, what companies spend in recruitment, training and nurturing employee loyalty is more capital expenditure than operating expense, and as with any other investment, these expenses have to be judged by the consequences in terms of employee turnover and key person losses.

    To the extent that key people deliver more value to companies, it stands to reason that they will try to claim some or all of that added value for themselves. In organizations where they are valuable key people, you should expect to see much greater differences in compensation across employees, with the most valued key people being paid large multiples of what the typical employee earns. In addition, to encourage these key people to make themselves less key, by building teams and grooming successors, you would expect the pay to be more in the form on equity (restricted stock or options) than in cash.While that may strike you as inequitable or unfair, it reflects the economics of businesses, and legislating compensation limits will either cause key people to move on or to find loopholes in the laws. 
    Lest I be viewed as an apologist for monstrously large top management compensation packages,  the key person framework can be a useful in holding to account boards of directors that grant absurdly high compensation packages to top managers in companies, where their presence adds little value. Thus, I don’t see why you would pay tens of millions of dollars to the CEOs of Target (a mature to declining retail company, no matter who runs it), Royal Dutch (an almost pure oil play) or Coca Cola ( where the management is endowed with a brand name that they had little role in creating). This may be a bit unfair, but I would wager that an AI-generated CEO could replace the CEOs of half or more of the S&P 500 companies, and no one would notice the difference.

In conclusion
    There are many canards about intrinsic valuation that are in wide circulation, and one is that intrinsic valuations do not reflect the value of people in a company. That is not true, since intrinsic valuations, done right, should incorporate the value of a key person or people in a business, reflecting that value in cash flows, growth or risk inputs. That said, intrinsic value is built, not on nostalgia or emotion, but  on the cold realities that key people can sometimes destroy value, that a key person in a company can go from being a value creator to a value destroyer over time and that key people, in particular, and human capital, in general, will matter less in some companies (more mature, manufacturing and with long-standing competitive advantages) than in other companies (younger, service-oriented and with transitory and changing moats. 

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Wednesday, November 1, 2023

Tesla in November 2023 : Story twists and turns, with value consequences!

I was planning to start this post by telling you that Tesla was back in the news, but that would be misleading, since Tesla never leaves the news. Some of that attention comes from the company's products and innovations, but much of it comes from having Elon Musk as a CEO, a man who makes himself the center of every news cycle. That attention has worked in the company's favor over much of its lifetime, as it has gone from a start-up to one of the largest market cap companies in the world, disrupting multiple businesses in the process. At regular intervals, though, the company steps on its own story line, creating confusion and distractions, and during these periods, its stock price is quick to give up gains, and that has been the case for the last few weeks. As the price dropped below $200 today (October 30,2023), I decided that it was time for me to revisit and revalue the company, taking into account the news, financial and other, that has come out since my last valuation in January 2023, and to understand the dueling stories that are emerging about the company.

My Tesla History

    When I write and teach valuation, I describe it as a craft, and there are very few companies that I enjoy practicing that craft more than I do with Tesla. Along the way, I have been wrong often on the company, and if you are one of those who only reads valuations by people who get it right all the time, you should skip the rest of this post, because I will cheerfully admit that I will be wrong again, though I don't know in which direction. My first valuation of Tesla was in 2013, when it was a nascent automobile firm, selling less than 25,000 cars a year, and viewed by the rest of the automobile sector with a mix of disdain and curiosity. I valued it as a luxury automobile firm that would succeed in that mission, giving it Audi-level revenues in 2023 of about $65 billion, and operating margins of 12.50% that year (reflecting luxury auto margins). To deliver this growth, I did assume that Tesla would have to invest large amounts of capital in capacity, and that this would create a significant drag on value, resulting in a equity value of just under $10 billion.

    In subsequent valuations, I modified and adapted this story to reflect lessons that I learned about Tesla, along the way. First, I learned that the company was capable of generating growth much more efficiently, and more flexibly, than other auto companies, reducing the capital investment needed for growth. Second, I noticed that Tesla customers were almost fanatically attached to the company's products, and were willing to evangelize about it, yielding a brand loyalty that legacy auto companies could only dream about. Third, in a world where many companies are run by CEO who are, at best, operating automatons, and at worst, evidence of the Peter Principle at play, where incompetence rises to the top, Tesla had a CEO whose primary problem was too much vision, rather than too little. In valuation terms, that results in a company whose value shifts with narrative changes, creating not only wide swings in value, but vast divergences in opinion on value. In 2016, I looked at how Tesla's story would vary depending upon the narrative you had for the company and listed some of the possible choices in a picture:

I translated these stories into inputs on revenue growth, profit margins and reinvestment, to arrive at a template of values:
Note that is multiple stock splits ago, and the prices per share here are not comparable to the share price today, but the overall lessons contained in this table still apply. First, when you see significant disagreements about what Tesla is worth, those differences come from divergent stories, not disagreements about numbers. Second, every news story or financial disclosure about Tesla has to be used to evaluate how the company's narrative is changing, creating multiplier effects that create disproportionate value changes.
    Along the way, Tesla (or more precisely, Elon Musk) has made choices that could be, at best, described as puzzling, and, at worst, as perilous for the company's long term health, from borrowing money in 2017, when equity would have been a much better choice, to setting arbitrary targets on production (remember the 5000 cars a week for the company in 2018) and cash flows (positive cash flows in 2018) that pushed the company into a corner. If you add to that the self-inflicted wounds including Musk tweeting out that he had a deal to sell the company at $420 a share, funding secured, in 2018, it is not surprising that the stock has had periods of trauma. It was after one of these downturns in 2019, when the stock hit $180 (with a market cap of $32 billion), that I bought Tesla for the first time, albeit labeling it as my corporate teenager, an investment that would frustrate me because it would get in the way of its own potential. 
    I profited mightily on that investment, but I sold too soon, when Tesla's market capitalization hit $150 billion, and just before COVID put the company on a new price orbit. In fact, I revisited the company's value in November 2021, when its market capitalization hit a trillion, marveling at its rise, but also noting that it was priced to deliver such wondrous results ($600-$800 billion in revenues, with 20%+ margins) that I was uncomfortable going along:

In 2022, the stock came back to earth with a vengeance, losing more than 65% of its equity value, leaving the stock (on a post-split basis) trading at close to $100 a share at the end of the year. Three weeks later, i.e., at the start of 2023, I revalued the stock, allowing for uncertainties in my estimate of revenues and margins to deliver a median value per share of $153, with significant variation in potential outcomes:

I was about a week late on my valuation, since the stock price had already broken through this value by the time I finished it, leaving my portfolio Tesla-free, in 2023.

Tesla Update

    My last Tesla valuation is less than ten months old, and while that is not long in calendar time, with Tesla, it feels like an eternity, with this stock. As a lead in to updating the company’s valuation, it makes sense to start with the stock price, the market’s barometer for the company's health. The stock, which  started the year in a swoon, recovered quickly in the first half of the year, peaking around mid-year at close to $300 a share. 

The last four months have tested the stock, and it has given back a significant portion of its gains this year, with the stock dropping below $200 on October 30, 2023. Since earnings reports are often viewed as the catalysts for momentum shifts, I have highlighted the four earnings reports during the course of 2023, with a comparison of earnings per share reported, relative to expectations. The first earnings report, in January 2023, has been the only one where the company beat expectations, and it matched expectations in the April report, and fallen behind in the July and October reports. 

    The earnings per share focus misses much of Tesla’s story, and it is instructive to dig deeper into the income statement and examine how the company has performed on broader operating metrics:

In the twelve months, ending September 2023, Tesla reported operating income of $10.7 billion on revenues of $95.9 billion; that puts their revenues well ahead of my 2013 projection of $65 billion, albeit with an operating margin of 11.18%, lagging my estimate of 12.5%.  That makes Tesla the eleventh largest automobile company in the world, in revenue terms, and the seventh most profitable on the list, making it more and more difficult for naysayers to argue that it is a fad that will pass. Breaking down the news in the financials by business grouping, here is what the reports reveal:

  • Auto business: Tesla's auto business saw revenue growth slow down from the torrid pace that it posted between 2020 and 2022, with third quarter year-on-year revenue growth dropping to single digits, but given the flat sales in the auto sector and a sluggish electric car market, it remains a stand-out. The more disappointing number, at least for those who were expecting pathways to software-company like margins for the company, was the decline in profit margins on automobiles from 2022 levels, though  the 17.42% gross margin in the third quarter, while disappointing for Tesla, would have been cause for celebration at almost any of its competitors.
  • Energy business: Tesla's energy business, which was grounded by its acquisition of Solar City in 2016, has had a strong year, rising from 4.8% of the company's revenues in 2022 to 6.2% in the twelve months ending September 2023. In conjunction, the profitability of the business also surged in the last twelve months, and while some of this increase will average out, some of it can be attributed to a shift in emphasis to storage solutions (battery packs and other) from energy generation.
In short, Tesla's financial reports, are an illustration of how much expectations can play a role in how markets react to the news in them. The post-COVID surge in Tesla's revenues and profitability led to unrealistically high expectations of what the company can do in this decade, and the numbers, especially in the last two quarters, have acted as a reality check.
    As a story stock, Tesla is affected as much by news stories about the company and its CEO, as it is by financials, and there are three big story lines about the company that bear on its value today:
  1. Price Cuts: During the course of 2023, Tesla has repeatedly cut prices on its offerings, with the most recent ones coming earlier this month, The $1,250 reduction in the Model 3 should see its price drop to about $39,000, making it competitive, even on a purely price basis, in the mass auto market in the United States. Some of this price cutting is tactical and in response to competition, current or forecast, but some of it may reflect a shift in the company's business model.
  2. Full Self Driving (FSD): Tesla, as a company, has pushed its work on full self driving to the forefront of its story, though there remains a divide in how far ahead Tesla is of its competition, and the long term prospects for automated driving. Its novelty and news value has made it a central theme of debate, with Tesla fans and critics using its successes and failures as grist for their social media postings. While an autopilot feature is packaged as a standard feature with Teslas,  it offers  FSD software, which is still in beta version, offers an enhanced autopilot model, albeit at a price of $12,000. The FSD news stories have also reignited talk of a robotaxi business for Tesla, with leaks from the company of a $25,000 vehicle specifically aimed at that business.
  3. Cybertruck: After years of waiting, the Tesla Cybertruck is here, and it too has garnered outsized attention, partly because of its unique design and partly because it is Tesla's entree into a market, where traditional auto companies still dominate. While there is still debate about whether this product will be a niche offering or one that changes the trucking market, it has undoubtedly drawn attention to the company. In fact, the company's reservation tracker records more than two millions reservations (with deposits), though if history is a guide, the actual sales will fall well short of these numbers.
This being Tesla, there are dozens of other stories about the company, but that is par for the course. We will focus on these three stories because they have the potential to upend or alter the Tesla narrative, and by extension, its value.

Story and Valuation: Revisit and Revaluation

    In my Tesla valuations through the start of 2023, I have valued Tesla as an automobile company, with the other businesses captured in top line numbers, rather than broken out individually. That does not mean that they are adding significantly to value, but that the value addition is buried in an input to value, rather than estimated standing alone. In my early 2023 valuation, I estimated an operating margin of 16% for Tesla, well above auto industry averages, because I believed that software and or the robotaxi businesses, in addition to delivering additional revenues, would augment operating margins, since they are high-margin businesses.     

    The news stories about Tesla this year have made me reassess that point of view, since they feed into the narrative that Tesla not only believes that the software and robotaxi businesses have significant value potential as stand-alone businesses, but it is acting accordingly. To see why, let me take each of the three news story lines and work them into my Tesla narrative:

  1. Cybertrucks: The easiest news items to weave into the Tesla narrative is the Cybertruck effect. If the advance orders are an indication of pent-up demand and the Cybertruck represents an extension into a hitherto untapped market, it does increase Tesla's revenue growth potential. There are two potential negatives to consider, and Musk referenced them during the course of the most recent earnings call. The first is that, even with clever design choices, at their rumored pricing, the margins on these trucks will be lower than on higher-end offerings. The other is that the Cybertruck may very well require dedicated production facilities,  pushing up reinvestment needs. If Cybertruck sales are brisk, and the demand is strong, the positives will outweigh the negatives, but if the buzz fades, and it becomes a niche product, it may very well prove a distraction that reduces value. The value added by Cybertrucks will also depend, in part, on who buys them, with Tesla gaining more if the sales comes from truck buyers, coming from other companies, than it will if the sales comes from Tesla car buyers, which will cannibalize their own sales.
  2. FSD: As I look at the competing arguments about Tesla's FSD research, it seems clear to me that both sides have a point. On the plus side, Tesla is clearly further along this road than any other company, not only from a technological standpoint, but also from business model and marketing standpoints. While I do not believe that charging $12,000 for FSD as an add-on will create a big market, lowering that price will open the door not only to software sales to Tesla drivers, but perhaps even to other carmakers. In addition, it seems clear to me that the Tesla robotaxi business has now moved from possible to plausible on my scale, and thus merits being taken seriously. On the minus side, I do agree that the world is not quite ready for driverless cars, on scale, and that rushing the product to market can be catastrophic. 
  3. Price cuts: The Tesla price cuts have led to a divide among Tesla bulls, with some pointing to it as the reason for Tesla's recent pricing travails and others viewing it as a masterstroke advancing it on its mission of global domination. To decide which side has the more realistic perspective, I decided to take a look at how price cuts play out in value for a generic company. The first order effect of a price cut is negative, since lowering prices will lower margins and profits, and it is easy to compute. It is the second order effects that are tricky, and I list the possibilities in the figure below, with value consequences:

    In short, price cuts can, and often will, change the number of units sold, perhaps offsetting some of the downside to price cut (tactical), make it more difficult for competitors to keep up or enter your business (strategic) and expand the potential for side or supplemental businesses to thrive (synergistic). This figure explains the divide on the Tesla price cuts, with the pessimists arguing that electric car demand is too inelastic for volume increases that will compensate for the lower margins, and the optimists arguing that the value losses from lower margins will be more than offset by a long-term increase in Tesla's market share, and increase the value from their software and robotaxi businesses.

To bring these stories into play, I break Tesla down into four businesses - the auto business, the energy business, the software business and the robotaxi business. I do know that there will be Tesla optimists who will argue that there are other businesses that Tesla can enter, including insurance and robots, but for the moment, I think that the company has its hands full. I look out the landscape for these businesses in the picture below, looking at the potential size and profitability of the market for each of these businesses, as well as Tesla's standing in each.

Note that the auto business is, by far, the largest in terms of revenue potential, but it lags the other business in profitability, especially the software and robotaxi businesses, where unit economics are favorable and margins much higher. Note also that estimates for the future in the robotaxi and auto software businesses are squishy, insofar as they are till nascent, and there is much that we do not know.My Tesla story for each of these businesses is below, with revenue and profitability assumption, broken down  by business:

With these stories in place, I estimate revenues, earnings and cash flows for the businesses, and in sum, for the company, and use these cash flows to estimate a value per share for the company:

Download spreadsheet

In sum, the value per share that I get with Tesla's businesses broken down and allowing for divergent growth and profitability across businesses, is about $180 a share. That is higher than my estimate at the start of the year, with part of that increase coming from the higher profit potential in the side businesses, and expectations of a much larger end game in each one. 
    Given that this value comes from four businesses, you can break down the value into each of those businesses, and I do so below:
Just as a note of caution, these businesses are all linked together, since the battery technology that drives the auto and energy businesses are shared, and FSD software sales will be tied to car sales. Consequently, you would not be able to spin off or sell these businesses, at least as these estimated values, but it does provide a sense of investors should watch for in this company. Thus, with a chunk of value tied to FSD, from software and robotaxis, any signs of progress (failure) on the FSD front will have consequences for value.

An Action Plan
    As you review my story and numbers, you will undoubtedly have very different views about Tesla going forward, and rather than tell me that you disagree with my views, which serves neither of us, please download the spreadsheet and make your own projections, by business. So, if you believe that I am massively underestimating the size of the robotaxi business, please do make your own judgment on how big it can get, with the caveat that making that business bigger will make your auto and software businesses smaller. After all, if everyone is taking robotaxis, the number of cars sold should drop off and existing car owners may be less likely to pay extra for a FSD package. 
    At $197 a share, Tesla remains over valued, at least based on my story, but a stock that has dropped $54 in price in the last few weeks could very well drop another $20 in the next few. To capture that possibility, I have a limit buy at my estimated value of $180, with the acceptance that it may never hit that price in this iteration. For those of you who wonder why I don't have a margin of safety (MOS), I have argued that the MOS is a blunt instrument that is most useful when you are valuing mature companies where you face a luxury of riches (lots of under valued companies). Furthermore, as my January 2023 simulation of Tesla value reveals, this is a company with more upside than downside, and that make a fair-value investment one that I can live with.  Put simply, the possibility of other businesses  that Tesla can enter into adds optionality that I have not incorporated into my value, and that acts as icing on the cake.
    Obviously, and this will sound like the postscript from an email that you get from your investment banking friends, I am not offering this as investment advice. Unlike those investment banking email postscripts, I mean that from the heart and am not required by either regulators or lawyer to say it. I believe that investors have to take ownership of their investment decisions, and I would suggest that the only way for you to make your own judgment on Tesla is to frame your story, and value it based on that story. Of course, you are welcome to use, adapt or just ignore my spreadsheet in that process.

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Data and Spreadsheets

Thursday, October 12, 2023

Good Intentions, Perverse Outcomes: The Impact of Impact Investing!

     I have made no secret of my disdain for ESG, an over-hyped and over-sold acronym, that has been a gravy train for a whole host of players, including fund managers, consultants and academics. In response, I have been told that the problem is not with the idea of ESG, but in its measurement and application, and that impact investing is the solution to both market and society's problems. Impact investing, of course, is investing in businesses and assets based on the expectation of not just earning financial returns, but also creating positive change in society. 

    It is human nature to want to make the world a better place, but does impact investing have the impact that it aims to create? That is the question that I hope to address in this post. In the course of the post, I will work with two presumptions. The first is that the problems for society that impact investing are aiming to address are real, whether it be climate change, poverty or wealth inequality. The second is that impact investors have good intentions, aiming to make a positive difference in the world. I understand that there will be some who feel that these presumptions are conceding too much, but I want to keep my focus on the mechanics and consequences of impact investing, rather than indulge in debates about society's problems or question investor motives.

Impact Investing: The What, The Why and the How!

    Impact investments are investments made with the intent of generating benefits for society, alongside a financial return. That generic definition is not only broad enough to cover a wide range of impact investing actions and motives, but has also been with us since the beginning of time. Investors and business people have often considered social payoffs when making investments, though they have differed on the social outcomes that they seek, and the degree to which they are willing to sacrifice the bottom line to achieve those outcomes. 
   In the last two decades, this age-old investing behavior has come under the umbrella of impact investing, with several books on how to do it right, academic research on how it is working (or not), and organizations dedicated to advancing its mission.  The Global Impact Investing Network (GIIN), a non-profit that tracks the growth of this investing movement, estimated that more than $1.16 trillion was invested by impact investors in 2021, with a diverse range of investors:
Global Impact Investing Network, 2022 Report

Not surprisingly, the balance between social impact and financial return desired by investors, varies across investor groups, with some more focused on the former and others the latter. In a survey of impact investors, GIIN elicited these responses on what types of returns  investors expected to earn on their impact investments, broken down by groups:

Global Impact Investing Network, 2020 Report

Almost two thirds of impact investors believe that they can eat their cake and have it too, expecting to earn as much or more than a risk-adjusted return, even as they do good. That delusion running deepest among pension funds, insurance companies, for-profit fund managers and diversified financial investors, who also happen to account for 78% of all impact investing funds.
    If having a positive impact on society, while earning financial returns, is what characterizes impact investing, it can take one of three forms:
  1. Inclusionary Impact Investing: On the inclusionary path, impact investors seek out businesses or companies that are most likely to have a positive impact on whatever societal problem they are seeking to solve, and invest in these companies, often willing to pay higher prices than justified by the financial payoffs on the business. 
  2. Exclusionary Impact Investing: In the exclusionary segue, impact investors sell shares in businesses that they own, or refuse to buy shares in these businesses, if they are viewed as worsening the targeted societal problem.
  3. Evangelist Impact Investing: In the activist variant, impact investors buy stakes in businesses that they view as contributing to the societal problem, and then use that ownership stake to push for changes in operations and behavior, to reduce the negative social or environmental impact.
The effect of impact investing in the inclusionary and exclusionary paths is through the stock price, with the buying (selling) in inclusionary (exclusionary) investing pushing stock prices up (down), which, in turn, decreases (increases) the costs of equity and capital at these firms. The changes in costs of funding then show up in investing decisions and growth choices at these companies, with good companies expanding and bad companies shrinking. 
With evangelist impact investing, impact investors aim to get a critical mass of shareholders as allies in pushing for changes in how companies operate, shifting the company away from actions that create bad consequences for society to those that have neutral or good consequences.

As you can see, for impact investing to have an impact on society, a series of links have to work, and if any or all of them fail, there is the very real potential that impact investing can have perverse consequences.
  • With inclusionary investing, there is the danger that you mis-identify the companies capable of doing good, and flood these companies with too much capital. Not only is capital invested in these companies wasted, but increases the barriers to better alternatives to doing good. 
  • With exclusionary investing, pushing prices down below their "fair" values will allow investors who don’t care about impact to earn higher returns, from owning these companies. More importantly, if it works at reducing investment from public companies in a "bad" business, it will open the door to private investors to fill the business void.  
  • With evangelist investing, an absence of allies among other shareholders will mean that your attempts to change the course of businesses will be largely unsuccessful. Even when you are successful in dissuading these companies from "bad" investments, but may not be able to stop them from returning the cash to shareholders as dividends and buybacks, rather than making "good" investments.
In the table below, I look at the potential for perverse outcomes under each of three impact investing approaches, using climate change impact investing as my illustrative example:

The question of whether impact investing has beneficial or perverse effects is an empirical question, not a theoretical one, since your assumptions about market depth, investor behavior and business responses can lead you to different conclusion.
    It is worth noting that impact investing may have no effect on stock prices or on corporate behavior, either because there is too little money behind it, or because there is offsetting investing in the other direction. In those cases, impact investing is less about impacting society and more about alleviating the guilt and cleansing the consciences of the impact investors, and the only real impact will be on the returns that they earn on their portfolios. 

The Impact of Impact Investing: Climate Change

    While impact investing can be directed at any of society's ills, it is undeniable that its biggest focus in recent years has been on climate change, with hundreds of billions of dollars directed at reversing its effects. Climate change, in many ways, is also tailored to impact investing, since concerns about climate change are widely held and many of the businesses that are viewed as good or bad, from a climate change perspective, are publicly traded. As an empirical question, it is worth examining how impact investing has affected the market perceptions and pricing of green energy and fossil fuel companies, the operating decisions at these companies, and most critically, on the how we produce and consume energy.

Fund Flows

       The biggest successes of  climate change impact investing have been on the funding side. Not only has impact investing directed large amounts of capital towards green and alternative energy investments, but the movement has also succeeded in convincing many fund managers and endowments to divest themselves of their investments in fossil fuel companies. 

  • As concerns about climate change have risen, the money invested in alternative energy companies has expanded, with $5.4 trillion cumulatively invested in the last decade:

Source: BloombergNEF

Almost half of this investment in alternative energy sources has been in renewable energy, with electrified transport and electrified heat accounting for a large portion of the remaining investments. 

  • On the divestment side, the drumbeat against fossil fuel investing has had an effect, with many investment fund managers and endowments joining the divestiture movement:

By 2023, close to 1600 institutions, with more than $40 trillion of funds under their management, had announced or concluded their divestitures of investments in fossil fuel companies.

If impact investing were measured entirely on fund flows into green energy companies and out of fossil fuel companies, it has clearly succeeded.

Market Price (and Capitalization)

    It is undeniable that fund flows into or out of companies affects their stock prices, and if the numbers in the last section are even close to reality, you should have expected to see a surge in market prices at alternative energy companies, as a result of funds flowing into them, and a decline in market prices of fossil fuel companies, as fossil fuel divestment gathers steam. 

  • On the alternative energy front, as money has flowed into these companies, there has been a surge in enterprise value (equity and net debt) and market capitalization (equity value); I report both because impact investing can also take the form of green bonds, or debt, at these companies. The enterprise value of publicly traded alternative energy companies has risen from close to zero two decades ago to more than $700 billion in 2020, before losing steam in the last three years:

Adding in the value of private companies and start-ups in this space would undoubtedly push up the number further. 

  • On the fossil fuel front, the fossil fuel divestments have had an impact on market capitalizations, though there are signs that the effect is weakening:

In the last decade, when fossil fuel divestment surged, the percentage changes in market capitalization at fossil fuel companies lagged returns on the market, with fossil fuel companies reporting a compounded annual percentage increase of 4.49% a year.. The negative effect was strongest in the middle of the last decade, but market prices for fossil fuel companies have recovered strongly between 2020 and 2023.

It is worth noting that even after their surge in market cap in the last decade, alternative energy companies have a cumulated enterprise value of about $600 billion in September 2023, a fraction of the $8.5 trillion of cumulated enterprise value at fossil fuel companies.

Investor perceptions

    Impact investing has always been about changing investor perceptions of energy companies, more than just prices. In fact, some impact investors have argued that their presence in the market and advocacy for alternative energy has led investors to change their views about fossil fuel companies, shifting from viewing them as profitable, cash-rich businesses with extended lives, to companies living on borrowed time, looking at decline and even demise. In intrinsic valuation terms, that shift should show up in the pricing, with lower value attached to the latter scenario than the former:

    On the green energy front, to see if investors perceptions of these companies have changed,  I look at two the pricing metrics for green energy companies - the enterprise value to EBITDA and enterprise value to revenue multiples:

The numbers offer a mixed message on whether impact investing has changed investor perceptions, with EV to EBITDA multiples staying unchanged, between the 1998-2010 and 2011-2023 time periods, but EV as a multiple of revenues soaring from 2.62 in the 1998-2010 time period to 5.95 in the 2011-2023 time period. The fund flows into green energy are affecting pricing, though it remains an open question as to whether the pricing is getting too rich, as too much money chases too few opportunities.

    Looking at fossil fuel firms, the poor performance in the last decade seems to support the notion that impact investing has changed how investors perceive fossil fuel companies, but there are some checks that need to be run to come that conclusion. 

  • Oil Price Effect: The market capitalization of oil companies is dependent on oil prices, as you can see in the figure below, where the collective market capitalization of fossil fuel companies is graphed against the average oil price each year from 1970 to 2022; almost 70% of the variation in market capitalization over time explained by oil price movements.

To separate impact investing divestment effects from oil price effects, I estimated the predicted market capitalization of fossil fuel companies, given the oil price each year, using the statistical relationship between market cap and oil prices in the twenty five years leading into the forecast year. (I regress market capitalization against average oil price from 1973 to 1997 to estimate the expected market cap in 1998, given the oil price in 1998, and so on, for every year from 1998 to 2023. Note that the only thing you can read these regressions is that market capitalization and oil prices move together, and that there is no way to draw conclusions about causation):

If divestitures are having a systematic effect on how markets are pricing fossil fuel companies, you should expect to see the actual market capitalizations trailing the expected market capitalization, based on the oil price. That seems to be the case, albeit marginally, between 2011 and 2014, but not since then. In short, the divestiture effect on fossil fuel companies has faded over time, with other investors stepping in and buying shares in their companies, drawn by their earnings power. 

  • Pricing: If impact investing is changing investor perceptions about the future growth and termination risk at fossil fuel companies, it should show up in how these companies are priced, lowering the multiples of revenues or earnings that investors are willing to pay. In the chart below, I look at the pricing of fossil fuel companies over time, using EV to sales and EV to EBITDA as pricing metrics: 
    While the pricing metrics swing from year to year, that has always been true at oil companies, since earnings and revenues vary, with oil prices. However, if impact investing is having a systematic effect on how investors are pricing companies, there is little evidence of that in this chart.
In sum, while it is possible to find individual investors who have become skeptical about the future for fossil fuel companies, that view is not reflective of the market consensus. I do believe that investors are pricing fossil fuel companies now, with the expectation of much lower growth in the future, than they used to, but that is coming as much from these companies returning more of their earnings as cash and reinvesting less than they used to, as it is from an expectation that the days of fossil fuel are numbered. Some impact investors will argue that this is because investors are short-term, but that is a double-edged sword, since it undercuts the very idea of using investing as the vehicle to create social and environmental change.

Operating Impact
    Impact investing, in addition to affecting pricing of green energy and fossil fuel companies, can also have effects on how fossil fuel companies perform and operate. On the profitability front, fossil fuel companies seem to have weathered the onslaught of climate change critics, with revenues and profit margins (EBITDA and operating) bouncing back from a slump between 2014 and 2018 to reach historic highs in 2022. 

A key development over the last decade, as profits have returned, is that fossil fuel companies are returning much of cash flows that they are generating to their shareholders in the form of dividends and buybacks, notwithstanding the pressure from activist impact investors that they reinvest that money in green energy projects:

In one development that impact investors may welcome, fossil fuel companies are collectively investing less in exploration for new fossil fuel reserves in the last decade than they did in prior ones:

If you couple this trend of exploring less with the divestitures of fossil fuel reserves, over the last decade, there is a basis for the argument that fossil fuel companies are reducing their fossil fuel presence, and some impact investing advocates may be tempted to declare victory. After all, if the objective is to reduce fossil fuel production, does it not advance your cause if less money is being spent exploring for coal, oil and gas?  
    Before claiming a win, though, there is a dark side to this retreat by public fossil-fuel companies, and that comes from private equity investors and privately-owned (or government-owned) oil companies stepping into the breach; many of the divestitures and sales of fossil fuel assets by publicly traded companies have been to private buyers, and the assets being divested are often among the dirtiest (from a climate-change perspective) of their holdings.. Over the last decade, some of private equity’s biggest players have invested well over $1.1 trillion in fossil fuel, with the investments ranging the spectrum.  
Source: Pitchbook

While there was an uptick in investments in renewables in 2019 and 2020, the overwhelming majority of private equity investments during the decade were in fossil fuels. In the process, private equity firms like the Carlyle Group and KKR have become major holders of fossil fuel reserves, and there are a few private buyers who have profited from buying abandoned and castoff oil wells from oil companies, pressured to sell by impact investors. While climate change advocates are quick to point to this public-to-private transition of fossil fuel assets as a flaw, they fail to recognize that it is is a natural side-effect of an approach that paints publicly traded fossil fuel firms as villains and shuns their investments, while continuing to be dependent on fossil fuels for meeting energy needs. 
    On the activist front, there is evidence that impact investing's capacity to change oil company behavior is losing its potency. While fossil fuel companies were quick to give in to pressure from impact investors to de-carbonize, for much of the last decade, the Russian invasion of Ukraine seems to have been an "emperor-has-no-clothes" moment for green energy advocates, laying bare how reliant the globe still is on fossil fuels for its energy needs. In the aftermath, the biggest fossil fuel companies have become bolder about their plans to stay in and grow their fossil fuel investments, with Royal Dutch taking a stake in Qatari gas fieldBP announcing it will produce more oil and gasExxon Mobil buying Pioneer Natural Resources, a shale driller for $60 billion, and Petrobras reversing course on divestitures

Macro Impact
    The success or failure of impact investing, when it relates to climate change, ultimately comes from the changes it creates in how energy is produce and consumed, and it is on this front that the futility of the movement is most visible. While alternative energy sources have expanded their production, it has not been at the expense of oil consumption, which has barely budged over the last decade.

EIA: World Oil Consumption
Fairly or unfairly, the pandemic seems to have done more to curb oil consumption than all of impact investing's efforts over the last decade, but the COVID effect, which saw oil consumption drop in 2020 has largely faded.
    Taking a global and big-picture perspective of where we get our energy, a comparison of energy sources in 1971 and 2019 yields a picture of how little things have changed:
IEA: World Energy Balances Overview

Fossil fuel, which accounted for 86.6% of energy production in 1971, was responsible for 80.9% of production in 2019, with almost all of that gain from coming from nuclear energy, which many impact investors viewed as an undesirable alternative energy source for much of the last decade. Focusing on energy production just in the US, the failure of impact investing to move the needle on energy production can be seen in stark terms:

Source: U.S. Energy Information Administration
Fossil fuels account for a higher percent of overall energy produced in the United States today than they did ten or fifteen years ago, with gains in solar, wind and hydropower being largely offset by reductions in nuclear energy. If this is what passes for winning in impact investing, I would hate to see what losing looks like. 
    I have tried out variants of this post with impact investing acquaintances, and there are three broad responses that they have to its findings (and three defenses for why we should keep trying):
  1. Things would be worse without impact investing: It is impossible to test this hypothetical, but is it possible that our dependence on fossil fuels would be even greater, without impact investing making a difference? Of course, but that argument would be easier to make, if the trend lines were towards fossil fuels before impact investing, and moved away from fossil fuels after its rise. The data, though, suggests that the biggest shift away from fossil fuels occurred decades ago, well before impact investing was around, primarily from the rise of nuclear energy, and that impact investing's tunnel vision on alternative energy has actually made things worse.
  2. It takes time to create change: It is true that the energy business is an infrastructure business, requiring large investments up front and long gestation periods. It is possible that the effects of impact investing are just not being felt yet, and that they are likely to show up later this decade. This would undercut the urgency argument that impact investors have used to induce their clients to invest large amounts and doing it now, and if they had been more open about the time lag from the beginning, this argument would have more credibility today.
  3. Investing cannot offset consumption choices: If the argument is that impact investing cannot stymie climate change on its own, without changes in consumer behavior, I could not agree more, but changing behavior will be painful, both politically and economically. I would argue that impact investing, by offering the false promise of change on the cheap, has actually reduced the pressure on politicians and rule-makers to make hard decisions on taxes and production.
Even conceding some truth in all three arguments, what I see in the data is the essence of insanity, where impact investors keep throwing in more cash into green energy and more vitriol at fossil fuels, while the global dependence on fossil fuels increases.

Impact Investing: Investing for change
   Much of what I have said about impact investing's quest to fight climate change can be said about the other societal problems that impact investors try to address. Poverty, sexism, racism and inequality have had impact investing dollars directed at them, albeit not on the same scale as climate change, but are we better off as a society on any of these dimensions? To the response that doing something is better than being doing nothing, I beg to differ, since acting in ways that create perverse outcomes can be worse than sitting still.  To end this post on a hopeful note, I believe that impact investing can be rescued, albeit in a humbler, more modest form. 
  1. With your own money, pass the sleep test: If you are investing your own money, your investing should reflect your pocketbook as well as your conscience. After all,  investors, when choosing what to invest in, and how much, have to pass the sleep test. If investing in Exxon Mobil or Altria leads you to lose sleep, because of guilt, you should avoid investing in these companies, no matter how good they look on a financial return basis.
  2. With other people's money, be transparent and accountable about impact: If you are investing other people’s money, and aiming for impact, you need to be explicit on what the problem is that you are trying to solve, and get buy in from those who are investing with you. In addition, you should specify measurement metrics that you will use to evaluate whether you are having the impact that you promised.
  3. Be honest about trade offs: When investing your own or other people's money, you have to be honest with yourself not only about the impact that you are having, but about the trade offs implicit in impact investing. As someone who teaches at NYU, I believe that NYU's recent decision to divest itself of fossil fuels will not only have no effect on climate change, but coming from an institution that has established a significant presence in Abu Dhabi, it is an act of rank hypocrisy. It is also critical that those impact investors who expect to make risk-adjusted market returns or more, while advancing social good, recognize that being good comes with a cost.
  4. Less absolutism, more pragmatism: For those impact investors who cloak themselves in virtue, and act as if they command the moral high ground, just stop! Not only do you alienate the rest of the world, with your I-care-about-the-world-more-than-you attitude, but you eliminate any chances of learning from your own mistakes, and changing course, when your actions don't work.
  5. Harness the profit motive: I know that for some impact investors, the profit motive is a dirty concept, and the root reason for the social problems that impact investing is trying to address. While it is true that the pursuit of profits may underlie the problem that you are trying to solve, the power from harnessing the profit motive to solve problems is immense. Agree with his methods or not, Elon Musk, driven less by social change and more by the desire to create the most valuable company in the world, has done more to address climate change than all of impact investing put together. 
I started this post with two presumptions, that the social problems being addressed by impact investors are real and that impact investors have good intentions, and if that is indeed the case, I think it is time that impact investors face the truth. After 15 years, and trillions invested in its name, impact investing, as practiced now, has made little progress on the social and environmental problems that it purports to solve. Is it not time to try something different?

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