The Historical Insufficiency of Financial Analysis
Mistaking past limitations for scripture & the culture war around ESG.
The purpose of finance and how it works
The purpose of finance as a discipline is to make rigorous decisions regarding how to allocate limited resources to achieve the most substantial results. Yes, there are some important debates about results for whom but we won’t get into that here, at least not right now (despite its obvious significance).
Finance has been conducted as a science for at most about 100 years; before that, the practice had hardly any scientific credibility. Early science-minded practitioners1 were focused on fundamental analysis of public-market stocks. In the decades that followed, finance-as-scientific-discipline built out its toolkit (and rigor) to become useful in the world of government, policy, society and environment, and within specific industries (e.g., insurance is not a health-science innovation, it is a financial-science innovation).
Modern financial theory “works” by first identifying future benefits, as well as associated risks. Statistical techniques are then employed to measure the magnitude and probability of the potential benefits and risks. These methods ultimately attempt to provide insight into the efficacy of investing limited resources (the costs) toward achieving specific intended results (or what finance practitioners refer to as the creation of value).
A unexpected new front in the culture wars
Recently, a particular dimension of investment analysis, or finance-as-science, has reached fever pitch. This is, of course, highly unusual, as investment analysis is not usually a topic that people tend to get heated about. And before you ask, no, it isn’t about the way dividends or employee stock options are treated—those would be too technical to invite mass participation in the debate. The debate raging today concerns ESG investing (ESG stands for Environmental, Social, and Governance), and has somehow become another front in the battle of liberalism vs. conservatism.
As with nearly everything these days, this discussion has been weaponized by non-investment and non-finance practitioners to assume where one stands on other culture-war issues.2 While it may be true that the average practitioner of ESG-related investment analysis commonly falls on one side of this often ill-nuanced two-party war of ideologies, the current dialogue (i.e., pushback) against ESG entirely misses the point.
Making do vs. scripture
For most of humanity’s existence, limitations in technology prevented surgeons from successfully conducting (or even attempting) certain procedures. Few, if any, begrudge the medical profession for not attempting these procedures when success clearly wasn’t possible; nor do they desire that surgeons approach new cases with these limitations in mind.
Sadly, this is exactly what is happening in the world of finance-as-scientific-discipline. Advances in the understanding of risks, costs and value have grown considerably in the last several decades, yet there are loud voices clamoring that the financial discipline should stick to the tools and practices of yesteryear—mainly, that previously-overlooked-yet-highly-impactful risks and costs should continue to be ignored. This is clearly a suggestion likely to destroy more value than it creates.
One of the most tangible examples of this in action is the coal-power-generation sector: no matter which way you lean ideologically, you would have made better decisions as an investor in this sector in the early 2000s had you been able to better estimate the costs (including health impacts, and now-required environmental-restoration initiatives), risks (including the risk of competition coming from solar and wind power generation), and ultimate benefits (the value derived from baseload coal power generation). Instead, a lack of tools and an inability to pinpoint the right risks and costs resulted in investment decisions that utterly failed to deliver upon their expected benefits and, ultimately, wasted precious resources that could have been directed elsewhere for greater benefit.
Nonetheless, “anti-ESG” movements are actively promoting a return to the science of yesteryear in evaluating such opportunities for current and future investment. While we shouldn’t punish practitioners for their past use of methods that we now know are faulty, this primitive, Luddite-ian approach that treats old methods as unchallengeable scripture simply makes no sense.
Why it matters
In part because there is much money to be made (and lost!), savvy, science-minded finance practitioners are already incorporating far more costs and risks into their analysis than in decades past, no matter what moniker these items go by. This is clearly the long-horizon approach.
While it may be appropriate to ask that finance practitioners not deliberately use financial engineering to promote their personal beliefs, what isn’t appropriate is to ignore risks that clearly impact the allocation of our scarce resources, resulting in waste and ultimately depriving society of the beneficial impacts of having made better use of those resources.
As usual, we ought to look past the surface-level debate happening in the popular media to better understand the real ideas at play: Sadly, social forces have been commandeered to advocate for wealthy private interests who have much to lose if more advanced financial methods are adopted.3 The result has been a call to dumb down finance-as-science, with ESG investment as the punching bag likeliest to instill suitable fervor.
I expect that this fire will rage for quite some time, though (thankfully) advances in science (of all disciplines) have proven hard to hide for long.
Go deeper: Graham and Dodd
To be clear, both sides appear to be weaponizing this particular topic.
Go deeper: Article or Full Report