Who cares wins?

“Most commonly, new positions open up because of change… new needs emerge as societies evolve…..When such changes happen, new entrants, unencumbered by a long history in the industry, can often more easily perceive the potential for a new way of competing. Unlike incumbents, newcomers can be more flexible because they face no trade-offs with their existing activities.” Michael E. Porter; What is Strategy? Harvard Business Review (Oct-Nov 1996)

Is excluding a company from investment based on what it sells, an arbitrary judgement based on values? Is it purely a principled act separate from investment returns? We think not.

The long-term negative externalities of unsustainable products (such as cancer or deforestation for example) create market frictions that eventually flow back to those that promote or facilitate them.  Where such market frictions exist and incumbents do little to resolve them, innovators and entrepreneurs eventually appear with solutions that remove them.

In resolving a meaningful societal or environmental friction (such as plastic waste for example), entrepreneurs create value for their shareholders. Furthermore, in doing so, these innovators create disruptive frictions for the incumbents. The more unsustainable a product is, the riper it is for disruption and the more aggressive the innovators are likely to be.

Extend this further. Is it time that “traditional” business school-trained investors started giving those who care about these things a bit more credit?  We are used to hearing about the “opportunity costs” of excluding certain sectors; but what about the opportunity cost of investing in these unsustainable areas instead of elsewhere? Like somewhere that is resolving damaging frictions rather than creating them?

Source:factset

For us, the sustainability of a company’s product is directly linked to its strategic positioning.  When we think sustainably, the long-term strategic positioning of a company comes into focus. Companies that sell unsustainable products will inevitably face strategic dilemmas.  As Michael Porter recognised and other leading thinkers have observed, incumbents find it very difficult to reposition or ‘pivot’ themselves strategically.  So as sustainable growth investors, why would we not focus all of our energy searching for the best and most impactful disruptive challengers to invest in?

Clients and regular readers will be familiar with our three dimensions of sustainability framework below. What if we replaced the words sustainable product with ‘strategic positioning’ and the words sustainable practices with ‘operational effectiveness’? To be clear, ‘operational effectiveness’ as described by Porter also directly links to our definition of sustainable practices (i.e. how well a company is run day-to-day). We believe it is a fallacy that you can get one without the other over the long-term.

Being strategically positioned away from areas that sustainable investors typically seek to avoid has provided a performance benefit over the last three and five years. Meanwhile daring disruptive innovators who are mission-driven (i.e. care) are inventing new business models and leveraging the declining costs of technology to deliver positive impact, many creating economic value as they do.  Perhaps caring is the way to win in the long-term?

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas.

He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience.  *As at 30 April 2019.

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Can technology disrupt and democratise drug development?

Pharmaceutical research and development is critical and offers health and hope to millions…. but it’s very expensive. A Deloitte study from 2018 reported that the cost to develop a new drug from discovery to launch ranges from $1bn to $4bn (average about $2.2bn) and this has been rising ahead of inflation for decades.  It also takes between 5 and 10 years to bring a drug to market (average 6.7 years).  This trend of stubborn inflation (or friction) is in sharp contrast to most technological disruption we see today.  Given these high and rising costs, it is easy to understand why pharmaceutical companies are predominantly focussed on generating a return on these investments. It is the economics (i.e. potential number of patients multiplied by the achievable price) and not societal benefit, which are the ultimate determining factor. It’s all about size, scale and pushing prices up. Furthermore, cultural frictions and conflicts of interest clearly arise within the system, thus delaying the development of promising new discoveries.


Source: Deloitte 2018: Measuring the Return from Pharmaceutical Innovation

In short, the barriers to drug development are very high and research and development productivity is low. Navigating your way to and through a phase III trial is a monumental undertaking for any scientist or entrepreneur, so success is highly unpredictable.  It’s a hero or zero binary outcome that even the experts have difficulty predicting.  Factor all this into the context of treating rare diseases (i.e. developing ‘orphan drugs’) and it is also obvious why they receive relatively limited resource. This is probably fair in an economic context, but that’s not much comfort to those who might have been cured.


Source: Deloitte 2018: Measuring the Return from Pharmaceutical Innovation

The appropriate mechanism(s) for encouraging new drug development – whilst also ensuring safety, efficacy and keeping prices low – is fraught with politics, but there are some things that everyone can agree would be good…..

  1. Increase the efficiency of the drug discovery / screening process
  2. Improve data quality & quantity throughout the process to maximise R&D resource allocation
  3. Increase the efficiency of human trials to minimise suffering, reduce time and reduce costs
  4. Improve drug efficacy and reduce side effects via more personalised medicine (without an associated decrease in the returns on investment)

We do not directly invest in any pharma or biotech companies within our representative global sustainable equity strategy, but we do invest in companies that are focussing their efforts on solving at least one of the above problems within the R&D process.

Company Country Kames Sustainability Area of focus Brief description and examples of positive disruptive potential
PeptiDream Japan Improver Drug discovery platform A proprietary drug discovery platform which contains trillions of peptides and allows researchers to screen for new drugs hyper efficiently versus traditional methods. Peptides have relatively high potency, high selectivity and low toxicity versus traditional antibodies. This means a much higher chance of finding efficacious drugs which have less side effects. As a result, peptide drugs have the potential to vastly expand the number of addressable and ‘drugable’ targets, including rare diseases.
Medidata US Leader Drug R&D data analytics platform A software as a services (SAAS) platform specifically developed for the drug R&D process. This mission-driven business was formed specifically to help bio-tech & pharma companies do detailed and dispassionate data analytics on nearly all aspects of a clinical drug trial. This improves resource allocation, increases success rates and drives cost efficiencies. Medidata are also pioneering the concept of “synthetic” trials which could dramatically reduce the required number of human participants needed.
Illumina US Leader Genomics Illumina are the global leader in gene sequencing or ‘genomics’, a rapidly evolving industry at the intersection of biology and technology. Illumina enables researchers to better understand genetic variations and thus unlock potential new treatments. Illumina has driven down the cost (per genome) which we believe has led to an inflection in research activity across a range of unsolved disease classes and under-researched rare diseases.
Icon Ireland (US listed) Improver Drug trial management A clinical research organisation (CRO) used by pharma & biotech industry to accelerate and improve their drug trial process. CRO’s add value by leveraging their experience and data in large scale late stage trials. CRO’s also provide small biotechs with access to this scale, thus meaning small players can hold on to and commercialise their own IP rather than selling out to big Pharma.

Technology-led innovations typically drive up the chances of success whilst also taking cost out of the system but such trends have been very slow to manifest within pharmaceutical R&D. We believe some technologies are now reaching tipping points that could provide a step change in productivity across multiple areas in this R&D process. This would be a win / win for everyone, including – we believe – the shareholders of companies who enable such positive advances.

Source: Illumina, JP Morgan healthcare conference presentation, January 2019

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas. He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience. (As at 30 April 2019).

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Does Sustainable Growth Drive You Crazy?

“Being right means being non-consensus at the time of investment. In sort of practical terms, non-consensus translates to crazy”  Alex Danco – Scarcity, Abundance and Bubbles [Invest like the Best, Episode 121]

Show the average investor the chart above, and there’s a good chance they’d roll their eyes. We’re taught to be cynical of such outlandish forecasts.  We’re constantly reminded of past bubbles and the naïve market behaviour that they imbue.  The pithy wisdom of legendary investors like Warren Buffet is usually translated to the mantra: invest in established quality companies and sectors at a discount, anything else is …. Crazy!

Dynamic power (getting there) is completely different from static power (being there), but the two are often conflatedThe key to strategy is identifying emerging scarcity. Scarcity is where innovation can create power”  -Hamilton Helmer, 7 Powers: The Foundations of Business Strategy

Helmer is a highly successful investor and strategist. Here he’s saying that identifying emerging competitive advantages requires a different approach to identifying established competitive advantages. A lot of investment value can be captured when evidence of advantage is just beginning to emerge.  This often arises around new innovation (technology and / or business models) which addresses an emerging scarcity.

In short, we should not measure the rebel on the same metrics we measure the Emperor.  The rebel won’t have a castle, but might have a new flying machine and a novel strategy for sacking the Emperor’s. The table below shows that some of the biggest rebel winners of the last 10 years looked very expensive on traditional metrics in 2008.

Best and worst performing stocks 2008-2018


Source: Factset. 8 Best performing and 8 worst performing stocks (continuously listed) within the MSCI AC World Index between the end of 2008 and the end of 2018.

So what’s my point? My point is that I believe investing in higher multiple growth stocks can be counter-intuitively contrarian.  It is psychologically challenging for the following reasons:

  1. It requires volatility tolerance: By definition, more of the value of a fast growing business will be in the long-term future. Thus, in the short-term share prices can be very sensitive (i.e. volatile) to seemingly slight changes in long-term growth expectations and / or the assumed cost of capital.
  2. It requires a thick skin: Being ‘crazy’ can draw a crowd of not so friendly onlookers. Sometimes they throw stuff.
  3. It requires being wrong… often: You strike out more often if you always swing for the fences, but this approach increases your chances of hitting home runs. This is called the “Babe Ruth Effect”.

Focusing on the last point, according to Kahneman and Tversky, the pain of loss is about 2.5 times as potent as the pleasure of an equivalent gain. As a result, people are a lot happier when they are frequently right. But being right more often does not necessarily determine investment fund performance. Weird I know, but more often a few stocks going up or down dramatically will have a greater impact. In equity markets, the distribution of returns is skewed positively towards a small number of stocks that deliver extreme upside.

Hendrik (Hank) Bessembinder, Do Stocks Outperform Treasury Bills? (May 2018)

Great.. but what does all this have to do with sustainability? Well nothing… unless……. Unless, sustainability trends are a form of disruptive change?

In the early 1900’s humans were encumbered with very high transport costs and a terrible horse manure problem. These frictions were resolved by relatively cheap oil, the combustion engine and Henry Ford.  It took a while to become clear (not as long as some like to pretend), but these solutions created clear frictions of their own…..

In my view, investors who have a sustainability mind-set combined with a disruptive growth mind-set will increase their chances of gaining exposure to the extreme positive returns of the future. The trade-off is that we will strike out more often, which will make us feel bad in the short-term.

Warren Buffet is a legend but we deliberately take a different approach. He backs the Emperors to stay in power, while we invest in the rebels that try to profit from their emerging weaknesses.  I’m not saying Mr Buffet is wrong….. he’s just a different kind of crazy.

“Our approach is very much profiting from lack of change rather than from change.” Warren Buffet

 

 

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas. He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience. (As at 30 April 2019).

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The power of perception: The sustainability survey results

“So much advantage in life comes from being willing to look like an idiot over the short-term” [a guy I follow on twitter]

I’ve got a confession to make.. well two actually.

Firstly, I’m biased. I have a vested interest in the Kames Global Sustainable Equity strategy being a success. Being a sustainable strategy, I also have bias towards wanting sustainable companies and investment funds to do well. Having reached the three year anniversary of our strategy, I’m more strongly motivated than ever to convince people of this. I always try to be wary of biases (especially my own) and one thing I have noticed over the three years co-managing and marketing our strategy is that sustainability is an emotional subject. And emotion increases the likelihood of bias.

Hypothesis
When focused on long-term or absolute returns, I have noticed that investors find the merits of sustainable investing intuitive. However, when focussed on short-term risks (less than 3yrs) relative to the market, the fear of missing out (FOMO) becomes the focus.  This focus on short-term relative risks is wrong. I believe that this bias means that any period of short-term relative underperformance is often viewed as proof that ethical & sustainable strategies have a performance cost. Meanwhile, there is increasing empirical evidence to the contrary.

Objective
I wanted to undertake a sustainable investing perception survey to test this theory. Do biases exist in the way ethical & sustainable investing is perceived?  This leads me to my second confession. We tricked you. I’m sorry… It was a wee white trick. We devised a series of positively framed questions and a series of negatively framed questions. Essentially the same 4 questions, except we split the respondents into two groups, one group received the positive questions and the other received the negative ones (this is called an A/B test).  The intention was to see if how the question was framed, affected how people responded. The 5th question was a neutral one, the same for all.

Scope
I’d like to thank the 590 wonderful people who took the time to complete the survey.  Many respondents also made qualitative comments which is great.  In terms of statistical significance, I think this number of responses puts us somewhere between a spurious “firmer skin in two weeks” beauty product claim and the certitude that climate change has been induced by humans. I’ll let you decide which it is closer to. It’s probably worth pointing out that I’m not a statistician or psychologist, and I’m not claiming a significant breakthrough here but I do think we can learn something from the results.

For those of you wanting to cut straight to the point, I’m going to go rogue and get straight to the juicy bit of every report – the conclusion. [For those with the time and curiosity to get into the detail, the question-by-question analysis is appended below along with some intuitive charts. Please contact me if you want to dig even deeper.]

Conclusion
It is clear that both groups believe companies benefit from acting ethically or sustainably (and that there are risks if they don’t). I had expected negative framing to effect the results but it did not. However, when considering the implications on fund manager performance, the results from each group was significantly different. A positive framing led to strong agreement of a performance benefit, whilst negative framing led to a meaningfully different skew. In fact, a negative framing led to more respondents suggesting it would hurt fund manager performance than help it. To me, this seems like a contradiction. On one hand, companies and their share prices will benefit from being ethical & sustainable, but on the other hand fund managers who invest in such companies will suffer a performance cost. It certainly confirms my prior bias anyway.

Finally we gave both groups a free option. Would you want to help the planet and society if there is no downside? Unsurprisingly, the response was overwhelmingly positive. I would suggest the fact that a small minority were willing to give up this free option, is indicative of an extreme bias against ethical & sustainable investing. A kind of protest vote against the whole notion of it.

Where to from here?

I believe the inclination to negatively frame ethical & sustainable investing (including tentative or apologetic language) cultivates the bias that there is a performance cost. Despite increasing evidence that ethical & sustainable investors can generate investment alpha and despite market support for this view, the short-term relative risk of underperformance still casts a long psychological shadow. This is still a barrier to adoption of ethical & sustainable investment strategies today, but I believe there are three ways we can collectively lower these barriers.

  1. Long-term performance: We need to aim for better than the market over a longer time frame. We will do this by investing in good ethical & sustainable companies, not managing short term factors. In short – as the quote at the outset suggests – if we want to gain an advantage (investment alpha) we should be willing to risk looking like idiots (underperform) in the short term.
  2. Education: Misinformation and historic biases exist. The weight of evidence is in our favour. Continually promoting the empirical and intuitive evidence of why it works should be a priority. This is why our sustainability soapbox exists
  3. Absolutely positive: Investors broadly appreciate that companies benefit from acting sustainably. When discussing sustainable investing, focus on these long-term absolute benefits rather than negative language which encourages short-term thinking and historic biases. See How to talk to sustainable investing sceptics

One last thing. We started our global sustainable journey three years ago. Our BHAG (Big Hairy Audacious Goal) was to be the best performing global equity fund in the world. We can’t claim to have achieved that (yet J) but we’ve done well over this relatively short time frame. It is our continued aim that our investments, our performance and this blog to have a positive impact on the planet, society and client returns.

Results in more detail

Sample bias is likely in the results with more sustainably minded investors (our blog readers etc.) being over-represented. Responses came from a variety of backgrounds including professional financial advisors, buy-side and sell side investment professionals, general financial professionals and a small number of interested retail investors.

Questions 1, 2 and 3 were designed to see if investors expected sustainable actions by companies to result in benefits or costs. I wanted to consider both fundamental economic impacts (i.e. revenue and profits) and market perception (i.e. valuation and risk). NB – Because of the A/B test, strong agreement to the positive questions = strong disagreement in the negative questions. The charts below show that respondents from both groups were in strong agreement that companies acting ethically & sustainably will see positive market / economic benefits. There is no significant difference.

Question 4 was designed to ask the all-important question (well to us fund managers anyway) of whether a fund manager’s performance is effected by investing ethically & sustainably. The charts below show that when framed positively, 67.4% of respondents agreed or strongly agreed that there could be a direct performance benefit to investing sustainably. When framed negatively, the equivalent response was only 41.9%. A 25.5% divergence. 43.2% of responses to the negatively framed question agreed or strongly agreed that performance could be impaired by excluding companies that have negative impacts. To put it statistically, there is a clear skew in the distribution of responses which suggests that the framing of the question has influenced the results.

Question 5 was the same for everyone (no tricks here). A simple hypothetical question.  Would you invest in an ethical or sustainable fund rather than “traditional” fund if the risk / reward was the same? An overwhelmingly positive response shows that 92.2% of respondents either agreed or strongly agreed that they would rather invest in a sustainable or ethical fund vs a “traditional” fund, all else equal.

 

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for co-managing global equities portfolios. He joined us in 2014 from SWIP, where he was investment director in global equities. In addition Craig also had analysis responsibilities for the tech, energy and utility sectors. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors, a member of the global environmental equity team. Craig has a 1st Class honours degree in Building Surveying, an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 17 years’ industry experience*. *As at 30 November 2018.

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How to talk sustainable investing to sceptics

A November 2018 Monmouth poll found that 78% of Americans now believe climate change is real, up from 70% three years ago. For the first time, a majority of Republicans (64%) accept it vs 49% in 2015. Moving in the right direction but still low percentages. Climate change deniers have long had more traction than they should and this is in part due to the dry way climate scientists communicate (i.e. via boring old boring old scientific journals and balanced debate). The scientific communication machine is simply not set up to counter a co-ordinated misinformation campaigns and social media memes.

I see some similarities in the ESG / sustainable investment debate. To be clear, I’m not saying alpha from sustainability analysis will magically make your fund manager a great stock picker, but it helps. There is a growing body of evidence of this and it is even stronger than many traditionally accepted “alpha factors”. Regular readers may remember my blog of June 2018, which supports this view and jests that 60% of the time it, works every time.

Some ardent ESG deniers will never shift their position, but too many swing voters are still in the wrong camp. The “performance cost” meme is strong and as mentioned in the blog above, researchers have noted that “clients want incontrovertible evidence that sustainability adds alpha before considering it”. This is not the case for any other alpha factors and is convenient for the denier because unlike climate change, incontrovertible evidence can never be found.

Which brings me to our communication problem. Like climate change scientists, I sense timidity (and frankly dullness) in how some of the ESG community communicate.  It’s the same problem. Dry and balanced debate meets cynical and often conflicted incumbents.

Dry / meek statements Positive / conviction alternatives
ESG is really just a risk management tool which reduces the chance investor exposure to controversies and disasters

My experience suggests sustainability analysis is useful for identifying sources of competitive advantage

ESG is less important to some companies than others

All companies are different and their material sustainability issues are different as a result, but that doesn’t mean they are less important. Facebook and Vale are two recent examples of this. We think it is self-evident that identifying those material issues and tracking them over time will add value
Alpha from ESG really just comes from the assessment of governance

Evidence suggests that E & S factors are equally as valuable sources of investment alpha*  Intuitively, environmental and social issues can be very material to many businesses

ESG is very difficult to do in emerging markets

This creates opportunity. Evidence suggest that the emerging markets are actually where ESG is most valuable* More bottom up hard work may be required though

We don’t believe there is value in judging a company on the sustainability of its products. Who are we to decide?

The sustainability of a company’s products is vital to its long-term strategic success. In this respect, strategic positioning and vision can be a long-term tailwind or headwind. An unsustainable product (i.e. coal) is a huge strategic headache for any management team, just as a sustainable one will create a tailwind of opportunities.

The risk adjusted returns of an ESG fund are only slightly better/worse than a traditional fund Many ESG studies show improved risk adjusted returns vs. traditional funds, lower volatility and higher returns. However, risk is a backward looking measure and the cohort of sustainable/ESG funds is historically small. We see no reason why a well-managed sustainable investment portfolio won’t achieve equal risk adjusted returns over the short-term and have the potential to achieve higher risk-adjusted returns over the long-term (it all depends on the quality of the stock picking)

There is a culture and history that goes some way to explaining the lack of ESG conviction. ESG research departments have historically operating like a risk management department. They were advisors who only stepped into an investment decision in extreme (typically bad) circumstances. N.B – With our global sustainable equity strategies, we deliberately counter-positioned ourselves from this approach, which I discussed in ESG Collaboration – A Third way?

Lately however, ESG integration has become a core requirement in everyone’s investment process and credible sustainable and ethical investment strategies are seeing strong demand. The average ESG Researcher or manager now has a vital communication role.  Whilst I’m always wary of hype and marketing in our industry (and the number of sustainable funds launched in the last year may be an indicator of such), I believe that we should now be bolder and more confident in the sustainable investment message we are sending. Hopefully my quick reference guide will help you do that.

* Friede, Busch, Bassen (ESG & Corporate Financial Performance: Mapping the global landscape). September 2016

 

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for co-managing global equities portfolios. He joined us in 2014 from SWIP, where he was investment director in global equities. In addition Craig also had analysis responsibilities for the tech, energy and utility sectors. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors, a member of the global environmental equity team. Craig has a 1st Class honours degree in Building Surveying, an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 17 years’ industry experience*. *As at 30 November 2018.

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