Less pain more gain

The source of my pain? An interview I read a while ago with a particularly impassioned ESG advocate (although I don’t think he was a fund manager). The topic of conversation was a controversial company that has experienced a substantial share price drop as a result of material sustainability issues. My bugbear was with the response of the ESG advocate though. I’ll paraphrase for convenience but when asked whether the stock might now represent a great buying opportunity the advocate replied:

“The whole point of ESG investing is to take pain. We should be willing to underperform if this means avoiding companies that do harm”

Ouch… that hurts. There’s the pain.

Who knew sustainable investing was a masochistic pursuit (not me)!

For me this is the clever work of a cynical journalist cherry picking sentiment, and it totally misses the point. For me, sustainability analysis involves assessing the sustainability of products and practices and the rate at which these factors improve (or regress). For me, it’s a meaningful alpha generating tool.

So back to “taking the pain”…do we think that’s a factor of sustainable investing. No. I see it this way. The point is to:

  1. a) Avoid the pain
  2. b) Identify disruptive sustainable growth opportunities before the market does

You may have to suffer through the short-term underperformance and watch companies and subsectors that we deem to be unsustainable outperform. BUT that’s very different from deliberately underperforming as the above quote implies.

If our analysis is correct (and before we get ahead of ourselves – no analysis is always correct), outperformance of an unsustainable company will be brief and its unsustainable products and/or business practices will be found out in the end, unless it takes steps to address these shortcomings. By definition, something which is unsustainable, will not sustain. And if it is not going to sustain, it is never going to be a good investment. So there you have it – in an unsustainable company you may get a short term speculative trade (perhaps), but never a good investment, in my opinion.

If nothing else, the original quote does teach us one thing – that as a group, sustainable investors need to do better at communicating the multiple advantages of sustainability. Yes we are intentionally trying to have positive impact with our clients’ capital, but it is not simply an ideological venture with a performance cost attached. So what would my response have been to such a question? Hopefully something like this:

 “Is the product that the company sells getting more sustainable? Is the company demonstrably improving its practices to address its material sustainability risks? If not, I will never think it is cheap enough to be a great investment opportunity.”

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Inevitable Intersections: The era of sustainable disruption

Year end special edition

I dislike commenting on short periods of fund performance primarily because it leads to short-term thinking, something which markets certainly don’t need more of. However, it’s important to be transparent to our clients and admit that the second half of 2018 has been a particularly tough period for our representative global sustainable equity strategies. Mid-cap growth investors like us have found these market conditions very challenging.

It is easy to be unsettled by the velocity at which the stock market has turned down and rotated into large-cap and traditionally defensive sectors. But we invest in companies, not sectors. We want to identify long-term disruptive trends, not short-term factors. When stepping back and framing things in this context, conviction is not hard to come by. We are positioned for a future beyond the next couple of quarters and history suggests that volatility will throw up great investment opportunities.

Figure 1: Relative large cap and small cap equities performance second half of 2018

Source: Factset

I believe we are at the intersection of two very powerful supply and demand curves.  Technology led deflation (supply) is converging with the greatest sustainability challenges the human race has ever faced (demand). Capital markets (particularly publically listed companies) can be the bridge between that supply and demand. The demand is unfortunately inevitable, but so is the supply. I am optimistic. It is evident to me that this intersection is driving a wave of positive change in global markets.

This will create opportunities for the forward thinking investor. I believe that the market repeatedly underappreciates this sort of disruption. It requires imagination to think beyond the world we inhabit. The market may be efficiently reactive (some might say over-reactive), but I do not believe it is efficiently proactive. The tyranny of the discount rate, short-termism and backward looking investment strategies (passive and quantitative) leave the market blind to the meaningful medium and long-term disruption caused by such change. So what are these ‘inevitable’ intersections?

Electric vehicles will disrupt transportation and truly enter the public consciousness over the next two years. Declining battery costs and an availability of highly desirable and affordable electric cars will intersect with a strong consumer demand to go green.

Lithium-ion Battery Pack Prices (US$/KWh)

Source: Bloomberg New Energy Finance

Disruption in power generation and transmission will become clearer over the next five years as cheap battery storage combined with the relentless decline in solar and wind power costs make traditional fuel sources increasingly uneconomic as well as unsustainable. This should upend geopolitics too as coal, oil and gas producing countries become less relevant in the world order. Distributed micro generation of power will flip the traditionally centralised power station utility business model, exacerbating risks to businesses deploying the traditional model.

Levelised cost of energy

Source: Lazard estimates. Levelised Cost of Energy (unsubsidised) .Primarily relates to North American alternative energy landscape, but reflects broader/global cost declines.

Genomic analysis will drive an exponential growth in our understanding of biology and disease, causing positive disruption in medicine.  Moore’s law will also increasingly permeate medicine with new software and hardware led healthcare technologies thus reducing the cost of healthcare and improving outcomes. Within ten years, cures and life-changing solutions that are currently viewed as pie in the sky, could become our reality.

Cost per Genome

Source: National Human Genome Research Institute

The cost of automation will keep falling. Physical robots, machine learning and artificial intelligence will disrupt labour markets and supply chains. Adoption will accelerate across new industries and consumer products, increasing productivity and dramatically reducing waste. Low skilled jobs will be lost and labour will shift back to developed markets. Previously unimagined new jobs will be created. We will experience a deflationary boom. Within ten years, fully autonomous driving will add to the transport disruption noted above.

Source: ARK Investment Management LLC ark-invest.com

I believe these intersections (and others that I don’t have space to include) to be inevitable. They provide an opportunity for sustainably minded investors to capture alpha. But identifying companies that can effectively bridge the gap between this supply and demand and having the courage to back them will not be easy. Despite the recent volatility and bearishness in the market, it is our intention to continue seeking out these #SustainableDisruptors and building investment portfolios with them.

Have a great New Year… and remember the falling prices we should be focussing on are not necessarily in the stock market.

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Subsidised Confusion

I recently attended a conference in Germany on ESG investing and its potential to have a positive impact on the world. Various issues were discussed and whilst there was agreement on some themes, there was divergence on others. This is unsurprising given the diverse approaches that can be taken to sustainable investing and is in keeping with the point that we often emphasise, that the devil really is in the detail.

So what were the talking points?

Why pay a premium for sustainable products when you could just buy a cheaper one?

One delegate insisted consumers wouldn’t pay a premium for a product just because it was sustainable. I fundamentally disagree with this from a philosophical perspective and evidence suggests that consumers are increasingly conscious of the product impact of the things they buy – especially millennials, who not only want to buy sustainable products but want to buy them from sustainable companies. 

I’m confused, is this sustainable or not?

There was an acknowledgement that sustainable investing can confuse clients… A number of managers then proceeded to give confusing presentations with tenuous stats, like ‘investing in a sustainable fund is 27 times more effective for the environment than cycling to work’ or ‘our portfolio prevented X number of sick days from work’. 

How on earth are clients meant to judge the effectiveness of sustainable investments when they are bombarded with stats like this? Whilst transparency and reporting on material factors is undoubtedly positive, it’s vital to keep these realistic and understandable. We look at the individual merits of each company to judge whether it is making a positive contribution. We might not always be able to measure that in lives saved or tonnes of CO2 emissions avoided, especially since these benefits can be indirect and further up or down the supply chain but by thinking about it holistically like this, we can be sure that each company we invest in is doing things the right way. 

Maybe what we need is more red tape

The idea of more regulation for sustainable funds was floated. There was little support for this other than a high level framework which respects the diversity of the sector.

The European Commission has taken an interest and has suggested that more specific disclosure requirements for sustainable investments are needed, stating “the overall sustainability-related impact of financial products should be reported regularly”. I am cautious on this for the reasons stated in the above section. I am all for transparency and reporting relevant data but setting specified metrics for such a nuanced subject has its dangers.

Throw money at it?

One suggestion was to subsidise sustainable investment funds to encourage people to invest in them… No, no, no. I disagree with this on a number of levels. For a start, it would result in ‘greenwashing’ where funds make a token, tick box effort to appear sustainable to qualify for the subsidy. Having more high quality managers investing sustainably would be a positive – as long as they do this in a genuine way and for the right reasons.

So, lots to take away and mull over. Debate is healthy and the fact that everybody has their own way of thinking about sustainability is part of the beauty of it. For our part, we will continue to focus on the detail and the nuances and share our insights and statistics where possible… Just don’t expect us to tell you that investing in a sustainable fund will save 14,521,325 trees, which will benefit from the 20,942,768 gallons of water saved and which you will be able to appreciate due to being ill in bed 17 fewer days per year.

About the author

Iain Snedden is an investment specialist in the equities team. He has responsibility for representing the firm’s equity capabilities both within and out with the firm, with a particular focus on our suite of global equity products. This involves ensuring colleagues and clients are kept up to date on developments within the funds and the wider market. Iain joined us in 2015 to work in the Client Management team with responsibility for a portfolio of UK-based institutional clients. Prior to that, he worked at Baillie Gifford and held roles within the client accounting and business risk functions. Iain graduated from University of Edinburgh with a first class honours degree in Accounting and Business Studies. He has 8 years’ industry experience (as at 30 November 2018).


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Heuristics are simple efficient rules that we all use on a daily basis. We have all learned these through experience, and often they aid our decision making. They are especially helpful in making decisions with the limited resources we all have, particularly in terms of time.

As an example: many people do not have time, or perhaps the inclination, to consider the various parties’ policies and form an opinion on their impact when voting in an election. Often the quick heuristic (a rule of thumb in this case) used is “Do I like / trust this politician?” (a single factor decision). This is far easier to evaluate than the party’s position (set against other parties’ positions) on the economy, healthcare, crime, education, etc. (a multi factor decision). Even those who do not have a strong view on political matters are highly likely to have a view on whether they like a particular candidate (or not). Often a referendum result can be dictated by the popularity of the PM responsible for asking the question, perhaps reflecting this tendency. It is easier to decide whether we like David Cameron (or Boris Johnson?) than to examine the full implications of a Brexit vote.

As is ever the case with rules of thumb, nuances are lost, which can sometimes lead to suboptimal outcomes. Similarly, when we look to apply rules of thumb to Environmental, Social and Governance (ESG) investing, we should be wary of unintended consequences. For example, where portfolios are not already excluding, let’s consider one of the ESG rules of thumb that has been suggested for investors to manage their coal exposure; specifically not investing in any company with more than 10 gigawatts (GW) of electricity production from coal-fired power stations.

Let’s quickly evaluate a company that would fall foul of this limit. If we take the Italian utility Enel, its installed coal capacity of 15GW in 1H2018 would dwarf the total installed capacity of many other utilities. However, Enel has embraced renewables generation more than many others in the industry (some of which, crucially, would pass this test), focussing their investments on green energy and grids (43 GW in installed renewable capacity). Even so, because of their sheer scale, they would fall foul of the coal capacity rule of thumb. Despite not investing in new coal plants, and despite reducing coal generation by 14% year-on-year in their first half results.

Taking a company which would pass this limit rule: CEZ are a Czech utility which uses lignite (also known as “brown” coal) in their coal and lignite power plants. Lignite is widely considered to be worse than coal from an environmental perspective and comprises 76% of CEZ’s thermal and 38% of total generating capacity. They also expect new and upgraded lignite plants to continue to operate for 25 years. Contrast this with Enel which talks about ‘renewables being the driving force of growth’.

In a carbon constrained future, which is the better choice? Enel or CEZ? We would argue it is Enel, but it is CEZ that passes this test! And even though most of our portfolios do not have coal powered electricity production restrictions, we have actively made the considered choice to invest in ENEL (we passed on the recent deal for CEZ).

This is taking only one rule of thumb, so is a single factor evaluation. However, it shows that nuances can be overlooked.

This is why our long history of running ethical funds has led to a multifactor approach in our ESG evaluation, and why our preference remains to evaluate the drivers behind the exclusions, rather than applying a heuristic rule of thumb.

About the author

Kenneth Ward is an investment manager in the Fixed Income team, specialising in the utilities and mining sectors. He initially joined Kames Capital in 2010 from RBS Trustee and Depositary Services, where was a securities analyst, and had been working as a performance analyst between 2010 and 2014. Kenneth studied Mathematics at Heriot-Watt University and is a CFA charterholder. He has 11 years’ industry experience (as at 30 September 2018).

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Intangible assets, tangible benefits

1980; Big hair, Rubik’s Cube, Pac-Man, The Empire Strikes Back J and ‘The lady’s not for turning’

And companies making stuff – actual things you could hold. Or rather tap, pump and burn according to the table below. The sort of things which required investment in physical, tangible assets (factories, machinery, inventory) and which in turn were the principal driver of company value.

Source – etfdb.com/history-of-the-s-and-p-500/

But fast forward quarter of a century and the value assigned to physical assets has declined significantly. To survive the knowledge, or information, revolution that has occurred, constant product and process innovation has been required, primarily enabled by investment in intangible assets such as R&D, patents, brands, information systems and people. Think intellectual (human) capital vs. bricks and mortar (physical); research and development vs. capital spending; services vs. manufacturing.

Source – Time to change your investment model – Feng Gu and Baruch Lev, Financial Analysts Journal, Volume 73, Number 4

What’s the ESG link? Intangibles means different things in different sectors but customer relationships are common to all and the way that companies behave determines whether the value of this goodwill is sustained or damaged. Similarly, pick a company, any company and you will probably find some reference from either the CEO or chairman about ‘our people being our most important asset’. However, these (often boilerplate statements) are actually true! Especially for the capital light, ‘virtualised’ companies that we invest in where employees perform highly skilled tasks.

As investors, understanding how a company treats its employees is important. Treat people well and you improve retention rates. Even more powerful, sociological theories argue that satisfied employees identify with the firm and internalise its objectives, thus inducing effort. This last point might seem abstract but intuitively it strikes us that employee welfare is intrinsically linked with shareholder returns. Think short-term and from a purely accounting perspective and a lot of this fluffy stuff is an expense. Conversely, if it leads to better processes, quality, supplier relations and customer satisfaction, eventually it also moves the needle on revenues, market share and ultimately earnings – which are much less abstract concepts for investors.

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GDP’s Dirty Little Secret

I recently discovered a dirty little secret. It had been hiding from me in plain sight. While searching for a podcast, I was intrigued by the episode title ‘How buying Cocaine helps the government’ in the new BBC series ‘Economics with Subtitles’. It cleverly explains how silly GDP can be as a measure of sustainable economic activity. The reason – as the name suggests – is because it’s GROSS. All that matters is volume and price, regardless of what the volume is or whether the price is worth paying.

As an example, the episode started with the story of the biggest drugs bust in UK history and explained why it would have a negative impact on GDP. Maybe I would have known this if I’d paid more attention in economics class, but I was staggered to learn that civil servants at the Office for National Statistics actually spend time estimating the value of the illegal drugs trade, primarily so that its value can be added to GDP.

As it happens, the Nobel Prize winning economist Simon Kuznets who first developed the modern concept of GDP never intended it to be used this way. In fact he was very angry about it for exactly the reason highlighted above. His novel view back in the 1930’s was that for economic activity to be valuable, it should have a positive impact. He felt that negative economic activity should be deducted from the gross number to provide value to policy makers. But in a quirk of history, politicians and central bankers wanted a number, this one was easier to calculate and suddenly ‘gross’ became the global standard. The genie was out of the bottle, never thus far to return.

Source: UK Office for National Statistics.  Millions GBP.

So, illegal drugs are a good thing according to GDP but what other unintended consequences are there and what impact does this have on society or the environment? Firstly, fossil fuel or tobacco production are considered unashamedly positive with no consideration of the negative environmental or healthcare costs incurred. Secondly, the quality of products are ignored. So an underperforming fund manager charging a high fee is valued more highly than an outperforming manager charging a low fee. Finally, high value free services such as volunteering and charity work are considered economically worthless. It seems obvious to me that if there was some attempt to measure the positive and negative impacts of economic activities, it would almost certainly lead to better policy making. Some societies have learned to tax consumption of damaging goods but this has usually been too little too late – mostly due to aggressive, self-interested lobby groups.

On a positive note, a recent Nobel Prize was awarded in the area of the economics of climate change which attempts to account such negative externalities proactively. Hopefully such approaches will become standard. In the meantime, remember that the ‘GDP growth’ so loved by politicians is not all it’s cracked up to be. For our part, we will keep focusing on analysing the net positive impact of each company we invest in from the bottom up. For loyal readers it should be obvious why. We believe measuring impact from the bottom up adds a dimension to our investment process that creates positive impact and the potential for better long-term returns.

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