Watering down tax structures

On 28 July 2010, the United Nations General Assembly explicitly recognised the human right to water and sanitation. It will also come as no surprise that in the UK we have enjoyed clean water for generations. Investing and supporting companies that deliver clean water certainly falls into ESG investing.

However, ownership of the assets that deliver water and sanitation has become political in the UK. As investors in bonds issued by water companies, we are keen to ensure that we maintain the value of our investments. There are three strands to our analysis. First is the effective management of these companies. Second, is the ability to reinvest in assets to deliver future cash flow and returns. Finally, exploring the social, regulatory and political environment in which companies operate.

It is this very last point that has recently become more material in our assessment of the UK water companies. At the start of February the Social Market Foundation issued a report claiming that the nationalisation of the water industry would cost in excess of £90bn. Water and its ownership have become a political issue; the election campaign in 2017 saw the Daily Mirror run this headline: “The Labour Party claims the water industry has been used for tax avoidance and says it’s time to bring it back into public ownership”. The use of offshore tax structures have become a political issue for an industry that has spent, and needs to spend, billions investing and delivering water in the UK.

Our fixed income team, together with our ESG-research team, has penned a letter to a number of major bond issuers in the UK water sector. We wrote that the nature of delivering clean water infrastructure requires further investment but that past and future investment should be conducted in a tax framework that, in itself, gives confidence to the public as consumers. There was no accusation of tax evasion but that certain efficient tax structures are not publically acceptable in times of strained public finances. We wrote that “Perceptions of what is acceptable have undoubtedly changed in recent years” and encouraged issuers to review tax structures that offer the perception of “cute” financing arrangements.

As investors our responsibility remains to the value of our investments. As such, and as our letter stated, “It is our responsibility to balance any reputational issues that adverse publicity may create within our overall risk assessment”. The rights and merits of public or private ownership are not ours to judge, but where we can influence to reduce uncertainty and volatility in the value of our assets, that is in our gift and interest.

Transparency builds trust and goodwill with all stakeholders (including investors). We hope that in some small part we can encourage transparency in how the companies we invest in manage their arrangements and in doing so, ensure effective delivery of water to all in the UK.

About the author

Adrian Hull is Co-Head of Fixed Income at Kames Capital. Previously, he was a senior investment specialist in the Fixed Income team where his role involved supporting the team in explaining how the company products and investment process add value for clients. Prior to joining Kames Capital, he worked as head of sterling trading and sales at Mizuho International, where he set up the sterling corporate bond trading and sales desk. Adrian studied Modern History at Oxford University and has 28 years’ industry experience*. As at 28 February 2018.  

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More hard questions for Facebook

On 7 February I published a Sustainability Soapbox article titled ‘Facing Hard Questions’, which discussed Facebook’s social responsibility credentials.

Since then we’ve seen revelations around how private data on millions of users was passed to third-parties. Facebook’s share price has fallen around 19% at the time of writing, with the most recent fall prompted by reports that the US Federal Trade Commission is to investigate the company.

Investment implications

The sustainability of Facebook from a social-impact perspective is inextricably linked to its sustainability as a business. So the recent news flow is important to assess.

Overall, I view the negative headlines and the subsequent market sell-off as an over-reaction. There is certainly an increased risk of further regulation of Facebook’s user-data, as well as faltering trust in the company, both of which threaten Facebook’s ability to leverage data to deploy adverts. However, I currently believe there is a relatively low likelihood of anything coming to fruition that would materially undermine Facebook’s ability to operate and grow its services (which include Facebook itself, but also applications such as Instagram and WhatsApp).

Facebook has been increasing its investment in user security for some time. So most of the headlines relate to old business practices which have been banished from the platform (in some cases several years ago).

Unscientific surveys of users claiming to have deleted the App; anecdotal examples of advertisers suspending activity on Facebook; or investors quarantining their shares do not in my view constitute a failing platform.

Furthermore, from a valuation perspective Facebook looks a compelling proposition. Valuation multiples (price-to-earnings and price-to-free-cash-flow) relative to growth, relative to history and particularly relative to peers are depressed. I can think of few other large-cap stocks that offer an equivalent combination of potential growth, attractive valuation, and quality (high returns on capital and strength of balance sheet). I strongly suspect that we will one day look back on this period as a buying opportunity.

However, we are dealing with unquantifiable controversy here. As bottom-up stock-pickers we specialise in ‘analysable risk’ and dislike ‘unanalysable risk’, which the investment case is becoming increasingly dependent on. The market is focusing on the downside risks which – although unquantifiable – are potentially greater than in the past and directly question the sustainability of Facebook’s business model. As such, we are taking a conservative approach and will not be adding to our holding until these issues are clarified.

A reminder of Facebook’s sustainability credentials

I accept that the repeated negative news flow is difficult to defend from a sustainability perspective. While I personally have a positive view of social media platforms and Facebook’s leadership, there are others within the responsible investment community who have strong negative views on Facebook, Mark Zuckerberg and social media generally.

Much of this comes down to subjective opinion, although we have assessed the historic and current actions of Facebook and Zuckerberg and lean in their favour. The recent news has not fundamentally altered this and I think the points expressed in my previous article remain true today. Remember, this is a company that was already on a very visible path to improving its products and practices.

I also believe that some context is required on the social impact of Facebook.  In the current environment of negativity it is easy to forget the positive impacts of what the company actually does:

  • Helps families and friends in distant (and not so distant) places share experiences with each other.
  • It enables two billion people to share funny, touching, positive, negative, inane, stupid, genius and pointless things with each other.
  • Remember £2 text messages? WhatsApp allows virtually free (£1 per year) and highly efficient communication via group chats, internationally.
  • Facebook’s market place increases price transparency for buying new and second-hand goods (consumer benefit and waste reduction).
  • The sharing of news (a small percentage of which is fake) and building communities of people with common (usually positive) motivations.
  • Help more than 70 million small and medium-sized businesses do targeted, affordable advertising.

The controversy

Ultimately, Facebook’s business model aims to securely leverage the huge amounts of data they hold to identify who likes what and then target advertising at them. The ‘deal’ is that users get all of the above services for the price of their data. This is something I believe most users appreciate – or if they didn’t before, they certainly do now.

Facebook will see increased regulation and Mark Zuckerberg appears to welcome it. Ironically, this may ultimately increase the power of the big platforms such as Facebook and YouTube, which have the resources to invest and respond.

As far as we know, Facebook did not misuse its data. There was a breach of trust with an academic party which passed the data to a third-party, which allegedly misused the data. This has now been shut down and the relationship between Facebook and academia will likely suffer as a result (some of which does a lot of good, such as through population health surveys).

The question of voter manipulation (particularly Russian interference) should certainly not be dismissed. However, this type of influencing has been done for decades through political advertising in traditional media, such as newspapers, billboards and television. The Facebook data in question was fairly basic and was blended with other data (including third-party psychometric tests) to profile and target particular demographics for television and social-media advertising. Although the data was allegedly illegally acquired, the end use was not particularly ground-breaking. Indeed, Barack Obama’s team used social-media targeting very effectively in his Presidential election campaigns, as did Hillary Clinton (although just not well enough).

Facebook has access to data on over two billion users. It has a huge responsibility to abide by its promise to keep it safe and not misuse it. The recent controversy highlights why this is so important.

Facebook has evolved and improved as its business has grown. It has responded to pressure to improve the transparency of user settings and invested heavily in security and removing harmful and fake content. The company is also trying to mitigate the negative unintended consequences of bad actors on its platform (which is unfortunately inevitable) and maximise the positive impact of good actors.

We continue to monitor and evaluate the news flow around Facebook. We will change our view if this situation evolves into something more serious, such as evidence of the company being grossly irresponsible or directly complicit in a negative act. Likewise, we will change our investment view if there is evidence of meaningful numbers of users voting with their thumbs and deleting Facebook’s platforms from their lives.

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Facing Hard Questions

Do people ‘connect in meaningful’ ways online? Or are they simply consuming trivial updates and polarising memes at the expense of time with loved ones? Is this facilitating foreign and / or populist propaganda that disrupts our democracies? Do we spend too much time on our phones when we should be paying attention to our families? Does technology make us ‘alone together’ and increase teen depression?

Facebook is the largest holding in the Kames Global Sustainable Fund and we have been asking ourselves these questions for some time. In fact, they are absolutely central to the long-term investment thesis for Facebook. Why? Social responsibility and social impact are hugely material factors for social networks. Whether or not Facebook has a positive social impact will be a key determinant of its long-term success. If Mark Zuckerberg was not already aware of that… well let’s just say the company he founded would not have 2.1 billion users and generate $40.6 billion revenue or $17.4bn of free cash flow (in 2017). Zuck gets it.

Here he is on the Facebook Q4 2017 earnings call (emphasis & paraphrasing ours):

“When people are spending so much time passively consuming public content that it starts taking away from the time people are connecting with each other, that’s not good… the most important driver of our business has never been time spent by itself, it’s the quality of the conversations and connections… in 2017 we made changes that reduce time spent on Facebook by an estimated 50 million hours every day to make sure that people’s time is well spent. These investments will help us build a stronger community over the long term”

Facebook is portrayed by many market commentators as an expensive and consensual investment with insidious Orwellian motivations. We strongly disagree on both counts. It is a disruptive, low-priced brand advertising platform for small businesses, with the power to reach an audience larger and more engaged than the Super Bowl (in the US alone) every day in a targeted way.

Facebook has a capital-light and dominant global business model that will deliver sustainable cash flow growth for a number of years. It is extremely cheap relative to its free cash flow (with a 5% unlevered FCF yield) and growth (25x 2018 P/E and <1x PEG). It is a responsibly managed business that is delivering a high-quality product to more than 2 billion users and in excess of 70 million advertisers (mostly small businesses), whilst simultaneously acting to minimise negative unintended consequences. Facebook is not perfect but it is demonstrably improving

Mark Zuckerberg has made some meaningful strategic decisions to address negative social impacts for the good of the users, which is for the good of the advertisers, which is for the good of shareholders. But the astute amongst you might ask, ‘how can Facebook still grow revenues if there is less time spent and less ads (which are shorter) on the platform?’

The answer: shorter, impactful ads, less often to more engaged users have a much higher return on investment for advertisers. Revenue per advert grew 43% year-on-year in Q4 2017 and is still way below TV. That’s called pricing power. As such, we believe Facebook’s consensus sales and EPS growth estimates are too conservative.

As sustainable investors of our clients’ money, we are not dodging the negatives and neither are Facebook. If you don’t believe me, the questions we opened with are direct quotes from a recent Facebook blog called Hard Questions. Ask them yourself here.

P.S – All of Facebooks new data centers are 100% powered by renewable energy.

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Boring, boring banks

Boring is good…sometimes. Especially when it comes to the banking sector. Typically, banks that get into trouble – and thereby become a burden to society – often have one thing in common: they take excessive risk. 

And their risk behaviours often reflect their corporate culture; since the global financial crisis many banks are still scrabbling about trying to convince everyone everything has changed. Of course it has….

There are always exceptions though. Neither First Republic Bank (US) or Svenska Handelsbanken AB (Swe) – both of which are in the top ten holdings of the Kames Global Sustainable Equity Fund – suffered significantly during the events of 2008. Key to the success of both has been their unrelenting focus on creating and maintaining the right culture. Despite the Atlantic divide, they actually have much in common. It’s always about ‘the long-term’, ‘what’s best for the customer’ and ‘empowering staff to take responsibility’. The outcome? Lower costs (including lower staff turnover and fewer bad creditors), more satisfied customers than other banks and higher profitability.

Which in turn provides a competitive advantage. Financial stability enables lending regardless of the economic or business environment. Relationships are strengthened further when customers know they can count on you even when others have pulled back. As the CEO and chairman of First Republic succinctly puts it: “culture trumps everything else” and in-turn, “size and growth are a result of quality”.

You won’t be surprised then that these customer-focused models have performed exceedingly well. First Republic was founded in 1985 and has delivered 32 years of consistent profitability. Average losses at the top 50 US banks were 18x those of First Republic over the last 5 years, and 90% of loans, since 1985, have been originated by bankers still with the bank! And by the way, the founder is still at the helm!

Handelsbanken has been similarly successful. No other bank in the world has a higher credit rating (for a bank) from Fitch, Moody’s and Standard & Poor’s. And the bank’s total shareholder return since the start of the financial crisis has smashed its European opposition. There are no bonuses or volume targets for staff and performance is simply measured in terms of the long-term relationships managers build with their customer. Instead, employees and executives receive shares in the parent foundation which are redeemable at the age of 60! Could you incentivise a more long-term perspective?!

Boring perhaps. But good.