Low and Dry

2018 brought a bumper summer for Europe – almost wall-to-wall sunshine, toasty temperatures and barely any rain. Great for relaxing in a beer garden and watching the World Cup and, you would think, for those choosing to holiday close to home (more on that later). However, while you were sipping those G&Ts and topping up your tan (or, if you are Scottish like me, cowering in the shade until the evening when it was safe to come out) there were less obvious (and less positive) consequences of the heatwave.

Take, for example, the Rhineland – Germany’s industrial heartland and home to many of Europe’s largest industrial producers. The river Rhine is the lifeblood of the area and a major logistical artery, underlined by the fact that over half of the containers that travel inland from the giant hubs at Rotterdam and Antwerp do so by barge.

However, this all depends on there being enough water in the river, which by the end of one of the driest summers recorded in Germany, there wasn’t. Water levels fell below those needed to run barges at full capacity and by late November, the situation had reached critical levels where even empty barges were unable to travel on some sections.

To put things into perspective, a standard sized barge has the capacity of about 160 lorries, so with water transport drastically reduced, is all of this supposed to be carried by road and rail? Supply chains simply don’t have that much slack and as a result, many major companies with production facilities in the area suffered.

BASF’s Ludwigshafen site, located on the Rhine, is the world’s largest integrated chemicals complex. Around a third of its material transport needs are met by barges, and as a result of low water levels, it had to reduce production to 60% of capacity. What’s more, facilities like this can’t just be ramped back to normal at the drop of a hat – it takes weeks! Add to this the increased costs of finding alternative sources of transport and the cost quickly mounts up – estimates are for an impact of around EUR200 million for BASF.

BASF is not alone, the likes of Covestro and Solvay announced significant impacts on their ability to receive shipments of raw materials. But it’s not just big chemicals companies… Commuters faced challenges topping up their tanks as supplies of petrol couldn’t get through to garages.

Even holidaymakers weren’t safe from the good weather! Buses had to replace boats on several stages of popular river cruise routes along the Rhine and the Danube, leaving tourists unimpressed as their leisurely cruise with a luxury cabin quickly turned into a cramped and bumpy coach ride.    

So there we have it, as a result of human actions, weather is getting more extreme and climate change continues to impact the way we live and the way companies operate. This may be a minor concern when you’re enjoying the summer sun and I suspect it previously wasn’t much of a worry for large industrial companies either. But when the impact starts becoming more tangible and can be measured in millions of pounds of lost profits, then I’m sure companies will very quickly start to care and take action. Until they do, they will be left high and dry by taking natural resources for granted and assuming they will always be able to use them on the same terms as before. 

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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Tick tock goes the Klöck

Climate change and general concern for the environment, they’re an ever-increasingly important issue for society, so why would it be any different for investors? It isn’t. This is something we’ve been watching for a long time; our ethical franchise will have been running for 30 years next year, so it’s something deeply engrained in our processes.

Lately, plastics and the pollution they cause have faced increasing scrutiny and regulation. This backlash has a fundamental impact on companies in the high yield universe. Take the metal can specialist, Crown Holdings. They suggest that the aluminium can is the world’s most recycled beverage container… and actually it is estimated that 75% of all aluminium ever produced is still in use today. Crown believe that a 1% shift from plastic bottles to metal cans for soft drinks alone could increase demand by billions of cans. This could be an impressive tailwind for positions that produce metal cans – companies like Ball Corp, Crown and Ardagh.

But for every winner, there’s a loser. Klöckner Pentaplast is one of the world’s largest producers of plastic films. This company makes the rigid plastics that cover your food, wraps around batteries, surround gift cards and the packs that your painkillers come in. As such, Klöckner is highly exposed to plastic packaging regulation (and backlash). While regulation isn’t the only problem that this company faces, it certainly hasn’t helped. Operating performance has been deteriorating, with limited revenue growth, falling earnings and negative free cash flow. To its credit, Klöckner has been trying to use more sustainable raw materials, focusing on recycled plastic. But so has everyone else, and the cost of recycled PET has been rising in response – compounding the problem.

Something else that’s interesting about Klöckner Pentaplast is how it has structured its debt. The company has issued a type of bond known as a Toggle PIK. These allow the company to pay interest in cash (like normal) or to elect to ‘pay in kind’ (this means adding more debt to its existing debt!). This toggle option means the company isn’t forced to pay cash away when it can’t afford to. But this extra debt means that the company is becoming increasingly indebted – even as it struggles to pay its existing obligations! This risk means that PIK bonds often come with large coupons, and can be an excellent investment when the business is doing well. This is where stock selection is so important.

We decided not to participate in the Klöckner bond when it was first issued at par (i.e. 100) this time last year. I reviewed the company when the bond was trading in the 50s last month, having lost almost half of its value. We chose to pass again, as the firm’s fundamentals had continued to deteriorate. This week, Klöckner announced it would elect to pay its interest in PIK. Today, the bonds are priced at 35. I can hear the Klöck ticking…

Meanwhile, our can makers in the portfolio continue to hold in very well amidst the recent market volatility. These are fundamentally strong businesses that may also benefit from a helpful regulatory tailwind.

About the author

David McFadyen is an investment analyst in the Fixed Income team, focusing on high yield bonds. David joined us from BlackRock in 2015 and held various roles across distribution including investment writing and client management before joining the Fixed Income team in 2018. He has an honours degree in Business Management from the University of Glasgow. He is a CFA charterholder and has 4 years’ industry experience (as at 30 November 2018).

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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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The collapse of civilisation and the natural world is on the horizon

Last week’s Change Summit in Poland came to an end and it was the stark warning from Wildlife Broadcaster, David Attenborough that left a resounding mark in everyone’s minds. At the summit he warned that today’s generation is essential if we are to prevent catastrophic global warming.

In response to this, Kames Capital’s, Craig Bonthron gives his view on the importance of public figures taking a stance…

“The gravitas of Sir David Attenborough is always welcome. He is a globally recognised figure who combines a vast knowledge of the natural world with a gift for communicating that is quite frankly unequalled. In a world of constant news and noise it is very easy to place non-immediate issues to the back of our mind and for most of us the UN climate change summit is probably one of those things. But some issues are too important.  Climate change is the gravest threat multiplier that the human race and the natural world we inhabit has ever faced and having Sir Attenborough speaking directly to world leaders about it was no mere PR stunt, it was very important. His words were stark and impactful. I believe that the human race has the technology and capital to meet the challenge but we need to move fast. We need both the carrot and the stick of global governments to us force the down paths that Sir David has urged us to take.  The UK is bidding to host the 2020 UN climate change summit, let’s hope that world leaders listened to him last week and we have made meaningful progress by then.”

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Life better, virtually

Last year 40k people died in the US while driving; 1.3m worldwide died in car accidents.  Productivity is lost and fossil fuel is wasted during commuting, a creaking infrastructure must be maintained and cars that are hardly used must be manufactured1. Then there is the impact on our mental health: The Office for National Statistics (ONS) reported that feelings of happiness and life satisfaction decrease with every successive minute of commuting.

This is the focus of academics like Stanford University Professor Jeremy Bailenson:   “My dream is for us to look back at my dad’s hour-long commute each way in a row of boxes the way we look back smoking in hospital beds”.

Better roads, public transport solutions, hyperloops and flying cars are solutions to these problems… maybe. But other things will contribute too.

One of these may be VR.  Mark Zuckerberg, talking to Kara Swisher co-founder of ReCode in July:

“One of the biggest issues economically today is that opportunity isn’t evenly distributed. You get all these people who have to move to cities, and then the cities get to be way too expensive, and if you have a technology like VR where you can be present anywhere but live where you choose too, then I think that that can be really profound.”

I can hear big yawns of “we’ve been here before, surely?” Norman Macrae thought this age was upon us when he wrote in a 1975 edition of The Economist that there “would be little coherent purpose to trudge long distances to work.” Looking out the window, I’m in a rainy business park.

If VR has been a perennial white elephant it is partly because the technology hasn’t been ready. We’re perhaps still not quite there yet, but it does appear closer than ever.  The technological issues have been nearly surmounted – for example new OLED displays are coming that are not far off achieving the upper bounds of human vision2.

The real barrier now appears to be empathy – interaction is about empathy and understanding subtlety of body language and facial expressions, things we interpret subconsciously.   Bailenson believes that “when it’s done well it’s an actual experience”.    He has studied the relationship between empathy and VR for more than 15 years and believes that richer content such as 360 degree video is bridging the empathy gap.  “In VR, content that moves the body will also move the mind.”

Virtual and augmented reality could change our lives dramatically. It could, for example, increase access to live events or allowing industrial design companies to give technical product demos on demand. A virtual retail experience certainly appeals to me, so good news that Wal-Mart has recently applied for a couple of patents.

If a hardware solution like VR can become a platform for a broad set of uses, it has a great chance of widespread adoption – in a diversity of applications we cannot yet predict. It is another object lesson in the way we investigate sustainable impact investing; sustainable solutions to current problems may come from unexpected places.

(1) https://www.reinventingparking.org/2013/02/cars-are-parked-95-of-time-lets-check.html
(2) https://www.theverge.com/circuitbreaker/2018/5/23/17383990/google-lg-vr-display-high-res-headsets

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