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 –

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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Could an ESG screen dilute your ESG alpha?

Would you be worried if your doctor – during a routine examination – confessed that she wasn’t an expert in legal matters, and that she couldn’t do your tax return? Given that this lack of knowledge shouldn’t affect her medical diagnosis, I’d expect not. Whilst lawyers and tax accountants have their place, (thankfully) they are not always important.

So should we worry if a software company fails to disclose its record on environmental spills, given that handling hazardous or polluting materials is not part of its business activity? How harshly should we treat a fast growing organisation of 1,000 software engineers working in a rented office space for not knowing how much water they use? Should, for example, they be held to the same standard as a global integrated oil company with 70,000 employees and hundreds of high impact operating sites across the world? We think not in this context.

Yet this is how ESG screens are often used. Different companies, in different industries, in different regions, at different stages of maturity are held to the same standards across a generic set of metrics. Remarkably, academic research shows that ESG screens work despite this. Even though the things that matter most are systematically deemphasised and the things that matter least are systematically overemphasised, they still work.

But we believe these generic screens underplay the value of ESG. Which brings me to ‘materiality’. Within our sustainable investment process, we focus on materiality from start to finish. We develop KPI’s for each company based on material factors, and track them. We consider ESG screen data but re-weight the ESG factors (at a subsector level) by materiality to make the data more applicable.  We give allowances for size (i.e. a company’s ability to dedicate resources to internal ESG analysis) and region (i.e. local regulations, listing requirements and cultural awareness) and do additional bottom up due diligence – focusing on material factors – where disclosure is light.

I’m sure this makes intuitive sense to all of our smart Sustainability Soapbox readers but is there any evidence that it works? Yes.

The above study suggests it works very well indeed. In fact focusing on immaterial factors appears to be a performance drag. We believe that there are three key reasons that the analysis of material sustainability factors is a source of investment alpha:

  1. These factors have a direct impact on company performance
  2. These factors are often ignored or overly discounted during traditional fundamental analysis
  3. ‘Traditional’ fundamental analysts have lost interest in ESG analysis, as immaterial factors in ESG screens tend to drive decision making thus making them cynical and leaving alpha on the table for those who appreciate how to leverage the data wisely.

So remember, each ESG metric has its place, but only in the right context. Focus on what’s important. The truth is in the nuance.

1 Friede, Busch, Bassen (ESG & Corporate Financial Performance: Mapping the global landscape). September 2016
2 Khan, M.,Serafeim, G., and Aaron Yoon, 2015. ‘Corporate Sustainability: First evidence on materiality.’ Harvard Business School

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Trading Permits

Since the start of 2017 to end August 18, the LME spot cobalt price has approximately doubled (at the top, in March 2018, it was 290% higher than in January 17)! But wait, there’s another ‘green’ commodity which has offered even better returns. Carbon… or more specifically the carbon permits that are traded under the EU Emission Trading Scheme (ETS), are up 390% since the start of 2017. Boom!

Source – Factset

The ETS is a cornerstone of the EU’s policy to combat climate change. It limits the emissions of more than 11,000 energy intensive operations and the airlines flying between the 31 countries it covers. It works by setting an overall cap on the amount of greenhouse gases (GHG’s) that participants can emit and each year participants must surrender enough allowances to cover their activity, or face being fined. If they need more (or less) permits, they can trade with other participants and this allows them to choose between actually cutting their emissions (via investing in cleaner technology) or buying allowances, whichever is cheaper.

So, why the big ramp up in the price? A squeeze is coming! From January 2019, the number of carbon allowances under the scheme is being significantly reduced. Hence the excitement; if you want to continue to emit post 2019, it will cost you more.

Although the ETS is the largest component, the global carbon ‘market’ is growing. Various regional, national and subnational carbon pricing initiatives now exist across the globe, with an aggregate value of US$8.1bn. A lot of money, yes, but still covering only 11 gigatonnes of CO2 – or to look at it another way, 20% of global GHG emissions. However, even where companies are not participating formally in carbon markets, increasingly they are anticipating their financial impact. The number of companies disclosing to CDP (Carbon Disclosure Project) that they embed an internal carbon price into their business strategies has quadrupled from 150 global companies in 2014 to over 600 companies in 2017.

It’s worth noting that EU ETS prices reflect the abatement cost of one tonne of carbon and not the estimated ‘social cost of carbon’. The latter is a more holistic estimate of the impact of climate change involving complex sums combining long time spans, economics and ethics. The EU ETS price is still some way short of the estimated social cost, but at least it’s going in the right direction. Meanwhile, in the US, President Trump just cut estimates for the social cost from $50 (the Obama administration’s central estimate which underpins the Clean Power Plan) to between $1 and $7….which (as Arnie says here) very much looks like just another way to try to prop up the ‘Blockbuster of the fuel industry’. You gotta love Arnie…..

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Shipping is going green

My colleague Euan Weir recently wrote an interesting piece on environmentally friendly shipping regulations, which should benefit refiners who produce low-sulphur fuel. About time too!…Goldman Sachs estimate 15 of the world’s largest ships emit more sulphur dioxide and nitrogen oxides than all the world’s cars combined.

It’s not just eco-warriors and refiners that benefit from this trend – there are second and third order impacts as well. Hydrogen is needed in large quantities to reduce sulphur content in fuel, so industrial gas companies like Air Products, which supplies hydrogen to the world’s refiners, also stand to benefit as we move towards implementation of the regulations in 2020.

Air Products is the largest hydrogen supplier in the world. Hydrogen is usually produced on-site at a refinery by steam reforming of natural gas, or transported by pipeline from a nearby plant. Gas is expensive to transport over large distances by truck, so local oligopolies tend to form within 200-250 miles of a major hydrogen plant. This creates a powerful economic moat.

Revenues are protected in others ways too. Supply contracts typically last 15-20 years and contain minimum pricing clauses to ensure payment, even if no hydrogen flows through the pipes (for example, during a recession when demand is low). This provides Air Products with a stable source of income throughout the economic cycle, and is one of the reasons they have been able to increase their dividend for 35 consecutive years.

With the shipping regulations likely to drive up demand for more complex, “cleaner” fuels and industrial gas companies seeing healthy volume growth and pricing trends, when it comes to the world of investments, going green can really pay dividends.

Opinions and views from the Equities team at Kames Capital are not an investment recommendation, research or advice and should not be considered as such. Content discussing investment strategies and stocks is derived from and solely relates to the investment management activities of Kames Capital.

About the author

Matt Harding is an investment analyst in the Equities team, responsible for generating investment ideas for our North American and global equities portfolios. He joined us in 2015 from Zolfo Cooper, where he worked in financial restructuring. Prior to that, Matt worked in similar restructuring and advisory roles for RBS and Deloitte. He studied Accountancy & Law at Glasgow University and is a chartered accountant, a chartered banker and a CFA® charterholder. He has 14 years’ industry experience.*

*As at 30 June 2018.

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