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It is hard to believe that this year marks the 40th anniversary of Transformers first hitting television screens. The fact that Paramount have confirmed plans for their eighth and ninth(!) films offers up two cultural observations: one is that film studios still can’t find any new ideas, and two is that the wider public have a long-standing affinity for anything robotic. 
The concept of Transformers was originally licenced by Hasbro from a Japanese toy company called Takara. They had created a line of smaller toys called Microman, supposedly in response to the high oil and plastic resin prices of the 1970s and to suit the limited storage space available in a typical Japanese home. An offshoot was exhibited at the 1983 Tokyo Toy Show and after a travelling Hasbro representative spotted them, the rest as they say is history.
Takara still enjoy the royalties today, but it is not the only case of Japanese behind-the-scenes ingenuity, efficiency and adaptation. The latest holding in the fund added at the start of year, Ebara, is more than one hundred years old, but houses a collection of businesses that collectively save energy, resources and money for their customers. It started with large-scale centrifugal pumps for water but soon broadened out into other applications and processes. Many companies have a corporate philosophy, but few have a “founding spirit” that sits above that. Ebara’s identity is translated as: “to address people and work with passion, repeated originality and ingenuity”.
The problem has been that this has not always gone hand in hand with healthy financial returns, despite technological success and the expansion of the company overseas. In some years profits might be reasonable, but margins would often revert back to the low single digits, and the company lost money in five out of the ten years from 1999 to 2009. Ebara had taken on debt in the 1990s and this became a burden when combined with falling infrastructure investment in Japan, a strengthening Yen and competition in the pump market. Revenue in 2012 was at roughly the same level as 1993, and the dividend was cut to zero in 2009 and 2010.
It can be dangerous to generalise this combination as being typical of most Japanese companies, or to write it off as unworthy of attention. Nonetheless, as was covered by Alex Stout in his <a href="https://river.global/news-insights/not-just-a-flash-in-japan">article</a> last year, many things in Japan are changing, and this includes Ebara. Unlike Transformers however, companies can’t shapeshift into something shiny and new at the press of a button. Generally, it takes lot of work, and time.
Starting in 2011, Ebara embarked on a series of 3-year plans to move into a position of decent profitability and growth. Despite not reaching some of its initial targets, it stayed the course, increasing research and development and added further divisional disclosures and improvement initiatives.
The efforts are paying off, and the company is now looking for at least a 10% operating margin and return on invested capital, and a 15% or higher return on equity. Given it already meets those, it also wants to improve growth, to be at a level of at least 7% in the coming years[1].
A division called Precision Machinery will do the heavy lifting, which makes a special type of vacuum pump, as well as chemical mechanical planarization systems. In the past these were small niches in the semiconductor supply chain. Now, the manufacturing requirements of new microprocessors are becoming far more demanding. Ebara’s products are among the few that can make sure that the facilities of its customers are clean, and their wafers flat. And not just flat, but very flat. If a wafer was scaled up to the size of a city like Singapore, one of Ebara’s machines could flatten it to within 1mm precision[2].
That division, which was losing money in 2008/2009, is on track to make up the majority of group profits. A significant difference. Along with improved project management, product development and incentives, the company has also made a step change in shareholder returns. The dividend payout ratio has moved up from only 10% around the time of the financial crisis, to 35% or greater today. With no net debt, the company should quickly start to produce excess cash flow for buybacks or acquisitions.
When we put all the components together, we were able to buy into an improving business with strong market positions, some unique technology, the potential for recovery and newfound pricing power and a strong balance sheet. At a dividend yield above 2% and a cash-backed earnings yield of above 10% within a few years, it was available for well within our valuation criteria. Just like Transformers, industrial companies come in many shapes and sizes. But rather than the fast, flashy and noisy ones, it can be the quiet and inconspicuous ones that are more impressive.
<a href="#_ftnref1" name="_ftn1">[1]</a> Ebara “E-Plan 2025” announcement, February 2023 
<a href="#_ftnref2" name="_ftn2">[2]</a> Ebara
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The focus of the fund is to invest in leading global businesses offering lower risk and modest share valuations.

We conduct proprietary research focusing on businesses’ long-term earnings potential, including ‘worst-case’ scenario modelling.

The outcome is a differentiated, conviction portfolio with a high active share.

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Robot in disguise

Article

<h3>March Outlook</h3>
Attending several recent conferences and company meetings, following the corporate reporting season, has allowed us to test individual investment cases and also pull together some coherent thoughts on what corporates are seeing and doing today. These have high-level implications that readers may find useful. We will provide further detail, including how it relates to our portfolio holdings, in our quarterly letter.
We are seeing the commencement of several positive cycles. Flavour and fragrance ingredients, memory, life sciences tools, paper and packaging, and US onshore wind are all examples of sub-sectors which have already witnessed a sharp downturn but have now moved from stabilisation into a genuine recovery phase. Conversely, the agricultural cycle has rolled over, with debate now centred around whether 2025 will also be a down year. Despite the AI boom, corporates remain cautious about global IT services spend, particularly relating to hardware, meaning the much-anticipated PC replacement cycle has been pushed to the right.
Power grid bottlenecks, which we discussed in our <a href="https://instinctdigital.blob.core.windows.net/funddata/r-m-global-sustainable-opportunities-fund/quarterly-report/65363194e1bb1-gsof-q3-2023-pdf.pdf" target="_blank" rel="noopener">Q3 2023 letter</a>, are rapidly emerging as the critical feature in the energy transition. This has been intensified by the enormous energy demands of AI and means this issue is of broader significance to equity markets, given the large concentration of market cap now exposed to the AI ‘theme’. There is a realistic scenario that lack of grid investment could act as a constraint to growth.
Linked to the energy transition, we have also investigated several interesting ‘capital cycle’ related opportunities within the building materials sector. Several niche products, such as natural gypsum in the US, now have remarkable pricing power and sustainable margin potential. Taking the gypsum example, this is because no new capacity is coming on due to environmental restrictions, while the competing, or substitute, synthetic gypsum volumes are being decimated because it is a by-product of coal-fired power plants.
Finally, we continue to investigate potential investments for the fund across a diverse opportunity set: flavour and fragrance ingredients, life sciences tools, chemicals, exchanges, utilities, semiconductors, software, and a handful of ideas in Brazil all feature among our current work-in-progress. The breadth of ideas speaks to our ongoing opportunity to offer investors a well-balanced, attractively valued opportunity to highly concentrated, momentum-driven benchmark indices.

<h4>Market Overview</h4>
Global equity markets remained buoyant in March (MSCI ACWI +3.1% total return in USD), taking the year-to-date return to +8.2%. MSCI ACWI Growth returned +2.1% compared to MSCI ACWI Value +4.3%, in a reversal of prior style leadership, albeit large cap continues to dominate smaller companies (MSCI ACWI Equal Weighted +1.8%). The Fed maintained its stance of three interest rate cuts this year and the US 10-year bond yield was flat at 4.3%. In the background, economic growth remains resilient. This is most notable in the United States, but even economies with a more challenging backdrop such as the UK, the Eurozone and even China have seen some combination of GDP growth above forecasts, lower inflation, and positively inflecting leading indicators (e.g, PMIs).
<h4> </h4>
<h4>Strategy Update</h4>
Performance
The fund returned +5.5% in March. In comparison, the MSCI ACWI index returned +3.2% (all in GBP). Since inception, the fund has returned +27.4%, compared to the global benchmark’s +26.0%.1
Baker Hughes (+13% in GBP) was the largest positive contributor. The share price benefitted from stronger commodity prices and the news that Qatar plans to boost its LNG production capacity to 142 million mt per year by the end of 2030. We held a meeting with the company, which reinforced conviction in the investment case. Samsung Electronics (+12%) rose as evidence builds that memory pricing is likely to be higher than current analyst expectations. Our original investment case was based on newfound capacity discipline within the oligopolistic supply structure, but this has been supercharged by the positive demand implications of growth in usage due to Artificial Intelligence. There were no material negative contributors to performance. Owning no shares in Apple and NVIDIA offset one another in relative performance terms, with Apple underperforming and NVIDIA continuing its remarkable strength.
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Activity
We added no new positions during March. We exited a position in Shell as the shares traded close to our fair value and technical indicators became less attractive. With other companies within the portfolio offering better risk-reward and similar portfolio construction benefits, there was opportunity cost to holding the shares.
1Inception: 7 July 2022. Fund: F share class (GBP), midday to midday pricing. Benchmark: close-of-business to close-of-business pricing. Performance shown to 28 March 2024 due to UK bank holiday on 29 March.
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For more information about the fund and how the fund is positioned, please visit our fund centre below:

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Start your engines

While it is fresh in the mind, did anyone else feel like Easter eggs aren’t what they used to be? There is always plenty of choice when it comes to sizes and prices. The bad news is that, compared to any previous year, they almost always contain less chocolate and cost more<a href="https://news.sky.com/story/some-easter-eggs-cost-50-more-this-year-and-others-are-smaller-which-study-finds-13098964" name="_ftnref1">[1]</a>.
I did my best not to forget the common wisdom of “you get what you pay for”, “ buy cheap, buy twice” and “penny wise, pound foolish”. These have long been passed down, or in many cases learned the hard way. Like many rules of thumb, they become accepted and then part of the subconscious. They make our lives easier, with less decisions, and we can spend valuable thinking time on other matters. That’s the theory at least.
If only life were that simple. For some goods, we would happily buy more if available at a lower price. Some we need only sparingly or infrequently. Some immediately, no matter the price. Then there are those strange cases where higher prices increase desirability, even if the product itself remains unchanged. The world loves being complex, and unfortunately for us consumers, we have to face off against sophisticated marketplaces setup to take advantage of all our weaknesses.
Companies have for years dedicated people, money and computers to refining tricks to maximise the extraction of our spending power. Research suggests that, even some of the oldest, such as ending a price with a 9 or 5, still work<a href="https://news.sky.com/story/some-easter-eggs-cost-50-more-this-year-and-others-are-smaller-which-study-finds-13098964" name="_ftnref2">[2]</a>. Since the advent of the internet and e-commerce prices and discounts change far more frequently than in the past<a href="https://news.sky.com/story/some-easter-eggs-cost-50-more-this-year-and-others-are-smaller-which-study-finds-13098964" name="_ftnref3">[3]</a>. As a consumer, it is a struggle to understand what a reliable price is any more. Even customer loyalty, which used to be rewarded, is now used against us. Supermarkets are effectively forcing the handover of data through exclusive member pricing, and woe betide anyone who doesn’t switch their utility, phone or insurance providers each year! They aren’t to blame; to the contrary, it is their job to maximise profits by any legal means available. 
Luckily, there has always been a strong counterweight; the competitive and globalising economy of the past twenty years, with outsourcing, plentiful labour and falling interest rates. Corporations were kept on their toes, if not by existing competition, then at least by new startups or entrants from overseas. Many regulations fell away, and overall inflation was negligible.
But several things changed. First, the re-emergence of trade tariffs. Then of course the pandemic. An unprecedented form of stimulus where any company that could get hold of supplies was able to charge a premium. Finally, the war in Ukraine and another round of spikes in commodity prices. If there was ever a time for companies to raise prices, this was it. And they did.
There is little doubt that this has been part of a bonanza for corporate profit margins. Measured by operating profit, net profit or even free cash flow, U.S. margins are at their highest levels in modern history. None of this is ideal for consumers, but with many stock markets at all-time highs, is this not nirvana for investors? Ever since Warren Buffett spelled it out after buying into Coca-Cola and See’s Candy, the concept of pricing power has continued to gain in popularity. There are even “pricing power” exchange traded funds. After all, how hard can this investing thing be? Find a few great brands that have spent years advertising, with stable, high and/or rising gross margins and let capitalism work its magic. If only life were that simple…
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Just like shoppers, investors are faced with analysing many different relationships between price and value. In the case of consumer categories such as confectionary, some large companies might appear to have found the holy grail. They have long perfected the art of making products more expensive and smaller at the same time. If a particular ingredient starts to get pricey, they have an army of scientists able to substitute them with cheaper alternatives. Few would argue that chocolate bars (or Easter eggs) taste better today than in the past. And what about new product innovation? Anything memorable spring to mind that didn’t disappear again? Perhaps it is a silver lining that with higher prices and smaller sizes we don’t have to eat as much of them.
The problem with this kind of pricing power is that, like the chocolate itself, too much of it is wonderful in the short-term but can prove to be unpleasant in the long-term. Several years ago, there was another kind of holy grail in consumer staples – cutting costs to grow margins. It worked well, until it didn’t.
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Contrast this with John Deere’s latest product launches. The new S7 combine harvester will be more expensive, but also 10% more fuel efficient. It automatically adjusts its speed by measuring and monitoring the incoming crop density, height and type using sensors and satellite data. This should bring productivity savings of as much as 20%. For many of John Deere’s products, the return on an upgrade has never been greater for farmers with sufficient scale.

If a rising tide lifts all boats, what happens in a falling one? As usual, nobody says it better than Warren Buffett, “you find out who’s been swimming naked”. Pricing power comes with strings attached, and if company managers pull them too far, they have a nasty habit of snapping.
As part of the team managing the Saracen Global Income &amp; Growth fund, we dedicate a lot of time to finding and understanding companies that create more value than they take. By investing in them at low valuations, we believe we can achieve high capital and income returns, without over-stretching other assumptions such as pricing. If you are interested in learning more, we will be discussing this in our upcoming webinar “Capex investing: but not as you know it”. It may be too late to avoid over-priced chocolate over Easter, but fortunately there is no deadline in avoiding over-priced investments.
[1] <a href="https://news.sky.com/story/some-easter-eggs-cost-50-more-this-year-and-others-are-smaller-which-study-finds-13098964">Some Easter eggs cost 50% more this year and others are smaller, Which? study finds | UK News | Sky News</a>
[2] <a href="https://www.sciencedirect.com/science/article/abs/pii/S0022435911000662">The Impact and Determinants of Nine-Ending Pricing in Grocery Retailing - ScienceDirect</a>
[3] <a href="https://www.nber.org/system/files/working_papers/w25138/w25138.pdf">More Amazon Effects: Online Competition and Pricing Behaviors (nber.org)</a>

How to avoid sticker choc

William Lough explains why his why his price disciplined, balanced portfolio, offers outstanding value today.
<h3>October Outlook</h3>
As we stand, the key risk in markets is high valuation multiples in long duration equities, in which lots of other investors’ capital is still invested. We have a ‘balanced’ rather than a ‘defensive’ portfolio, as we are not trying to make a directional bet on the macro cycle. Instead, we are simply staying true to the price discipline at the heart of our investing philosophy &amp; process.
We believe that the price discipline of our strategy is one of its key differentiators in a market that has appeared to favour chasing the share prices of popular companies higher over considering downside protection. It is worth highlighting that, despite falling for three consecutive months, the Tech-dominated NASDAQ 100 index is still up +33% year-to-date. The lack of follow-through from higher rates to the share prices of longer duration (“growth”) equities has surprised us thus far in 2023. We are not convinced that the recent weakness makes such companies exciting investment prospects, above all because investors can find superior risk-reward elsewhere.
Despite the re-emergence of a ‘proper’ yield in the bond market, multi-asset investors must not forget that one can also put together equity portfolios today with very attractive future return profiles and highly asymmetric risk-reward. Our well-diversified portfolio of equities yields 8% today but, crucially, that yield should rise to over 20% due to earnings growth. We think it offers outstanding value today.
 
<h4>Investment Background</h4>
Global equity markets fell for the third successive month in October (MSCI ACWI -3.0% total return in USD). The global benchmark has now fallen ~10% from its July peak. Risk-off sentiment continued in October as cross-asset volatility picked up due to rising rates, weak Q3 results, and geopolitical tensions in the Middle East.
Gold (+7%) and the US dollar were among the few assets up on the month, while within equities low volatility was the best performing factor. One traditional safe haven that didn’t fulfil the moniker last month was US Treasuries: US 10-year bond yields continued to march higher, from 4.6% to 4.9%, and breached the 5% level during the month. However, they have subsequently fallen back below 4.7% following Fed commentary in early November. Within Q3 results so far, weakening revenue momentum has been a more widespread feature, suggesting that monetary tightening has started to take effect.
 
<h4>Strategy Update</h4>
Performance
The fund returned -4.8% in August. In comparison, the MSCI ACWI index returned -2.4% (all in GBP). Since inception, the fund has returned +7.8%, compared to the global benchmark’s +5.9%.1
October was notable for punishing share price reactions to earnings announcements which showed any sign of weakness in demand or reduction in margins. According to Morgan Stanley, the divergence between short-term winners and losers in Europe is the highest since 2007.2
The largest detractor from relative performance was not holding a position in Microsoft (+7%). The largest detractors within the portfolio were US dental and healthcare distributor Henry Schein (-12% in USD terms) and US industrial Valmont Industries (-18%). The whole dental space performed poorly following a weak update from Align Technology. Recent survey data has been more positive regarding industry volumes. Specific to Henry Schein was the news of a cybersecurity incident. The company has not yet scaled the financial impact, but we are currently inclined to see this as a one-off, rather than an ongoing effect on profitability. Valmont reduced its full year guidance and now expects a modest decline in group sales. We had constrained our position size based on the potential for this near-term outcome (albeit it was not our original base case) and the shares now trade near trough valuation multiples.
Willis Towers Watson +13% was the top positive contributor. It delivered Q3 results which were ahead of analyst expectations. Having built up an unenviable reputation for reducing guidance, which has contributed to the stock’s valuation derating, this positive performance and re-iteration of 2024 guidance was well-received by investors. McKesson (+5%) had another strong quarter. Alongside the merits of its defensive characteristics in a weak market, investors view it as a potential winner from the distribution of new and rapidly growing weight-loss drugs.
<a href="#_ftnref1" name="_ftn1"></a>
Activity
We built a new position in the CDW, the US-listed value-added-reseller of IT products. CDW is an underappreciated compounder, having delivered mid-teen EPS growth and 40%-plus cash return on capital over a sustained period. It has consistently taken share in a fragmented but large ($460bn) addressable market and continues to expect revenue growth 200-300bps above market growth rates. CDW sits between customers and technology vendors, creating value for both: on one side, it provides a wide range of technology providers, such as PC producers, software publishers, and cloud providers with cost-effective access to over 250,000 predominantly small- and medium-sized businesses; on the other, it supports these customers by using an understanding of their specific requirements to help them navigate the changing tech environment. The management team are excellent capital allocators, consistently widening the competitive advantage with bolt-on M&amp;A which adds incremental distribution or technology capabilities. We anticipate that a new wave of technology which is complex but productivity enhancing, such as AI, means IT budgets for smaller businesses will grow. Constrained internal resources to implement this suggest both addressable market expansion and an acceleration in the demand for the higher margin services within CDW’s offering.
Our position in Kenvue was sold following analysis into litigation related to its Tylenol product. Calls with US legal experts lead us to believe that, while Kenvue is likely to be able to successfully defend itself and limit settlement payouts within the range consensus expects, the legal process has potential to drag on for five years. Kenvue was bought as an attractively valued spin-out with margin upside, within the most defensive consumer category, not a litigation ‘special situation’. In addition to our desire to follow process and avoid ‘thesis creep’, we are also aware of the challenges similar investment cases have faced in recent years (e.g., Bayer / Monsanto). Therefore, while disappointing to sell so soon after purchasing the shares, we felt it best to move on with limited damage done due to our favourable entry price. We also exited the remaining small position in glass bottle manufacturer Verallia. Our view that there is near-term risk to the profitability per tonne of glass produced has subsequently been confirmed, with the company’s guidance lowered at the Q3 results.
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<h4>Upcoming Webinar</h4>
We will be giving an update on the Global Sustainable Opportunities Fund, hosted on BrightTalk, on Thursday 30th November at 10.30am (Duration 20 mins). You can register to attend <a href="https://bit.ly/3ugtqSj" target="_blank" rel="noopener">here</a>
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1Inception: 7 July 2022. Fund: F share class (GBP), midday to midday pricing. Benchmark: close-of-business to close-of-business pricing.
2https://www.reuters.com/markets/europe/investors-deliver-harshest-punishment-earnings-warnings-16-years-2023-10-27/

The price discipline of our strategy is one of our key differentiators.

William Lough reflects on the opportunities within global equities as part of his June monthly fund update.
<h3>June Outlook</h3>
The recent market dynamics remind me most recently of October-November 2021 during the speculative blow-off phase of the last tech/growth bubble. When the world’s financial markets are intently focused on a narrow band of ‘guaranteed’ winners, whose valuations have already expanded a lot, history suggests they are usually presenting better opportunities for future returns in corners of the markets which are not currently in the spotlight.
Market volatility, induced by a combination of interest rate hikes and a fear of recession, has driven mis-pricings across multiple sectors in both higher quality compounders and turnaround companies or cyclicals at or near the bottom of their cycle.
Today we find many share prices (particularly in smaller companies and/or cyclical companies) which already reflect recessionary conditions, or are extrapolating short-term issues such as destocking as being more structural and longer lasting in nature. The opportunity in smaller companies appears particularly good, since it’s not confined to a handful of sectors or select geographies but is a global feature (albeit more pronounced in some places, such as the UK).
The relative value offered by our portfolio today, with its 14% cash return on capital and 10% sustainable growth rate, is the best it has been since at least 2015, when compared to the global market-cap weighted indices. A date from which our global strategies delivered very strong absolute and relative performance.
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<h4>Investment Background</h4>
Global equity markets were very strong in June (MSCI ACWI +5.8% total return in USD). While there was almost no disparity between returns from the Growth benchmark versus the Value benchmark, indicating lower style dispersion than we’ve witnessed year-to-date (where the performance gap is 20%), MSCI Equal Weighted continued to underperform the headline (market-cap weighted) index by -2.1% in June and is now -9.2% behind year-to-date. US 10-year bond yields continued their recent move higher, from 3.6% to 3.8%. Defensive assets, such as the US dollar (DXY index -1%) and gold (-3%), lagged riskier assets’ returns.
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<h4>Strategy Update</h4>
Performance
The strongest contributors were primarily building materials companies in the US. TopBuild (+32% in USD) and Owens Corning (+23%) responded well to news of US housing starts at the highest monthly level in over a year, despite the shares already performing well year-to-date. Baker Hughes (+16%) rose with support from a higher gas price and positive comments from the Chair/CEO at a broker conference. Fiserv (+12%) recovered recent weaker performance, which may have been related to its sector classification switch (from Technology to Financials). There was nothing notable regarding fundamental news. Sony (-5%) was our biggest detractor. New uncertainty around the Zee-SNPI merger in India created a distraction in June away from attractive fundamentals. We expect earnings momentum to pick up throughout this year with attractive growth prospects over the intermediate term. A couple of more defensive holdings, Tate &amp; Lyle (-4%) and Roche (-3%) held back relative returns.
Activity
No new positions were bought. Following our review of the Topgolf Callaway investment case, including a meeting with the company, we sold the small remaining balance in our position. We lacked sufficient conviction to rebuild to a full weight, primarily due to greater complexity in the investment case than we had originally analysed, particularly relating to the economics behind Topgolf sites. We have learnt from experience that simplicity often trumps complexity in the stockmarket.

The relative value offered by our portfolio today …  is the best it has been since at least 2015.

Lucy Cheng considers how investors evaluate the impact of their portfolios on the environment and society, with a closer look at the United Nations' sustainable development goals.
<h4>The requirement for impact reporting</h4>
In recent times the term ‘greenwashing’ – misleading claims about environmental (and wider) ESG practices[1] – has had investors fearful of being associated with it in any manner. Allegations and fines from regulators for greenwashing in the financial industry has dominated our news headlines over the past few years, with companies including DWS2, Deutsche Bank[2], BNY Mellon[3] and BlackRock[4] in the headlines. To distance themselves from any chance of being associated with ‘greenwashing’ and with increasing sustainability disclosure regulation, investors are now reporting the impact of their investment and stewardship strategy on the environment and society to clients, regulators and wider stakeholders. There are several ways investors are reporting impact; some methods focus on positive impact (such as number of cars taken off the road equivalent to a carbon-tilted fund or examples of successful engagement), other reporting techniques hone in on mitigating negative impact (such as the SFDR Principle Adverse Impacts). One popular framework used by investors is the United Nations Sustainable Development Goals (UN SDGs) – let’s look at this one in closer detail.
<h4>What are the UN SDGs?</h4>
“The 2030 Agenda for Sustainable Development, adopted by all United Nations Member States in 2015, provides a shared blueprint for peace and prosperity for people and the planet, now and in the future. At its heart are the 17 SDGs which are an urgent call for action by all countries – developed and developing – in a global partnership.” – United Nations[5]

<h4>Use of UN SDGs by the investment industry</h4>
Despite the SDGs being primarily aimed at governments, the SDGs have become an important framework for many corporates as material factors to business planning and operations. In the investment sphere, many investors are now reporting their impact against the SDGs and allocating capital to contribute to the achievement of the SDGs with some investors even launching thematic products that align themselves to a portion of the SDGs. To quote Principles for Responsible Investing (PRI) Blueprint for responsible investment “Driving sustainable development in line with the UN SDGs will create a more prosperous world, to live in today and to pass on tomorrow.”[6]
Through investors reporting impact against the SDGs, it signals transparent reporting and, for those consuming the information, can provide a standardised framework in which to demonstrate impact allowing comparability. SDGs can also be used as a universal benchmark for sustainability progress to be measured, bringing consistency for investors to analyse companies. Additionally, to achieve the SDGs, global coordination between governments, businesses, and society – including investors - is required therefore companies’ alignment to the SDGs can demonstrate they are aligned to sustainability, forward looking and potentially indicate that they are sustainability leaders. Investor alignment to the SDGs can also demonstrate alignment to the UN’s sustainability campaign.

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<h4>PVT Equities team view</h4>
The PVT team recognises that the SDGs can be a useful tool to help identify sustainable initiatives, however we believe there are certain drawbacks to using them as the sole method for demonstrating sustainability impact.
UN SDGs were designed for governments rather than investors
The nature of SDGs is to incentivise governments into making policy changes to create a more sustainable planet and society, they were not designed as an investor impact measurement tool. Consequently, it is often large cap companies in developed countries that have resources to commit to SDG alignment disclosure, excluding a large portion of the investment universe. Additionally, it can be challenging for some companies to determine which SDGs they are aligned to where their direct impact is limited; for example, a renewable energy company installing and operating wind farms would naturally positively contribute to SDG 13 – Climate Action however, one of the wind turbine component manufacturers may find it hard to align themselves to this SDG as they are part of an extensive supply chain. Companies’ own assessments of SDG alignment is rarely verified externally, meaning analysis is often subjective and biased.[7]  The Sustainable Finance Disclosure Regulation (SFDR) Principle Adverse Indicators (PAI), which was designed for companies and investors to disclose social and environmental impact, may be a more appropriate framework with a standardised methodology.
Differing methodology
Where investors are determining alignment to the SDGs themselves, there are limited standardised methodologies to determine this, and external validation is scarce. This means reports are subjective and lack standardisation. Where third party data providers are used to determine SDG alignment, reporting and measuring SDG methodologies vary widely. Some providers measure SDG impact based on alignment to a firm’s products as well as an operational aspect, while other data measures align more broadly as a percentage of revenue exposure. Additionally, some providers only look at either positive or negative alignment to the SDGs (which can result in sustainability opportunities/risks not being captured) whilst others combine both positive and negative impact to rate portfolios.
Lack of clarity on the type of UN SDG impact
As described by Stewart Investors[8], the contribution companies make to the SDGs can include:
<ol>
	<li>Direct contribution to targets</li>
	<li>Enabling/supporting activities</li>
	<li>Sustainable and socially useful products and services, but not directly relevant to a target</li>
</ol>
Therefore, SDG impact can be misinterpreted when the type of company contribution is not clarified.
We are confident in our S-PVT Philosophy and Process
The PVT team integrates sustainability into its investment process through our Sustainable PVT (S-PVT) framework centred around the pillars People, Innovation and Environment. Our company analysis is focused on material sustainability issues which vary by industry, business model and stage in a company’s life cycle (more information about our S-PVT philosophy can be found on our website <a href="https://river.global/wp-content/uploads/2021/09/PVT-Sustainability.pdf">here</a>). We believe, at a company level, that our S-PVT philosophy and process allows us to identify sustainability risks and opportunities and embed this within the investment process. By investing in improvers[9] and enablers[10] as well as existing sustainability leaders – as assessed through the aforementioned S-PVT framework – we believe we can support positive change within society and the environment. Such companies might not screen well through SDG alignment as they can be sustainability laggards today but through our analysis, we identify opportunity and potential for improvement and material real-world impact.
UN SDGs are currently a framework of choice
SDGs are currently the favoured impact reporting metrics by a wide variety of stakeholders, including corporates and investors. We understand the attraction, in principle, of a well-defined, standardised framework sponsored by supranational bodies and which has broad adoption by governments, companies and investors, and there are indeed some useful aspects to the SDGs. However, we also identify a number of limitations to the SDG approach and believe that it can give incomplete assessments of the nuanced sustainability credentials of an investment. It is also open to the risk of third parties, or even companies themselves identifying SDG impact when the reality can be a more tangential contribution.
<h4>So, is there a ‘one size fits all’ solution to impact reporting?</h4>
No, we do not think so – SDGs can certainly be a technique used by investors to demonstrate impact however, we believe they should be used as part of a wider framework. Taking the discussed drawbacks into consideration, we believe that for investors to demonstrate their true impact, it is important to demonstrate output and impact, both positive and negative, through a range of reporting frameworks.
As a firm (and as part of our overall impact reporting), we are able to provide SDG alignment reports for all of our portfolios. However, alongside the UN SDG reporting, we believe that disclosing our stewardship activities and showcasing case studies of ‘improvers and enablers’ best demonstrates the impact our portfolios, and underlying companies, have on the environment and society. We are currently working on our first impact report for 2022 – please get in touch with a member of the team should you wish to hear more on this topic or request access to this report once ready.
&nbsp;
[1] CFA ESG Investing Official Training Manual, Edition 3, 2021
[2] <a href="https://www.ft.com/content/ff27167d-5339-47b8-a261-6f25e1534942" target="_blank" rel="noopener">FT - German police raid DWS and Deutsche Bank over greenwashing allegations</a>
[3] <a href="https://www.ft.com/content/ff0097c4-3f1c-49d8-8189-153fc56aeeb3" target="_blank" rel="noopener">FT - SEC fines BNY Mellon over ESG in first case of its kind</a>
[4] <a href="https://citywire.com/wealth-manager/news/hedge-fund-giant-accuses-blackrock-of-being-full-of-greenwash/a1300927" target="_blank" rel="noopener">Citywire - Hedge fund giant accuses BlackRock of being 'full of greenwash'</a>
[5]  <a href="https://sdgs.un.org/goals" target="_blank" rel="noopener">THE 17 GOALS | Sustainable Development (un.org)</a>
[6] <a href="https://www.unpri.org/annual-report-2020/delivering-our-blueprint-for-responsible-investment/a-prosperous-world-for-all/enable-real-world-impact" target="_blank" rel="noopener">Enable real-world impact | PRI Web Page | PRI (unpri.org)</a>
[7] Aegon Asset Management makes a similar argument <a href="https://www.mrm-london.com/whats-happening/press/beware-sdg-rainbow-washing-aegon-ams-beacham/" target="_blank" rel="noopener">Beware SDG “rainbow washing”: Aegon AM’s Beacham - MRM (mrm-london.com)</a>
[8] <a href="https://www.stewartinvestors.com/all/insights/sfg/rainbow-washing.html" target="_blank" rel="noopener">Rainbow washing the SDGs away (stewartinvestors.com)</a>
[9] Improvers – companies whose sustainability credentials are improving
[10] Enablers – companies whose business activities contribute to improving sustainability credentials of wider stakeholders/society/whole sectors e.g., business activity will allow decarbonisation of a whole sector

A sustainable SFDR-9 fund focused on the transition of polluting activities which aims to achieve real-world positive impact for the environment.

Is there a ‘one size fits all’ solution to impact reporting?

In Daniel Kahneman’s classic behavioural finance book “Thinking, Fast and Slow” (2011) he describes two modes of thought: System 1 (thinking fast) is fast, instinctive and emotional; System 2 (thinking slow) is slower, more deliberate, and more logical. Here, William Lough, portfolio manager, posits that during times of intense geopolitical upheaval, it is key to pull on System 2 thinking and maintain a keen eye on the true investment drivers of the companies we are investing in, and not be sidetracked by short -term market movements into a System 1 mindset.
<h4>Avoiding system 1 thinking</h4>
The Russian invasion of Ukraine during the last quarter, along with the ongoing terrible ensuing humanitarian crisis,has been the the most meaningful geopolitical development in many years. There can hardly be anything more ‘System 1 thinking’[1] inducing than war, with the visceral images displayed across TV (with wall-to-wall coverage), newspapers and social media engaging with our most basic human instincts. How does one think clearly about investment when nuclear apocalypse is seemingly one of the cards on the table? An analyst research note (shown below) garnered significant attention with its precise attempts to assign a probability to a “civilisation-ending global nuclear war” – 10%, apparently – and equally intriguing conclusion about asset allocation flowing from this insight: “The risk of Armageddon has risen dramatically. Stay bullish on stocks over a 12-month horizon.”

System 1 thinking relies on shortcuts. Three such shortcuts investors have been applying which have created inefficiencies in market pricing might be regional exposure, sector exposure and pricing power.
<h4>Looking under the bonnet</h4>
Regional exposure and sector exposure become the quick-fix decision-making proxies for analysts, strategists and (yes, we’re guilty too) portfolio managers. War in Europe? Sell European-listed companies (regardless of  where they generate revenue). Cost of living crisis in Europe? Definitely sell European consumer discretionary companies. We lost count of the sell-side analyst reports recently downgrading recommendations on companies due to having the ‘highest exposure to Europe among coverage’ (or words to this effect). Maybe in aggregate these conclusions turn out to be correct, but in the stampede for the exit inefficiencies are created – the babies are thrown out with the bathwater.
Take sector classifications. In certain instances these can give misleading signals as to the true drivers of the investment case. They are are commonly used to infer whether a company – and by extension portfolio positioning – is cyclical or defensive[2]. Take for example, the consumer discetionary sector. Within that sector we hold Sony, with its broad array of businesses such as imaging semiconductors (technology), music and TV/film (media) and insurance (financial); we also hold Nikon, where the key driver of the investment case is the growing profit contribution from lithography equipment systems (technology) rather than the cameras for which it has historically been known. Booking Holdings, another investment in some of our portfolios,  is exposed to travel, historically a horrible place to be operating in a recession as business travel was a large, high margin contributor. Furthermore, its revenue base is predominantly European. But the base line for business travel today is low so if there is a recession, travel will not be hurt by a weakness in business travel to the extent it was in the past. Then you have a massive pent-up demand impulse from consumers. The evidence is thin so far that consumers are willing to forego their summer holiday due to the war in eastern Europe. On top of that, its business model is a technology platform which operates like a toll-road on the traffic it generates for hotels so has linear pricing power. Should investors avoid this stock  because of its sector classification and geographic exposure? Judging by the share price of Booking, many holders did but this doesn’t strike us as the right decision for investors like us with a longer time horizon.[3]

Hayward Holdings, meanwhile, appears in the industrials sector, although the front page of its website illustrates a couple sitting by one of the residential pools for which it provides essential kit.   No doubt, were it re-classified it would be as consumer discretionary – either way, from the top-down it would be considered a cyclical business. The near-term market focus is on risk to the business in a slowdown for new pool installations following the pandemic boom and if the volume of new build homes drops in a rising interest rate environment. These high-level observations can be challenged by zooming out for longer-term historical perspective – both in terms of number of pool installations and number of single-family housing starts relative to history – and simultaneously zooming in to better understand the drivers of value for the business. In Hayward’s case, our analysis suggests by far the bigger driver of value (via future cashflows) is the renovation, upgrade and replacement parts revenues that are a function of the installed base of pools. In this sense, ~80% of revenues coming from aftermarket services should prove less discretionary than the initial decision to install a pool.[4]

<h4>Identifying real pricing power</h4>
We also see short-cuts being used to assess pricing power[5], particularly relating to earnings risk for companies with energy comprising a large percentage of total costs, such as glass bottle manufacturer Verallia. The quantum and speed of commodity price moves is such that, even for companies with strong market positions which enable pricing pass-through over time, many will not be able to put all price increases through in one go and will do so in amounts that protect the nominal value of gross profit rather than the percent margin. This is important in two ways: [1] what matters in discounted cash flow valuation is the nominal figure, not percent margin, and it is immaterial for the valuation if cost recovery is achieved via a series of price rises which result in a six month hit to earnings and [2] a decrease in gross margin, even where absolute profit is protected (shown in the scenario below), can lead to modelling errors if analysts use the same gross margin for longer-term forecast assumptions, should commodity prices fall. Companies with pricing power can in fact use a reduction in commodity prices to ‘march up’ margins over time, so selling the short-term margin impact risks a ‘System 1’ error.

Looping back to lasting impacts from the Ukrainian conflict. While we do make data-led and risk management decisions regarding portfolio construction, my portfolios are not built on attempts to make precise predictions about the macro-economic future, but rather by building our convictions at the individual company level through a systematic bottom-up approach. Nonetheless, my colleague James Sym’s <a href="https://river.global/february-2022-commentary-james-sym/">commentary</a> sensibly sums up some potential investment conclusions (in terms of broad direction) emerging from the fog of war.
This note is taken from a section of the <a href="https://river.global/wp-content/uploads/2022/05/ES_RandM_Global_High_Alpha_Fund_2022Q1.pdf">ES R&amp;M Global High Alpha quarterly report</a>.<a href="https://river.global/the-fog-of-war-avoiding-system-1-thinking/#_ftnref1" name="_ftn1"></a>
&nbsp;
[1] The main thesis of Daniel Kahneman’s classic behavioural finance book Thinking, Fast and Slow (2011) is that of a dichotomy between two modes of thought: "System 1" is fast, instinctive and emotional; "System 2" is slower, more deliberate, and more logical.
[2] We prefer the classifications cyclical versus less cyclical – in Howard Marks’s words, “It’s essential to remember that just about everything is cyclical”.
[3] As another example, TopBuild (1.5%) and Owens Corning (2.0%) operate in the same profit pool – Owens Corning provides insulation material which TopBuild distributes and installs into residential housing – yet one is classified consumer discretionary and the other industrial.
[4] Renovation is typically done every 10 years, pumps, filters &amp; cleaners (Hayward’s core products) aren’t discretionary items within this. This decision to maintain the pool properly and to upgrade to Hayward’s modern pumps has strong economic rationale – 90% energy efficiency gains and 50% chlorine use reduction, while it costs ~$5-10k to remove a pool or $2k to drain (which also induces underground water risks).
[5] More on pricing power can be found here. <a href="https://river.global/higher-inflation-for-investors/">https://river.global/higher-inflation-for-investors/</a>
[6] In scenario 1, the business maintains its gross profit per unit i.e., reduces its pricing in line with the cost decrease; scenario 2 assumes that with some pricing power, the business only gives back half of the decline to its customers via price; scenario 3 assumes that pricing is held flat from the prior year.

The Fog of War – Avoiding System 1 thinking

R&amp;M's Head of ESG, Roger Lewis, provides an overview of the key ESG themes for 2022, why we expect these to be big, and what investors can do, as well as considering the ‘now what’ for net zero carbon.
<h4>Summary</h4>
Whether ESG starts <a href="https://river.global/will-2022-be-the-year-the-industry-stops-playing-at-esg-and-starts-doing-it-properly/" target="_blank" rel="noopener">to be done properly</a> this year or just continues to head in that direction remains to be seen. The past year saw commitments for investors to net their portfolios to zero carbon exceed half of worldwide assets under management ($57tr), the ‘forgotten middle child’ – Social - catching up to Environmental and Governance, and some very active stewardship.
Expect more of the same this year, with two new themes joining. The first is almost certain to gain a lot of attention and prominence: new sustainability disclosure standards and regulations will emerge. The second has been discussed for some years now but its importance in 2022 is uncertain: the risks, opportunities and disclosures for nature and biodiversity.
<h4>2021 continued</h4>
Just like going in to the office five days a week feels a long time ago, the first net zero carbon commitments were made at a similar time to this change, in 2019. It is therefore no longer enough just to have made the commitment. Expectations of clients, staff, journalists, analysts, industry associations and regulators are rightly shifting towards the need for evidence of the commitment and a clear set of objectives to achieve it.
Critical here for 2022 are pathways and the interim target of a 50% reduction in carbon emissions for a portfolio from Dec 2019 to Dec 2030. These are starting to be published by signatories to the Net Zero Asset Managers initiative. As stakeholders become more and more familiar with these, strong vs. poor examples should become clear to see. Compare two pathways:
<ul>
	<li>Slick Asset Management Plc.

<ul>
	<li>covers 100% of a firm’s AUM</li>
	<li>has clear pointers for start, duration and end. For example, with 1.5m tonnes of carbon, it targets an annual reduction of 75,000 tonnes with the aim to achieve an output of 0.75m by the end of the decade</li>
	<li>a sensible investment strategy covering top-down sectoral allocations, bottom-up stock picking impacts and structured engagement to manage the data and then <a href="https://river.global/responsible-investment/#ghgTraining" target="_blank" rel="noopener">reduce the emissions of investees</a>.</li>
</ul>
</li>
	<li>Slack Asset Management Plc:

<ul>
	<li>has minimal AUM in scope for the interim target</li>
	<li>doesn’t have any emissions data to identify the baseline</li>
	<li>hasn’t put a climate reporting and disclosures policy in place</li>
	<li>and plans to rely on carbon offsets – also known as an ‘easy way out’.</li>
</ul>
</li>
</ul>
While these are extreme examples, it is not difficult to imagine reactions, and ultimately fund flows and support, to both asset managers.
Related to this net zero activity within asset management is the green revolution in the wider world gaining pace this year.
In the UK, decarbonising the Grid by closing coal power generation facilities and increasing renewables (or importing gas) continues, as does the Committee on Climate Change monitoring progress and providing carbon budgets towards our (legally binding) net zero emissions target.
The impacts of the UK’s own <a href="https://www.gov.uk/government/publications/net-zero-strategy" target="_blank" rel="noopener">Net Zero Strategy</a> and related <a href="https://www.gov.uk/government/publications/greening-finance-a-roadmap-to-sustainable-investing" target="_blank" rel="noopener">Greening Finance Roadmap</a>, both released in Q4 2021, should start to be seen. Expect Sustainability Disclosure Requirements for corporates, the UK’s own Green Taxonomy, a verdict on sustainability standards disclosures (more below) and sectoral focuses on hydrogen, transport, heating buildings and, of course, power.
In the EU, SFDR should gain critical momentum as asset managers focus on launching or re-classifying funds as Article 8 or 9, in order to demonstrate transparency as well as their own ESG credentials.
Notwithstanding the debate over New Year on whether to class natural gas and nuclear as green, the Taxonomy labelling system will be implemented in order to help investors identify ‘activities that contribute substantially to climate change mitigation and adaptation objectives’.
Finally, for the EU, there could be the introduction of carbon border taxes to ensure the negative externality of emitting greenhouse gases into the atmosphere is paid for, regardless of where in the world it actually occurs.
The focus in the US is likely to continue to be on the decarbonising success story through energy efficiency programmes and using shale gas which, despite being a fossil fuel, contains around half the carbon of coal. This is in addition to Biden’s already well-documented ‘Build Back Better’ reforms and the $0.5tr spend planned for climate and clean energy.
A focus on individual companies’ emissions (known to investors as Scope 3) may be seen in the US too. This is especially likely when considering the climate-friendly directors that shareholders installed on the Board of ExxonMobil, or the order for Chevron to report the use of product emissions for the fuel it sells in petrol forecourts.
Across all regions, the Glasgow Climate Pact is, in theory, now in force, from development finance and a global carbon market to revised Nationally Determined Contributions (NDCs). These NDCs can be viewed as a country-level equivalent to a fund manager’s own net zero plan, as discussed above. COP27 in Egypt will be a good time to reflect upon progress and the success of the Pact.
The final carryover from 2021 is the evolution of ‘S’. <a href="https://river.global/responsible-investment/#evolutionS" target="_blank" rel="noopener">We previously cited four clear instances</a> where this is occurring, and all bar one are very much still underway.
Results from the Dept. for Work &amp; Pensions consultation on social factors within occupational pension schemes are expected soon and could have material implications for pension assets integrating ‘S’.
There is focus on a company’s supply chains, both for emissions and also for labour or human rights, as the ten principles of the UN Global Compact track. Remaining with the UN, we have just entered the third year of the ‘decade of delivery’ for its 17 Sustainable Development Goals (SDGs). An increasing number of clients are asking us to rate their portfolios against these SDGs, to show the impacts of their assets.
The one exception is social disclosure platforms. Unlike CDP (formerly the Carbon Disclosure Project) for climate, these do not exist, nor are there plans for any that we are aware of.
<h4>Happy new ESG year</h4>
CDP has been a huge success. Over 20 years, it has become the only real source of standardised, robust and independently validated environmental data for an entity.
Wider ESG disclosures are a different story, with no generally accepted principles. Many corporates do now publish non-financial <a href="https://river.global/wp-content/uploads/2021/11/RandM_Sustainability_Report.pdf" target="_blank" rel="noopener">sustainability reports</a> . But the quality and content varies widely, an issue compounded by the multiple guidelines, associations, standards and regulations that exist worldwide for ESG reporting – even in this short article, we are illustrating how complex the landscape for reporting can be.
Following the success of their accounting standards, IFRS (the International Financing Reporting Standards) have turned their attention to sustainability disclosure standards with the International Sustainability Standards Board. Working groups are now penning the Standards, drawing upon inputs like SASB (the Sustainability Accounting Standards Board) for ESG materiality and TCFD (the Task Force on Climate-Related Financial Disclosures) for climate. Expect further details before year-end. The UK’s own consultation on adopting and endorsing these Standards will be a major signal for how they’ll be integrated into investment, engagement and reporting activities by fund managers.
While one COP is now front-page news, there is another COP that will receive attention over Q2. This is the ‘Conference of the Parties to the Convention on Biological Diversity’, the 15th COP on biodiversity, taking place in China. Crucially, this will look at global frameworks and resources for natural climate change mitigation and food production.
Similarly, hoping to replicate the success and almost-mandatory de facto climate- related financial-disclosures of TCFD, the Taskforce on Nature-related Financial Disclosure (TNFD) framework should evolve over 2022. Testing and pilots of the data and templates are planned, with launch expected next year.
Just like nature is one ecosystem, a proper environmental strategy should consider climate, net zero, air, water, carbon, natural capital and waste as one framework, rather than individual, siloed solutions. This can be from a corporate, from an investor and from a provider of debt or equity to that corporate point of view. The two examples above should provide the inputs for nature to this framework, and we await their outcomes.
It just remains to be seen whether there is as much attention given here as there is to the other Conference of the Parties – to the Framework Convention on Climate Change…
<h4>Looking forward</h4>
All this points to an exciting 2022 in the world of ESG. River and Mercantile remains very active in all the above. Our own milestones include our plans to launch the first SFDR Article 8 and 9 funds, investing in renewable infrastructure, contributing to the Climate Action 100+ collaborative engagement with the heaviest polluters, publishing our own net zero carbon plan in July and further integrating the SDGs to our investment and engagement.

Top ESG themes in 2022

It’s hard to read an asset management article today that doesn’t contain reference to ESG, and many stocks with high ESG ratings are currently trading at a premium. R&amp;M’s Anna Pugh argues that it’s possible to find companies with robust growth drivers and stock-specific fundamentals that are exposed to sustainability driven tailwinds on attractive valuations. You just have to look a bit harder, sometimes in less conventional places.
Paper has become unfashionable. The oft-seen “Please consider the environment before printing” slogan, combined with technological advancements has been effective in driving a paperless shift in many aspects of modern life. Dusty office archive rooms, the paper round and last-minute searches for misplaced concert tickets have largely become things of the past, contributing to the industry’s archaic reputation. Whilst it’s right to move away from wasteful practices, we believe this narrative misses paper’s pivotal role in the transition to a circular economy, as one of the world’s few natural, renewable and sustainable resources.
First, let’s address the common misconception of deforestation. Net European forest standing volumes have grown consistently since 1990 under sustainable management schemes, safeguarding biodiversity and the climate. Forests are actually a net carbon sink[1] with a proportion of commercial land managed for conservation to maintain the ecological network[2] – it is in the industry’s interest that a sustainable supply remains available as a raw material for future generations after all. The Confederation of European Paper Industries (CEPI) estimates that European forests and the forest-based sector has a net positive climate effect (through carbon capture and substitution) equivalent to 20% of all fossil emissions in the European Union[3] on an annual basis. Paper’s production process also uses a higher proportion of renewable energy from by-products and has a low carbon intensity relative to other industrial industries.

Alongside the industry’s strong environmental credentials, structural growth in e-commerce is providing a catalyst for investment. Lockdown restrictions accelerated the underlying shift away from traditional retail channels in all industries, with the UK recording just shy of £100 billion in online retail sales in 2020[4]. Whilst e-commerce penetration of 30% (up from 20% in 2019[5]) may not be the “new normal”, companies of all sizes have witnessed the benefits of an omnichannel approach to which consumers have likely grown accustomed. Changing consumer behaviour sets up a long runway for growth in global e-commerce, as Jeff Bezos reminded us in Amazon’s 2018 Letter to Shareholders[6]:

As retailers compete to maintain share in the face of Amazon’s growth ambitions, they must find a way to service growing demand in a sustainable manner – online sales require (up to seven times!) more packaging. This presents a significant opportunity for the paper &amp; packaging industry, where we are currently finding a number of attractive investment ideas. Circularity is one of paper’s key attractions: it is a renewable raw material, which is biodegradable and primarily sourced from certified forests; it has one of the highest recovery rates in Europe (over 70% recycled versus 14% for plastics) and can be recycled many more times than plastic; and corrugated packaging is made with a high proportion of recycled content (89% of fibre used[7]). The industry is working hard to further increase these figures.
The substitution effect is an important and often underappreciated factor in assessing the sustainability of the whole paper &amp; packaging value chain – that its production facilitates reduced usage of fossil-fuel intensive alternatives. As FMCG brands seek to deliver to ambitious ESG and regulatory-driven targets, we expect a further structural tailwind as companies switch from plastic towards paper-based packaging solutions. This is currently in its nascency. Material Economics calculates that 25% of European plastic packaging could be replaced[8], though it won’t be a simple process. Complicated trade-offs between recyclability, carbon and food waste provide opportunities for innovative players to work more closely with their customers to meet their changing needs.

With an improving demand outlook, the final piece of the puzzle is that consolidation combined with value accretive capital expenditure over the last cycle has made the industry fundamentally more attractive relative to history. This is one of the reasons that we favour Mondi, a vertically integrated paper and packaging provider and Europe’s largest paper bag manufacturer, which is held in a number of our UK portfolios. Significant investment in processing efficiencies has driven margins higher, whilst lowering its carbon emissions, underpinning its sustainable cost advantage (80% of its operating capacity is in the lower half of the cost curve). UPM-Kymmene Oyj, a Finnish pulp and forestry company held in our European and Global Recovery portfolios, has repositioned into differentiated and higher return on capital segments such as speciality packaging, in addition to investing in a new cost-competitive pulp mill, which will add 50% to their existing capacity. We believe that the market misses – and valuations have not yet reflected – these structural improvements in profitability and returns.

On a longer-term view, we believe demand for wood biomass will grow to replace fossil fuels across a range of processes from energy to petrochemicals. This has created a market for renewable by-products from the pulping process, such as tall oil, providing new revenue streams to the integrated players like Mondi. Our investment in Valmet, a leading supplier of technologies and services for the pulp industry, is directly exposed to the reforestation and commercialisation of the world’s forests required to enable this shift. In our view, the current valuation and expectation set underappreciates the company’s medium-term growth potential.
And last – the cherry on top from a portfolio perspective – is that by virtue of their large well-invested asset bases, the companies with greater vertical integration should well be relative winners if we are to return to a more inflationary environment[10]. This sets the paper &amp; packaging names apart from many of their highly rated ESG peers, which are often longer duration growth assets, evidencing our differentiated approach to finding sustainable investment ideas that can perform in a range of market environments.
At River and Mercantile, we do not think that you have to pay a premium to construct portfolios with positive societal impact. As our paper &amp; packaging holdings have demonstrated, sometimes the oldest and seemingly old-fashioned sectors can successfully innovate to morph from old to new economy investments[11]. It is the combination of this underlying transition with structural tailwinds that can be so powerful for valuation. One of the skills of an active fund manager should be to identify these gradual changes, and invest ahead of a re-rating as these transformations are more widely recognised.
Notes:
[1] Statista
[2] ONS
[3] <a href="https://s2.q4cdn.com/299287126/files/doc_financials/annual/2018-Letter-to-Shareholders.pdf">https://s2.q4cdn.com/299287126/files/doc_financials/annual/2018-Letter-to-Shareholders.pdf</a>
[4] Exane note 14/12/2020 (Source:FEFCO).
[5] <a href="https://materialeconomics.com/publications/sustainable-packaging">https://materialeconomics.com/publications/sustainable-packaging</a>
[6] A carbon sink is where the net balance of carbon emissions is negative, meaning the forest helps to combat climate change. See <a href="https://unece.org/forests/carbon-sinks-and-sequestration">https://unece.org/forests/carbon-sinks-and-sequestration</a> for more information.
[7] European paper supply is not simply sourced by harvesting ancient trees and planting new trees (clearly, this model would be unsustainable). Mondi describes how working forests are managed to create landscapes of varying ages and species: <a href="https://www.mondigroup.com/en/sustainability/approach/working-forests/">https://www.mondigroup.com/en/sustainability/approach/working-forests/</a>
[8] <a href="https://www.cepi.org/wp-content/uploads/2020/06/Cepi-Climate-effects-of-the-forest-based-sector-in-the-EU_Exc-summary.pdf">https://www.cepi.org/wp-content/uploads/2020/06/Cepi-Climate-effects-of-the-forest-based-sector-in-the-EU_Exc-summary.pdf</a>
[9] <a href="https://www.mondigroup.com/en/newsroom/press-release/2020/mondi-and-biohof-replace-plastic-wrapping-with-fully-corrugated-solution-for-fresh-produce/">https://www.mondigroup.com/en/newsroom/press-release/2020/mondi-and-biohof-replace-plastic-wrapping-with-fully-corrugated-solution-for-fresh-produce/</a>
[10] Businesses with well invested capital bases – such as forests which are effectively ‘mines’ that grow, in addition to plant and machinery meaning a large proportion of the cost base is fixed – should perform better in a higher inflation environment. See Equity Investing For Inflation note written by James Sym for a more detailed discussion **link
[11] Incredibly, modern paper machines contain more electronics than a Boeing 747. Source: CPI <a href="https://thecpi.org.uk/library/PDF/Public/Publications/Other/Myths%20and%20the%20Facts.pdf">https://thecpi.org.uk/library/PDF/Public/Publications/Other/Myths%20and%20the%20Facts.pdf</a>

The gift that keeps on giving: the pivotal role of the Paper & Packaging industry in the transition to a circular economy

Our first commentary of 2021 is rather different from a usual monthly fund update. From an investment perspective we remain very positive on the potential for a strong recovery post-covid and have built a portfolio to benefit from this. Here however, we are going to elucidate how the fund is contributing to positive change in the world and why clients – myself, my family and you – can be proud of owning this fund.
This commentary is split into two parts. The first is a brief description of how we are satisfying our mandate to build a portfolio that not only is generating investment performance, but that clients – particularly the end clients whose capital it is – can be very proud of owning, because they are contributing to a better world.
By way of three examples, the second section is a practical demonstration of the specific contribution that clients’ capital – through the companies they own – is making to society. If this practical demonstration is of the greatest interest, then readers should skip the first section.
<h4>Section 1: incorporating ESG</h4>
When we launched the fund a key aim, which I believe is increasingly important to the end client, was to bring to life the impact that the companies we invest in have on society. In a world of ESG jargon and accusations of industry greenwashing, we are keen to take a back to basics but innovative approach to incorporating sustainable investing into our process. In fact, with a blank sheet of paper we can define the fund’s terms and so we have defined a clear mandate: alongside our quest for investment returns, we are only interested in investing in companies which have a positive impact on society.
The word alongside is very important. We are not neglecting any of the fundamental parts of our process such as a desire for strong management, a robust franchise, or valuation discipline. In fact our ethical considerations enhance those investment pillars. We also take a holistic view and consider direction of travel to be important. In practice, our ability to build the right portfolio for any given point in the cycle, composed of robust bottom up investment cases is and remains unconstrained and even improved. Through engagement and deployment of capital we in turn have a positive impact on wider society.
Within the PVT team, we have developed a robust framework where we assess each company’s activity and behavioural impact on wider society through three pillars which are People, Innovation and Environment. The process covers the business model, the corporate behaviour, ESG risks and controversies, governance and where appropriate, engagement and is summarised below.

One question we are asked, is “what does a positive impact actually mean?”
In reality, every company has both positive and negative externalities to both their fundamental business model and corporate behaviour. For example, at a very high level they will employ people and by aiming to increase profitability sustainably should contribute to productivity and economic growth, but their business activities probably emit carbon, or they may sell a product which can do harm to their customers. These negative externalities are rarely acknowledged in ESG commentary, which too often focusses on ‘ticking the boxes’ and this lacks credibility. For us it is the balance of these positive and negative impacts which is important and we are looking for the net effect to be one which is making the world a better place. This is an additional vector to more traditional ESG considerations which are also of course important and incorporated in our process.

<h4>Section 2: the positive impact of the fund</h4>

Figure 2 above shows all 17 of the UN’s sustainable development goals. In this note I intend to reveal three examples of the positive impact our companies are making with reference to these goals.

<h4>Example 1: Volkswagen</h4>
Ever the contrarians we will start with a controversial one! The interplay between a positive and negative contribution – and how both need to be acknowledged – is clearly seen in our holding of VW which we believe has a strong claim that it is making a positive contribution, in contrast to the consensus view.
We are all aware of a significant controversy involving VW – namely the “dieselgate” scandal. Indeed some third party ESG analysts give VW their lowest possible score on the back of the scandal, and the stock market capitalisation is one eighth of Tesla which is a reflection of the low rating the earnings attract. It is right to acknowledge this extremely poor corporate behaviour.
However on a holistic basis - considering all the positive and negative impacts of VW on society - I strongly disagree with the above assessment. Whilst appalling corporate behaviour, the scandal gave impetus to direct VW’s R&amp;D program (the third largest R&amp;D spend in the world behind Amazon and Google) firmly at transitioning to electric vehicles (EVs). They are the only European Original Equipment Manufacturer (OEM) with the scale and innovation to have a fully dedicated Electric Vehicle (EV) platform – the MEB platform for their ID series of cars – at a cost of about €30bn. As a consequence, by 2023 VW will be selling almost as many electric cars as Tesla, but at fraction of the valuation, and with a very large and profitable traditional auto business too!

<h4>Example 2: NKT</h4>
Next we discuss the theme of renewable energy and the conundrum of valuation bubbles.
There is no doubt that pure-play, well known ‘energy transition’ stocks are highly valued – time will tell whether the companies are able to grow into these multiples – my somewhat unhelpful prediction is that some will, and many won’t! However, off the beaten track in Europe there are still lots of opportunities which are less well discovered (‘twas ever thus). We can happily invest in these without having to risk the valuation bubbles bursting. Indeed, this is a key exposure for the fund as energy transition will be a dominant investment theme for this upcoming business cycle. By owning this fund your clients’ capital is helping to contribute to that energy transition which is something to be proud of.
How do we gain exposure to these themes without the bubbles? Consider an off-shore wind farm – the growth of which is going to be very significant. The pre-eminent operator of these is the Danish company Ørsted which is a fantastic business with a fantastic management team. We are clearly not the only ones to think so though, with the share price up 431% since IPO and the valuation is much too high for our tastes. Even more fundamentally there is trouble brewing: almost every European oil and gas company is trying to muscle in on their market. Competition is just about to get a lot tougher…
But the growth in offshore wind is very real. Maybe we could gain exposure via the wind turbine manufactures or OEMs? Siemens Gamesa has the highest exposure to offshore turbines of these OEMs: making wind turbines is all it does. Long seen as a bit of a disaster investment given its huge cyclicality and habit of profit warning, the company has rerated to a cool 101x price-to-earnings from its usual 15-20x. This is borderline bubble stuff.
But digging a little deeper we find the cable companies – who connect up these offshore windfarms using high voltage cables – to be much more interesting investment cases. Because they have other strings to their bows than just offshore windfarms, such as grid infrastructure and industrial production (the outlook for both being attractive) we can access the long-term theme of energy transition without paying excessive premia. Time and again in our investment universe these ‘second line’ opportunities present themselves.
After an ill-advised acquisition in 2017, the cable company NKT is a recovery phase investment of ours which we bought at fund launch to take part in the recent recapitalisation.  It has been a successful investment since. To connect an offshore wind farm High Voltage DC cable is required, which is a very technical product dominated by three (European) companies with consequently very good margins, and an amazing growth outlook. By supporting the rights issue of NKT not only have we made money, we have strengthened the balance sheet and funded a capacity increase for the business.  This will allow them to support the accelerated roll out of offshore wind – a positive contribution indeed and again, an investment of which to be proud!

<h4>Example 3: Novo Nordisk</h4>
Innovation is the lifeblood of a sustainable business – in fact it is one of the key pillars of our Sustainable PVT framework for analysing the ESG impacts of our investee companies. All else equal, good innovation is a win-win for society and the company doing the innovating.
The final example is a more traditional example of a company with strong sustainability credentials. In our portfolio Novo Nordisk is a great example of a highly innovative company. The company invests heavily in R&amp;D, which is borne out in its consistent track record of new and improving products for their customers which have transformed, and continue.to transform millions of lives. Despite this heavy investment, it is the highest return business we own. This Danish diabetes drug company is the only business I have come across whose goal is to do itself out of a market – to “defeat diabetes” – a disease which kills twice the number of people per year that Covid has to date (at the time of writing). Why then do we invest in the company? And why can your clients be proud of owning it?
Apart from the transformational impact their R&amp;D has on the millions of diabetes sufferers worldwide, their new generation of drugs, so called GLPs, have the ability to be used in a far wider suite of applications than just the direct treatment of diabetes. Without their wonderful culture of innovation, these are applications and drugs which may not have been developed. The most notable of these is the biggest underlying killer in the developed world – not heart disease or cancer – but obesity. As they continue to build a franchise addressing this issue, the world will become a healthier, happier place for it. It is this opportunity to build another Novo Nordisk franchise in a different end market which makes for an interesting fundamental investment too.
These are but three examples. Clients should know that across the portfolio, every day, their investee European companies go to work to generate returns for them, and at the same time improve society as a whole. And in a world that for a long time never had so many different global societal challenges, that is something to celebrate. We will return to this topic again.

European equities: Contributing to a better world

The investment environment across asset classes, and certainly within equities, over the last couple of years has been accurately described by a leading strategist as dominated by “T-zero investing”*. By this, he means that decision-making often appears to have been driven by what is happening at just that moment – be it a tweet or any other announcement or news release – rather than by ‘zooming out’ to take the longer-term perspective, looking back to the past to gain perspective as well as casting into the future. This T-zero world has brought some challenges for investors who, like us, believe that the greatest pricing inefficiencies are often found where the perception of a company’s fundamentals and prospects today are markedly different from how they have been viewed in the past and may be viewed in the future.
Let me explain a little more. One of the key deficiencies of human nature of which we seek to repeatedly take advantage is ‘recency bias’, which shows itself in over-extrapolation of the most recent pieces of information. Stocks which are viewed as ‘dish of the day’ today can very quickly find themselves off the menu if the ‘trend’ underpinning investors’ willingness to pay higher prices turns out to have been either a fad or at the peak of a cycle. In the last decade or so, I can think off the top of my head of West African iron ore miners, shale gas and Research in Motion (RIM, later Blackberry), as three examples of this but there are clearly many more.
Instead, within the ES R&amp;M UK Dynamic Equity Fund, I’m trying to find potential holdings where the quality of the business – typically its competitive advantages or the irreplaceable nature of its asset base – is not obvious to the average investor today, meaning it isn’t the most popular dish on the menu today, but can become so in the future. In our experience, some reasons that franchise quality is temporarily hidden from the mainstream are typically (but not limited to) because the company:
<ul>
	<li>has cyclical earnings and its end markets are at a low point in that cycle;</li>
	<li>is investing (or has recently invested) significant costs to grow a future revenue stream, obscuring attractive margins at maturity;</li>
	<li>has experienced a hiatus in growth as some parts of the business reach maturity so grow more slowly, while faster-growing parts have not yet reached 'critical mass';</li>
	<li>has experienced operational issues, which may be the result of production bottlenecks or integrating an acquisition;</li>
	<li>is perceived to face competitive (e.g. a new entrant) or regulatory threats;</li>
	<li>has a small market cap, so is off the radar of some investors, or may be considered riskier.</li>
</ul>
Evidently, during our analysis we need to assess whether these issues are structural (more permanent); but where we consider these conditions to be temporary in nature, or their risk to be overstated, we will often also find a low valuation which puts the probabilities of better outcomes – i.e. that growth re-accelerates, or margins improve, or investors start looking at smaller companies again – in our favour. Note that these opportunities exist across the company life cycle (Growth, Quality, Recovery and Asset-backed).

A good example in the portfolio is Tyman, an engineered window and door components manufacturer selling most notably into the US residential market. Cyclical end markets and some operational issues had conspired to hide the true quality of a franchise that was still making a 17% return on capital in 2019, despite not firing on all cylinders. Layering on the fact its market cap was below £500 million, we were able to buy shares near enough 5x the free cash flow that they had proven they could deliver and with consensus forecasts which implied a significant slowdown in the housing markets, in contrast to the trends the company was experiencing.
Opportunities today for investors who are prepared to fish in less crowded pools are as rich as they have been in a long time. There are few less crowded waters in financial markets than UK equities today, but in contrast to our fishermen and women we welcome international investors to come and fish in our sea!
*T+ is broadly explained as a dealing terminology used to denote the time at which a purchase or sale will take place in relation to the day in which the trade is done. For example, a trade placed on a Monday where the transaction is concluded on a Wednesday will be T+2.

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