Previously I’ve explained our reasons for optimism about the health of the UK economy (click <a href="https://river.global/news-insights/the-case-for-the-uk-in-3-arguments-part-1" target="_blank" rel="noopener">here</a>) and consumer (click <a href="https://river.global/news-insights/the-case-for-the-uk-in-3-arguments-part-2" target="_blank" rel="noopener">here</a>).  Finally, I take a look at the political landscape and what this could mean for a UK recovery.
&nbsp;
The UK’s political backdrop is boring… great!
2024 is being called a record year for elections around the world.  For once, pleasingly, the UK’s general election appears unlikely to have investors on the edge of their seats.  An expected victory for a Labour party led by Sir Keir Starmer will likely be welcomed if it is seen to herald a prolonged period of dull governance. 
The Shadow Chancellor, Rachel Reeves, has seemingly had breakfast with every FTSE CEO over the past year and has been at pains to emphasise the party’s rediscovered zeal for business.  While a Conservative victory appears unlikely, a Sunak-led government is by this stage a very much known quantity with Jeremy Hunt viewed as a safe pair of hands at the Treasury.
&nbsp;
All quiet on the northern front  
North of the border, the SNP has endured its very own annus horribilis.  Nicola Sturgeon’s fall from grace during 2023 was spectacular, although it does highlight the depressingly small-time nature of Scottish politics that one of the key factors was the purchase of a £110k campervan.  Her successor as party leader, Humza Yousuf, has already acquired the unfortunate epithet ‘Useless’ and appears unable to generate the same level of personal support.  However, the question of Scottish independence is firmly on the political backburner.
&nbsp;
Normalisation of UK politics
Whilst Brexit still continues to generate headlines and has helped portray the UK as a country divided, it is far more cohesive than is given credit for. In fact, unlike Europe, where parties on the radical right such as Germany’s AfD and Italy’s Lega Nord have gained ground in recent years, the mainstream parties continue to dominate UK politics.  And in the US, whose Presidential Election does represent one of the year’s biggest risk factors, partisan polarisation has gone far beyond anything seen in the UK.
&nbsp;
What is all this telling us?
A duller political environment will not in itself direct more investment towards the UK, but an end to the instability and chaos of recent years removes a barrier.  It helps investors refocus on the strengths of the UK such as its depth of expertise in areas like finance, law, and life sciences. 
If this can be combined with some sensible government reforms to capital markets legislation, then the whole UK equity market should benefit.  In particular, though, we’d expect domestic-exposed stocks to appreciate the most.  These are the companies who have seen their equity impacted most by investor antipathy towards the UK.
For more information about the fund and how the fund is positioned, please visit our fund centre below:

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If you missed my previous arguments as to why I’m optimistic about the UK, you can click <a href="https://river.global/news-insights/the-case-for-the-uk-in-3-arguments-part-1/" target="_blank" rel="noopener">here</a> to read my first argument, and click <a href="https://river.global/news-insights/the-case-for-the-uk-in-3-arguments-part-2/" target="_blank" rel="noopener">here</a> to read my second argument.

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The case for the UK in 3 arguments. Part 3

Article

Read the original article posted on SVM <a href="https://www.svmonline.co.uk/InvestmentProfessional/The-Value-Key/Posts/Read/5503/Question_everything/">here</a>
&nbsp;
We have made no material changes to the portfolio since Q1 2023. Here we explain the reasons behind the recent disposal of Barclays and 3M and the purchase of Caterpillar and Banorte. Our stance is to ‘question everything’ and constantly re-appraise each investment to ensure it is heading in the direction we expect. Typically, we are not phased by interim results, but if a business persistently surprises, we re-appraise our assumptions and investment expectations. Furthermore, we are always trying to improve both the quality and valuation potential of the portfolio. Having a deep bench of substitutes keeps the bar high. When we find better options, we act.
&nbsp;
Barclays – We sold the shares for modest capital gain. The investment case was that this was a very lowly rated bank at a 50% discount to tangible book value. We felt the share price had been impacted by ongoing corporate governance incidents and management turnover. While we have no enthusiasm for investing in investment banking, we felt this had turned a corner, while the traditional banking and credit card businesses were well placed.
&nbsp;
While Barclays continued to take share in investment banking, it remained far from being a top 3 player. There continued to be mishaps, the last being the £450m hit from bond over-issuance. Following a meeting with the business and an appraisal of H2 results, we felt that there was still a lack of focus. This included a limited appetite to significantly shrink the investment bank (over 60% of Risk Weighted Assets), the expensive acquisition of a UK buy-to-let mortgage lender and unambitious cost to income targets. We prefer industry leaders and we could not see how Barclays could ever reach this position. Cheap, but more likely a value trap.
&nbsp;
Grupo Financiero Banorte – Despite selling Barclays, we remain confident that, for banks in general, the next ten years look better than the last ten years. We also believe that the market generally overvalues poor quality banks, even on low multiples, but equally undervalues good quality banks. Good quality banks with opportunities to grow can be especially valuable.
&nbsp;
It was for this reason that we replaced Barclays with Banorte, one of the largest companies in Mexico. Our research showed Grupo Financiero Banorte to be a quality bank. It has a record of conservative lending, a best-in-class cost to income ratio in the thirties and a straightforward strategy. It also operates in a market with a proactive regulator and promising growth. Banorte has risen from a minor regional player to number 2 or 3 depending on the measure and is arguably the national champion being the only large bank without majority foreign ownership. Mexico is emerging as a top destination for foreign direct investment, and this will gradually spill over into demand for financial products. Banorte has grown lending at high single digit to low double-digit rates but has always shown control over risk, and still has additional capital buffers from the pandemic. The announced withdrawal of Citigroup from the Mexican market has been protracted and chaotic and looks set to provide ongoing market share to the others.
&nbsp;
Banorte's recent results were positive and it both upgraded its guidance and proposed an extraordinary dividend, with plenty of capital leftover. Its return on equity is around 20%. Leading banks in India can be found at 18x earnings whereas Banorte is on 8x, the kind of number you would expect for a much lower growth developed market equivalent. Its dividend yield is high single digits and we have added it as a new bank holding, with a cleaner record and superior overall characteristics compared to Barclays.
&nbsp;
Caterpillar – Over the past year we have been looking for companies that will benefit from capex driven by infrastructure spending, automation and new regulations. Caterpillar, the global leading manufacturer of construction and mining equipment is a great example.
&nbsp;
There are three reasons we were attracted to Caterpillar. The first, lower cyclicality. Through heavy investment into its offering, service sales are expected have grown from 26% of machine sales in 2016 to just under 40% today. Service sales tend to be recurring and higher margin and Caterpillar has 1.4m connected vehicles where it can track usage, service needs and faults. As a result, the company is targeting adjusted operating margins that are 3-6% better over the cycle vs. the period 2010-2016. Demand in mining, infrastructure and non-residential construction looks set to remain a tailwind, as the age of the existing fleet of machinery is elevated.
&nbsp;
Secondly, automation. Although still a nascent market, Caterpillar was an early leader in developing autonomous machines. With pressure on labour productivity, this could grow from 10% to 50% of addressable vehicles over the next 5-10 years. As seen with John Deere, one of our other industrial holdings, over the longer term this can result in strong pricing power and increased customer loyalty.
&nbsp;
Finally, electrification. The issues of weight and grid connection mean the first commercial electric trucks will not come to the market until after 2027. However, in the construction market Caterpillar has already made inroads and launched multiple vehicles, especially for urban areas. There is increased demand from customers who want to reduce their emissions and crack down on air pollution.
&nbsp;
We believe Caterpillar is experiencing an elongated cycle. However, the market has valued the shares as if we will see a severe recession soon, i.e. at 13x 2024 PE. We would still expect any recession to be short and shallow. But even then, Caterpillar should weather this well due to the increased margin profile and a still healthy order book. The market will also start to look through to the strong balance sheet (net debt/EBITDA of only 0.1x), improving return on invested capital (around 14%) and growing track record of dividends (Caterpillar just had its 29th year as dividend aristocrat and offers a dividend yield of 2%). We used this disparity between short-term concerns and long-term opportunities to initiate a new holding.
&nbsp;
3M – We financed the purchase of Caterpillar by exiting our holding in 3M. Although the shares are attractively valued, and recent results appeared positive at a headline level, we have become concerned about the complexity and state of the business. Some of the PFAS claims were recently settled, but this is still only the start of many outstanding legal processes, which will continue to take up management time. We also saw difficulties with large IT projects, a lack of innovation breakthroughs and executive turnover as affecting performance. The proposed spin-off of the healthcare business creates further risk to disrupting R&amp;D, and along with more cost cutting made us feel that while 3M remains an impressive company, the next ten years are less likely to be as good as the last ten years. We saw a better risk / return profile in Caterpillar and switched our holding.

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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Question everything!

The pound tumbles, inflation surges and the Ukraine war persists. Whilst attempting to navigate such challenging markets, it is vital that investors do not succumb to the “danger that environment falls down the agenda” (Nicolai Tangen, Head of Norway’s $1.2tn oil fund[1]) and continue to note the importance of considering ESG (environment, social and governance) factors in the investment decision making process.
One of the fundamental reasons why investors consider ESG factors in investment analysis is that material ESG factors have an impact on a company’s bottom line. This has been highlighted by many researchers who have shown that ESG integration can lead to reduced costs and increased efficiencies[2]. With current market turbulence resulting in increased cost pressures on companies’ financials, considering material ESG factors allows investors to identify high-risk companies that will be less resilient to shocks. Additionally, the ‘G’ aspect of ESG is critical in a crisis as businesses with good corporate governance and high-quality management have more chance of navigating external shocks due to effective decision-making.
Reputational and regulatory risks experienced by companies are heightened during a downturn, particularly when they do not consider their ESG credentials. During challenging times, corporates tend to be observed with heightened scrutiny by investors, regulators and governments alike. For example, material controversies such as health and safety under the ‘S’ pillar can have serious consequences for stakeholders’ perception of the company with ramifications exacerbated under watchful eyes. Additionally, governments have started to issue regulations to mandate companies’ climate transition and the financial consequences of not abiding by these will only create more pressures. On the other side, government financial incentivisation aligned to the climate transition, such as tax incentives indicated in the figure below, can still provide opportunities for companies to manage and enable the transition.

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Should ESG fall down investors’ agendas during a downturn they risk missing investment opportunities in sustainability enablers that benefit from continued CAPEX spend during this period. Stocks such as NKT (pioneer in the cable industry) which is beneficiary to the offshore wind boom to secure energy supplies following the Russian-Ukraine war[4] or Metso Outotec and Weir which are providing decarbonisation solutions for the mining industry, continue to be ESG winners and present strong investment opportunities. Portfolio manager William Lough will expand on this point in an upcoming thought piece.
Sustainability presents long-term risks and opportunities, such as the net zero by 2050 trajectory which represents a transition over more than 25 years. Considering the ESG credentials of our companies and portfolios must prevail as we experience market peaks and troughs during these medium to long-term transitions. Additionally, we believe consistently considering the ESG factors financially material to individual companies is in line with our fiduciary duties as investors by continuing to generate attractive risk-adjusted returns for clients and have a longer-term positive impact on environment and society.
It is therefore our duty as investors not to forget about ESG during times of economic and geopolitical deterioration as it presents an important tool to help identify investment risks and opportunities.<a href="https://river.global/why-investors-should-not-forget-about-esg-during-a-downturn/#_ftnref1" name="_ftn1"></a>
&nbsp;
[1] <a href="https://www.ft.com/content/f0067d64-dcf2-47b4-a19b-a6b6debd16c5" target="_blank" rel="noopener">Norway oil fund warns of ‘danger’ that environment falls down agenda | Financial Times (ft.com)</a>
[2] For example: ‘Sustainable Investing: Establishing Long-Term Value’, Fultun, Kahn and Sharples <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2222740%20" target="_blank" rel="noopener">https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2222740</a>
[3] <a href="https://www.c2es.org/content/cap-and-trade-basics/" target="_blank" rel="noopener">Cap and Trade Basics - Center for Climate and Energy SolutionsCenter for Climate and Energy Solutions (c2es.org)</a>
[4] <a href="https://www.cityam.com/offshore-wind-primed-to-benefit-from-investment-boom-and-energy-transition/" target="_blank" rel="noopener">Offshore wind primed to benefit from investment boom and energy transition (cityam.com)</a>

Why investors should not forget about ESG during a downturn

In this Masterclass three experts discuss how they integrate ESG and sustainability into their global portfolios, how they use engagement and how they encourage better governance. Taking part are:
<ul>
	<li>Michael Paul, Head of Fund Research, Brewin Dolphin</li>
	<li>William Lough, Manager of R&amp;M's Global Sustainable Opportunities strategy</li>
	<li>Saurabh Sharma, Fund Manager, Regnan Water and Waste Fund</li>
</ul>
Learning Outcomes:
<ol>
	<li>The difference between thematic and sector-based investing</li>
	<li>How the energy crisis has re-invigorated the ESG debate</li>
	<li>Finding alpha opportunities for ESG portfolios</li>
</ol>
Please note that this video is hosted by AssetTV and requires you to sign in via LinkedIn or AssetTV directly.

Asset TV Fund Selector Masterclass | Equities & ESG with Brewin Dolphin

Video

This is a different sort of ESG paper.
We have reflected deeply and philosophically on the current sustainable investing phenomenon and find it enormously unsatisfactory. Excluding companies with low scores from third-party ESG[1] rating agencies, or conversely investing in those that screen well on a particular metric such as low emissions, makes limited practical difference to the amount of greenhouse gas emitted. As we (the industry) sit in our steel and cement buildings, all the while refusing to invest in those sectors, we are starving these industries of the very capital they need to reduce overall CO2 emissions. We therefore (counterintuitively) believe sustainability represents the greatest contrarian investment opportunity of our careers.
What then? If we are to hit our climate targets, we unequivocally need to decarbonise the polluting sectors, rather than just avoiding the issue by only investing in companies which happen to be low carbon by virtue of their business model. The capital investment required to decarbonize the world, address water needs and shore up transportation and other critical systems is $6 trillion per annum to 2030[2].
Spending on renewable energy has been taking place for decades and as interest in all things ESG has increased significantly over the past few years, some of the more high-profile companies have seen their stock market valuations soar. As valuation conscious, contrarian investors, we look at some of the well-known ESG darling stocks with amazement. Yet in dozens of other sectors and industries these changes are just about to start. This is our broad investment opportunity to make the returns we want for our clients, and the investment that is going to allow society to hit our climate targets.
Put another way, is it better to invest in a company with a low carbon footprint because it is capital light, or does it do more actual good, for example, to invest in a steel company with the technology to halve the carbon intensity of its products? As an industry we’ve tried the former and it has undoubtably failed to produce the reduction in carbon emissions we so desperately need to achieve, as we discuss later.
We are absolutely focussed on changing this, for the good of society and for the good of our clients’ investment returns. This opens up a huge number of unloved areas of the market, which are likely to experience a better cycle than they have over the last decade. Our approach results in a happy confluence of having a positive impact on the world and operating in line with our contrarian, pragmatic philosophy; exposing our investment strategies to re-rating potential.
By investing in companies undergoing positive change, (in line with our sustainability and investment philosophy) we will have more real-world impact and build contrarian, valuation-disciplined portfolios, in stark contrast to the plethora of consensual, ‘ESG good’, growth funds in the market today.<a href="https://river.global/seeing-the-wood-for-the-trees/#_ftnref1" name="_ftn1"></a>
<a href="https://media.river.global/2022/06/Seeing-the-wood-for-the-trees-a-different-approach-to-sustainable-investing_STRATEGY.pdf" target="_blank" rel="noopener">Click HERE to read the paper in full.</a>
&nbsp;
[1] ESG stands for Environment, Social and Governance. The term ESG was first coined in 2005 in a landmark study entitled “Who Cares Wins” by the UN.
[2] Singer et al. (2021). “Green Capex: Making Infrastructure Happen”. Goldman Sachs.

Our distinct investment philosophy and process for our UK, global and European equity strategies places sustainability at its heart



Sustainable Investing

Seeing the wood for the trees

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

R&amp;M's Head of ESG explains how the business is turning talk into action following its commitment to achieve net zero carbon emissions.
In recent years, significant carbon reduction undertakings have been made, and it will be interesting to see the solutions that start to emerge on how to actually achieve these hypothetical cuts to greenhouse gases by the middle of this century.  This is even more significant when we consider there is almost 60bn tonnes of carbon emitted into the atmosphere worldwide per annum[1], an amount that has been steadily rising since 1990 with increasingly visible physical effects of climate change[2.
It seems therefore apposite at the moment to give a brief overview of the journey to Net Zero covering three areas:  Understanding emissions, Stages to Net Zero, and what we are doing as a firm.
<h4>Understanding emissions</h4>
Understanding emissions “Scopes”, as defined by the Greenhouse Gas (GHG) Protocol, is an essential first step.
The GHG protocol sets the standards &amp; principles for measuring and managing carbon emissions and has divided all emissions from businesses into operational boundaries, defined as Scopes 1, 2 &amp; 3 as outlined in Figure one.

As a financial firm, for R&amp;M, with three office locations, minimal purchase of power and no physical distribution of products, our own Scope 1 &amp; 2 emissions are comparatively small, at 369 tonnes for the last financial year. That said, Scope 3 indirect emissions include 15 areas of activity that depend on an organisation and for us are by far the most material (80%+) and important to report. For a fund manager, Scope 3 is the Scope 1 and 2 emissions from the companies in which we invest. Some studies have shown that these financed emissions from investee activities can be up to 1,000 times bigger than the investor’s own.
<h4>R&amp;M stages to net zero</h4>
We should remember it’s net zero, not gross zero. There will still be emissions and the R&amp;M solution is all about identifying and managing them. Adding the word ‘to’ in the middle of ‘net’ and ‘zero’ helps clarify the objective.  Our solution has three distinct stages:
Data. We need our investees’ emissions data i.e. the Scope 3 detail. The GHG Protocol sets the standards to measure and manage emissions. The Partnership for Carbon Accounting Financials (PCAF) has launched a global standard for measuring  and reporting GHG emissions associated with loans and investments, which provides detailed instructions for listed equity and fixed income.
Based on ‘follow the emissions’, with a scale for quality of inputs from those that are independently verified by CDP[3] to estimates by the emitting firm itself and phasing in Scope 3, PCAF provides valuable guidance for carbon accounting. Our proportional ownership share of a given company is multiplied by its emissions, and this is the quantity of emissions we are responsible for.
Reduction. This is where we engage and collaborate with investees to lower emissions and to disclose. Important here is the idea of ‘net gain’. If a real estate investor is planting 100 trees that each absorb 20 tonnes of carbon, engagement for planting 100 trees is of limited value as this was going to happen anyway; engagement to encourage an extra 100 trees to be planted, providing saplings, explaining the carbon capture properties of roots, soil etc. is much more valuable and provides a gain.
Offset. Just like R&amp;M is carbon neutral, investees offsetting emissions is required. There can be no net zero without carbon sequestration, and this can be natural (trees, oceans, peat bogs) or mechanical (sucking the carbon out of the air as it’s emitted and storing underground). We are seeing a wide range of offsets emerging for purchase, covering both types and with varying ‘credit quality’. Internal offsetting is also permitted within the same fund, so an asset that emits 100t can be offset by another asset that absorbs 100t.
<h4>What we are doing at River and Mercantile</h4>
At River and Mercantile, we are turning talk into action for the areas outlined. Our net zero focus for the rest of this year and into 2022 is:
<ul>
	<li style="list-style-type: none;">
<ul>
	<li>Evolving the business model for net zero (governance, data and reporting)</li>
	<li>Engaging key stakeholders</li>
	<li>Embedding our exclusions (in particular coal) and climate policies: <a href="https://river.global/responsible-investment/">learn more</a></li>
	<li>Identifying the initial funds and mandates in scope for emissions reduction by 2030. And then for these funds, setting the baseline emissions (as at Dec 2019), followed by top-level tilts towards or away from certain sectors, bottom-up understanding of an investee’s emissions pathway, ongoing engagement with investees and monitoring their emissions reductions and offsets.</li>
</ul>
</li>
</ul>
&nbsp;
[1] Source UN Environmental Program and Intergovernmental Panel on Climate Change (UNEP), 2019,
[2] Source IPCC, 2013.
[3] Previously the Carbon Disclosure Project

Netting to zero

River and Mercantile Investments Limited and River and Mercantile Asset Management LLP have both been accepted by the Financial Reporting Council (FRC) among its first set of signatories to the UK Stewardship Code 2020, published today.
The UK Stewardship Code 2020 replaces the Stewardship Code 2012 in setting out best practice principles on stewardship for asset managers and asset owners. It requires signatories to go substantially beyond the legal and regulatory minimum, setting out twelve “apply and explain” principles.

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Done properly, successful stewardship and engagement can be a source of investment alpha and achieve net environmental, societal or governance benefits by encouraging companies to make positive changes.

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We recognise the trust our clients place in us and the importance of our responsibility as stewards of our clients' assets. The UK Stewardship Code 2020 raises the bar for stewardship across the UK investment industry, and therefore we are delighted that our approach and the actions we are taking on behalf of our clients has been recognised by the FRC.
For more details, our annual reports detailing our approach to voting and stewardship can be accessed by the link below.

R&M amongst first set of signatories to FRC UK Stewardship Code

One of the key parts of our investment process is that as well as trying to work out how undervalued a company’s share price might be, we also seek to identify why this mispricing might be occurring. In other words, we ask “what is the market missing?”
Identifying what the market is missing allows us to see the path to how the value gap might close, and therefore be more efficient by focusing analysis on the issues that really matter. Further, by categorising our investment targets by their stage in the company lifecycle (Growth, Quality, Recovery or Asset-backed), we have a head start as the key reason for mispricing within each category will typically have a common thread. So, within Growth or Quality, the market is likely to be mispricing the sustainability of growth and/or return on capital, in Recovery it’s probably missing the extent to which profits can return to prior levels. The trick to build conviction is to keep ‘burrowing down a level’ to understand the company-specific thing or things relating to this on which we can take a differentiated view. I touched on a few of these things in a prior post.
One item we have in our analytical or ‘burrowing’ toolbox is our consideration of sustainability, or ESG[1]. As my colleague James Sym recently discussed[2], “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. Some managers’ approach to ESG is to screen out companies early on based on their business activities, sector or 3rd party ESG rating[3]. Instead of this, as part of our fundamental analysis of each potential investment, we assign it to one of our own four sustainability tiers shown below.

When considering the benefits of integrating sustainability credentials as part of our fundamental analysis, something of particular interest is how noticeable it is that large gains can be made – sometimes rapidly – from stocks within the S3 tier. This happens when we can identify companies where improvements to the sub-par element(s) of ESG, potentially accelerated by targeted engagement from ourselves and other investors, are not yet being recognised by 3rd party ESG rating providers. The rating providers can be slow to react to the positive change taking place, or place undue emphasis on a single issue, leading to a rating which reflects past ‘sins’ rather than the path that the company is on today. There are a couple of likely reasons why this creates opportunity via a mismatch between buyers and sellers. Some investors may have screened the company out as a matter of process due to their low ratings, so as the rating eventually increases to reflect improvement the shares become ‘investable’ again for a wider set of investors. Alongside this more practical reason, behavioural factors which are more aligned with the traditional rationale for why the value factor has delivered positive alpha over the long term can play a role. Investors may have overestimated the scale of the issues or might not want to be seen to hold a ‘difficult’ stock from an ESG perspective. In this sense, we can therefore consider ESG as one of our potential reasons why a mispricing might occur.
On top of this, we’ve observed that these gains can be turbo-charged if the underlying business is revealed to have attractive sustainability characteristics (beyond the issue identified by ratings providers). To use some examples from our global portfolios, Chinese technology company Baidu and Korean auto parts provider Hyundai Mobis have risen ~200% and ~50% since their ESG ratings were upgraded by MSCI, in May and October 2020 respectively, from the lowest-possible CCC (Baidu has risen ~140% since last September alone, when it was upgraded another notch). In both cases, we had identified improvements being made in key areas of corporate governance which were dragging down the external perception of the companies, while the businesses themselves scored well under our framework regarding most areas of People, Innovation and Environment – particularly the latter two. Tying back to the Howard Marks quotation at the start, a perception of ‘weak ESG’ relating to a single (albeit important) issue had effectively caused investors to underestimate (and therefore misprice) the other strengths.

Recent share price performance has been supported by the realisation that both companies are well positioned to benefit from the growth in electric vehicle (EV) usage and autonomous driving growth. Baidu has formed a joint venture with Chinese auto manufacturer Geely to monetise its leading technology IP in the space, alongside existing monetisation opportunities around their Apollo system for intelligent driving and smart transportation (autonomous / connected vehicles). Hyundai Mobis, meanwhile, has the potential to gain share outside their ‘captive’ market of the Korean auto manufacturers due to strong product positioning in power modules (inverters and traction motors), onboard charging units and the assembly of the battery system. Like Baidu, they also have strong IP in autonomous driving / connected vehicles, so should benefit from long-term structural growth here.[4]
Other holdings, such as Japanese logistics and auto parts company Toyota Industries, continue to be overly penalised (in our view) for elements within the pillars of sustainability which are below best practice but improving. Its current B rating from MSCI (one level above the lowest) doesn’t account for improvements to board structure. We think this could be a reason investors are missing the opportunity to buy the market leader in electrified forklifts (including leading fuel-cell technology) and warehouse automation software for barely more than the value of the company’s net cash and investments.[5]
In Ernest Hemingway’s novel ‘The Sun Also Rises’, a character called Mike is asked how he went bankrupt. “Two ways,” he answers. “Gradually, then suddenly.” We think we’re witnessing the reverse in companies with strong underlying ESG characteristics, where a rectifiable issue is currently clouding the market’s view, often through the lens of a poor ESG research provider rating. By doing our own research and forming our own judgements, allocating our S-PVT tier and identifying the areas for and path to improvement, we can build confidence that we’ve unearthed a genuine mispricing. If these clouds dissipate in the way we expect, we’ve seen from the Baidu and Hyundai Mobis examples that share prices can rise gradually, then suddenly.
[1] I will use the two terms interchangeably in this note.
[2] https://river.global/european-equities-monthly-update-contributing-to-a-better-world/
[3] As with the bond rating agencies S&amp;P and Moody’s, there are now ESG ratings agencies such as MSCI and Sustainalytics.
[4] An interesting note is that the level of innovation at Hyundai Mobis is marked down by MSCI but we believe they aren’t comparing “apples with apples” – they compare R&amp;D as a % of group sales versus peers, however this unfairly penalises Mobis, which has some 25% of sales from high margin after-sale servicing. This is an attractive, niche feature (typically the car manufacturer takes the servicing revenues) which is not capital intensive in the form of requiring high upfront R&amp;D.
[5] In addition, like Hyundai Mobis, growth in EVs will allow Toyota Industries to expand share beyond their current ‘captive’ customers (the Toyota Motor Corp parent company) due to market leadership in electric compressors which previously had the sole use of air conditioning, but are now required in a much greater scale to cool batteries.

Gradually, then suddenly

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River and Mercantile (R&amp;M) has announced a series of further Infrastructure hires from Aviva to support the recent recruitment of Ian Berry, former Head of Infrastructure Equity at Aviva Investors. Ian joined R&amp;M to establish an infrastructure investment business which over time will launch a range of infrastructure strategies.
The team joining R&amp;M comprises Allan Vlah, Fergus Helliwell, Anne Sophie Eveno and Dan Wilcockson. It is expected that they will start over the coming months after they complete their contractual obligations with Aviva.
The first infrastructure investment initiative at R&amp;M will be the launch of an Infrastructure Equity Income Fund which will focus on delivering long term, stable cash flows to institutional clients through investing in long-life infrastructure. The sustainability of returns to investors and the asset-level environmental, social and governance (ESG) factors have always played a key role in Ian’s investment philosophy and processes and will sit at the very heart of this investment strategy. This focus on the sustainability of income for clients is entirely aligned with the significant demands for new infrastructure to support the energy and digital transition required by the economy.  The investment strategy allows institutional investors the ability to combine attractive financial returns while positively contributing to the world we live in – now and in the future. Further details will follow in due course.
Ian Berry, R&amp;M's Head of Infrastructure, commented:
“I am delighted that my former colleagues are joining me at River and Mercantile. We will all be working with the wider R&amp;M team to ensure a timely launch of our first fund as we have a number of exciting projects underway and in development.”
James Barham, Group Chief Executive, commented:
“Ian and his team have a proven track record in this competitive market, and I am delighted that we are able to reunite them in the development of our infrastructure business. As a team they are highly regarded by clients and investment partners alike and I look forward to them all joining shortly.”
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For further information, please contact:
River and Mercantile Group PLC: 
James Barham, Group Chief Executive 
020 7601 6260
MRM Communications:
Chris Duncan, Director 
020 3326 9907
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River and Mercantile announces further Infrastructure team hires

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River and Mercantile has today announced that Roger Lewis has joined the Group in a new role as its Group Head of ESG.
Roger will be responsible for implementing and overseeing the group’s ESG philosophy and core principles across its various investment divisions and integrating these important factors within the firm’s investment processes and asset management activities.  The coordination of these important factors horizontally across our businesses and vertically into our corporate responsibilities is an important and key development.
Roger previously worked at Aviva Investors, where responsibilities included aligning ESG strategy and factors with investment functions across its £47.3bn Real Assets platform, which invests in property, infrastructure and private debt. Prior to this, Roger held roles at Legal &amp; General Investment Management and J.P. Morgan.
Group Chief Executive James Barham, speaking of the appointment, said: “We welcome Roger’s appointment which underscores our commitment to place environmental, social and governance factors at the heart of everything we do. ESG has been a key part of our investment thinking for many years as has our clients’ interest and awareness of the importance of sustainable investing. This appointment will enable us to enhance our commitments and continue to deliver exciting ESG investment opportunities to both current and future clients.”
Roger Lewis said: “With approximately half of all asset managers’ ESG strategies allocated to listed equities, a unique position to influence asset owners through its investment consultant role and a commitment to long-term active management, River and Mercantile is extremely well positioned to capitalise on the opportunities, while mitigating risks, that ESG presents. Several sustainability mega-trends are emerging where financial institutions play an important role, like rapidly increasing awareness of climate change and drive to achieve 1.5 degrees above pre-industrial levels. This is therefore an exciting time to be joining the Group and I look forward to working with its talented team of investment professionals as they continue to seek opportunities to deliver sustainable, positive returns to investors.”
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ENDS
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For further information, please contact:
MRM Communications 
Chris Duncan, Director 
020 3326 9907
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River and Mercantile recruits Group Head of ESG

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.

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