The gift that keeps on giving: the pivotal role of the Paper & Packaging industry in the transition to a circular economy
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&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 with a proportion of commercial land managed for conservation to maintain the ecological network – 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 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.
Figure 1: Swedish forests - growth in harvest volumes has not come at the expense of growing stock
Source: Peter Holgren, Swedish National Forect Inventory
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. Whilst e-commerce penetration of 30% (up from 20% in 2019) 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:
“Amazon today remains a small player in global retail. We represent a low single-digit percentage of the retail market, and there are much larger retailers in every country where we operate. And that’s largely because nearly 90% of retail remains offline, in brick and mortar stores.”
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 & 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). 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 & 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, 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.
Figure 2: Sustainability-driven innovation - Mondi's 100% recyclable solution replaces plastic film wrapping
“At River and Mercantile, we do not think that you have to pay a premium to construct portfolios with positive societal impact.”
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.
Figure 3: The containerboard industry has turned from being a serial value destroyer to delivering sustainable returns above cost of capital since 2013
Source: Credit Suisse HOLT LensTM, as at 25 March 2021. Analysis weighted by assets and includes DS Smith, International Paper, Mondi, Packaging Corp, Smurfit Kappa and WestRock.
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. This sets the paper & 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 & packaging holdings have demonstrated, sometimes the oldest and seemingly old-fashioned sectors can successfully innovate to morph from old to new economy investments. 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.
 Exane note 14/12/2020 (Source:FEFCO).
 A carbon sink is where the net balance of carbon emissions is negative, meaning the forest helps to combat climate change. See https://unece.org/forests/carbon-sinks-and-sequestration for more information.
 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: https://www.mondigroup.com/en/sustainability/approach/working-forests/
 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
 Incredibly, modern paper machines contain more electronics than a Boeing 747. Source: CPI https://thecpi.org.uk/library/PDF/Public/Publications/Other/Myths%20and%20the%20Facts.pdf
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