282. How value investing and sustainability can be good bedfellows

5 October 2023 (pre-recorded 19 September 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the ‘Investing on the go’ podcast brought to you by FundCalibre. To continue with our Good Money Week coverage, today’s guest discusses value investing and sustainability.

James Yardley (JY): Hello, I’m James Yardley, and today I’m joined by Will Lough, the manager of the R&M Global Sustainable Opportunities fund. Will, thank you very much for joining us today.

Will Lough (WL): Thanks very much for having me, James.

[INTERVIEW]

JY: Now Will, your fund is quite interesting. It’s a new fund, I think it launched just in July 2022, so, it’s probably one which our listeners are not very familiar with, so can you give us a quick introduction to it?

WL: Yeah, sure. So, the R&M Global Sustainability [Opportunities] fund is a multi-cap, multi-sector, benchmark agnostic, sustainable equity strategy, and it has a value tilt, which we think is a bit of a differentiator. It’s a high conviction portfolio, so around 50 holdings at any time, which we build via fundamental bottom-up research, so, going company by company with our research efforts. And we use a proprietary quantitative tool for idea generation. So, the key features I would say for the fund when you’re thinking about it are strong quality characteristics, so things like high returns on capital overall, attractive valuations on measures such as free cashflow yield, and a skew to smaller companies throughout. Now, that skew can change from time to time in terms of how large it is. But, you know, we will always have more of a skew to smaller companies than the benchmark.

From a sustainability point of view, we are kind of looking generally at companies which might have improving characteristics in terms of their sustainability credentials, or those companies which are enabling others to improve theirs.

And then the final point, I would say, which is a really important angle for us, is around engagement. So, engaging with companies to either support positive change where it’s already happening or to accelerate that change where it’s necessary. And so, we’ll have around a third of the fund at any one time where we’re doing direct engagement with the companies, setting them goals and targets to deliver against.

JY: Well, it is certainly unusual to have a sustainable fund with a value bias, so that’s certainly something interesting and new. So, can you tell us a bit more about your sustainable ‘potential, value and timing’, and how the process works?

WL: Sure. So, our investment approach – I would say we’re not trying to reinvent the wheel. And I think what you pick up on there is interesting, and something that I alluded to at the start, which is that, for several years, this concept of value investing and sustainability have kind of appeared at odds with each other, not really comfortable bedfellows. And our view, just very quickly before we get into R&M’s own investment approach, is that that idea rests on defining those two concepts, so value investing and sustainability, in very narrow terms. And so, we’re not actually sure that that’s helpful ie. you know, you don’t just choose stocks which are undervalued because they’re low price to book. That’s just one measure of doing it, for example.

And similarly on the sustainability side, just excluding companies which have high emissions, for example, is not necessarily going to deliver you good sustainability outcomes. So, we try and define things a little bit more broadly.

We have four defining principles behind our approach. So, the first one is that we are looking to own companies with very clear drivers for future shareholder value creation. We think there are three phases of a company’s lifecycle where that can be delivered; growth, quality and recovery. And the drivers of successful value creation will differ depending on that phase.

So, in the growth phase, you want your companies to be reinvesting heavily. If they’re in a recovery phase of the lifecycle, actually to deliver value, you want them probably to be cutting costs or to be doing things like selling non-core assets, so not really reinvesting, it’s kind of the opposite. So, that’s potential.

We want to identify mis-pricings. So, the second point, we want to identify mis-pricings between the current stock market valuation and the long-term fair value that we determine. We think that increases the probability of generating attractive returns if we’re right about finding companies with the value creation opportunities. And it manages our downside – really importantly, it manages our downside if we’re wrong about those things, which does happen <laugh> you know, more than most managers would care to admit. So, that’s the valuation side.

The third defining aspect of our approach is that we think you can use some behavioural factors. You take those behavioural factors into account in determining the best time to buy and sell. So, you might think that something’s cheap relative to fair value, but is it the best time to buy it or could it get cheaper? And, in effect, we’re just trying to minimise the risk of buying too early or actually at the other end, leaving too much on the table. So, we want to consider catalysts that will basically make other market participants, other investors, reassess the value of the business. So, that’s timing.

And into all of this, the fourth key principle is that we integrate the analysis of material risks and opportunities relating to sustainability. So, in simple terms, what are we doing here? We’re just saying, how does sustainability impact the business fundamentals and the valuation – is it a headwind for the business? Is it a tailwind for the business?

And if it’s a headwind today, is it one that could shift over time and therefore create a re-rating, you know, an upwards movement in the valuation because those sustainability characteristics have improved?

And we look at that sustainability lens, we look at that through three pillars: so, we say you’ve got people, innovation, and environment. Those are the three key pillars you should think about; people represents the stakeholders – so the suppliers, the customers, the employees and also the governance of the business. Innovation covers R&D, but also business model adaptability. And then I guess environment would be quite self-explanatory.

And the importance that we place on those different pillars will differ depending on the business model that we’re looking at. So, if you think about a software business, you’ll probably place more influence on the people and the innovation than maybe the environment. And if you were looking at an energy or a materials business, it would be the other way around; you know, you’d be definitely thinking about the environmental factors, you’d be thinking about things like health and safety for employees.

So, we think this just overall allows us to take quite a holistic view and is about proper integration into the investment case. So, it’s not about the tail wagging the dog. We’re not only thinking about the sustainability characteristics of the business, we’re not only thinking about whether something’s got a very low valuation or not.

JY: And do you have any exclusions in your approach at all? And do you ever come across conflicts between sustainability and profitability?

WL: We do operate exclusions, probably lighter ones than many sustainable investing funds. So, we exclude tobacco, for example. We exclude certain activities within fossil fuels, like oil sands; we exclude thermal coal exposure. And we exclude companies which fail the UN Global Compact* measures. So, we do have exclusions but philosophically we prefer to have a wider net and to kind of then assess businesses on their merit. And that probably enables us to kind of look at a wider set of opportunities in terms of those companies which can improve their outcomes. And we think that that actually delivers a more significant real-world impact for our investors.

JY: And you wrote recently that you’re taking more contrarian positions at the moment. And you are particularly excited about global smaller companies. Is this still the case?

WL: Yeah, it certainly is. So, at the moment, we have around 30% of the fund invested in companies which are below $10 billion in market cap. And that will compare to around 6% in the main global benchmark, the MSCI ACWI. What that reflects is going company by company and just the opportunities that we find. I mentioned at the top that we will typically have a skew towards smaller companies relative to the benchmark; that will be a common feature for the fund. But we are at the maximum that probably I’ve ever managed at the moment in terms of accessing that.

And I think if you were to put it into, you know, to zoom out to 30,000 feet and try and describe what the opportunity is, over the last 15-20 years global smaller companies have typically traded at a 20-25% premium on a price to earnings basis vs the headline MSCI ACWI. At the moment, they trade at a 5-10% discount, so that’s over two standard deviations below the long-term average. And we think that just reflects for us, opportunity. It embeds a lot of concern about the outlook, which perhaps you are not getting in some of the large caps. So, we’re just trying to say really that the risk / reward in small caps is really attractive.

It’s a global feature, so you’re not having to take huge regional bets with that smaller companies’ exposure. It’s multi-sector, so again, you’re not having to take huge sector bets to achieve it. And it’s also, in terms of the type of opportunities we can access, it’s both quality compounding franchises, but also turnaround. So, we just really like the breadth of the opportunity.

JY: And Japan is another big feature of the fund. I think it represents more than 10% of your holdings. It’s no secret that Japanese equities are back in vogue. Do you see this continuing?

WL: Yeah, the performance of Japan has been one of the tailwinds for us this year. So, we’ve been invested quite heavily in Japan for the last two or three years and been doing a lot of engagement there, so, writing letters to boards, eventually getting meetings with those board members, and putting our case to them about certain improvements that we felt could be made around things like capital efficiency, so, very cash-heavy balance sheets or ownership of cross shareholdings – so, owning the equity of other companies. But also, things like the governance structures, so a number of diversity of boards, both from a nationality perspective, but also gender.

And all these things actually have really come to a head this year where, for those who aren’t kind of seasoned Japan observers, effectively, the Tokyo Stock Exchange came out early this year and said that, you know, really, it’s a bit of a joke that – I’m paraphrasing – but they kind of said, it’s a bit of a joke that so many Japanese companies trade at such a low valuation. So, over 50% of the TOPIX** at the time was trading below 1x book. And they said, if you’ve consistently traded below book value, you need to demonstrate strategies which will improve your capital efficiency, improve your profitability, and drive your valuation towards 1x book. So, it’s a very explicit kind of dictat from the top.

And at the same time within Japan, there have also been changes in terms of what’s being mandated for things like board structure; so, you know, having female representation on boards. And this is causing, you know, a really big shift in Japanese corporate culture. So, a colleague of mine was out there in May this year for a conference and met a number of companies, and this is front and centre in terms of presentations. There’s a big shift in terms of what’s being said, but very importantly, there’s a big shift in terms of what’s being done.

We would kind of call out things like the proxy advisors, so ISS [Institutional Shareholder Services] and Glass Lewis [& Co.] who help institutional investors around their voting; they’ve really shifted their terms, so, getting people to vote against boards who are not enacting some of these things is a big change.

And similarly, we’re seeing a number of companies announce big sell downs of their equity holdings, and then do buybacks or special dividends to reward their shareholders for their patience. And in the last few days, for example, you’ve seen Aisin [Seiki Co. Ltd] which is quite a small company, which might go below the radar, but as part of the Toyota Group, saying that they’re going to sell their shareholdings down to zero.

And, if you understand kind of how important that is for the Toyota Group, [how important] all these cross shareholdings have been, for one of the subsidiaries to come out and say they’re selling down to zero is really quite meaningful. So, we’re seeing all these kind of anecdotal changes, which add up to quite a lot in aggregate. And it has a lot of runway because, you know, this is basically, decades in the making and it’s not going to just correct itself overnight, and there’s still deep undervaluation in Japan. So, you know, again, a little bit like what I was saying about small caps, we just like the breadth of opportunity in Japan. And there are several things around the economy which are kind of interesting, but I think we’re most focused on the stock-specific stuff.

JY: And one of your Japanese holdings is Nikon which most of our listeners will be familiar with. What’s the story there? And do you have a sustainable strategy in place for that name?

WL: So, Nikon, as you mentioned, most UK listeners would be familiar with the cameras. And, you know, that technology, the imaging technology, is kind of core to the group, but they have other divisions as well. So, they’re involved in equipment for the semiconductor industry, which most people at the moment would say has a decent, long-term growth trajectory supported by things like AI over time. And, [it’s] also into healthcare imagery. So, it has these kind of core bits of the business.

Why do we like it? We like it because it has a management team that’s really grasped the opportunity in terms of some restructuring efforts, so, improving profitability – I spoke about the recovery stage of the life cycle earlier, well, that is what Nikon is. So, they’ve been consistently improving profitability across the business. They do have those longer-term growth opportunities. It’s very cheap, so it trades below its book value. It has a lot of cash on the balance sheet and a number of cross shareholdings, and it is committed to reducing those by buying back shares. So, these are all big ticks in the box for us.

And it has to be said that those items were not always there. So, those are things which we engaged with the company on maybe one to two years ago, and then they put in place subsequently. And then they, you know … the other aspect – you asked about the sustainability characteristics of the business, aside from the kind of end markets that they’re involved in, in terms of things like healthcare, in terms of the semicons and all the derivative benefits that you get from a sustainability point of view from that; for these guys specifically, they are, I would say, among the better companies in Japan on a lot of this stuff. So, they’ve had a science-based net zero target in place since 2019. They’ve moved towards 50% board independence over the last couple of years. They’ve been adding female board representation. Those are also things which we have been consistently engaging with them on.

And then the final point is around compensation. So, you know, we think that compensation is a really important driver of change in behaviour and, at our behest and that of other investors, they put in place a range of new compensation structures, which include return on capital targets, and also a broad set of sustainability-related KPIs, which give them a really nice rounded approach to have the management team get compensated.

JY: And Baker Hughes [Limited] is one of your largest holdings – I believe they’re an oil service company. So, what makes the investment case so strong there and, and why is that appropriate in a sustainable fund?

WL: Yeah, so I think, I think that Baker Hughes would definitely call you out quite early on with that description of them as an oil services company. They would very much describe themselves as an energy services company, and we would agree with them. It’s one of the big shifts for the business, which we think is not yet fully reflected in the valuation. It is probably still perceived with that kind of oil lens, if you like.

There are three parts to Baker Hughes’ business, each of which we think has attractions. The first part is traditional hydrocarbon, so oil and gas services. We would view this as very much in a recovery stage, generating a very attractive free cash flow, which can be fed into the other two parts of the business, which I’ll describe in a second.

For us, one of the key things that we have to think about when we’re thinking about these traditional hydrocarbon businesses is, are you, like Baker Hughes, an enabler of improvement? And if you are, you are potentially creating a really big, positive impact. So, if you think about traditional hydrocarbon is actually a big area of emissions of things like flaring and methane leaks. Baker Hughes has the technology [with] which it supports reductions in those, ok. And if you look at what we need to do to deliver net zero, actually around 40% of the reductions come from efficiency solutions of the sort of which Baker Hughes sells. So, a really important service that they’re providing there.

The second division is operating in LNG. And they – Baker Hughes – provide very sophisticated, very efficient turbines which go into the LNG supply chain. Again, if you think about efficiency, you know, that more efficient the turbine, the less the emissions. Natural gas, we think is the most important transition fuel. So, although in the West we might be trying to move ourselves off it, actually, the big growth is probably in Asia where you’re moving from coal to gas, and again, kind of significantly reducing the emissions profile of those economies by doing so. Baker Hughes as a business there, is super attractive because around half of the revenues come from services. So, over the next decade or so, you have very strong growth in installation of new LNG, and then Baker Hughes will be able to harvest that revenue over a long period of time. And that is a very attractive, high-multiple business when you look around the rest of the market, to get those repeatable service revenues.

And then the final part of Baker Hughes’ business, that third strand that I spoke about, is that by being part of the traditional oil and gas supply chain, that has actually given them really amazing market positions in things like carbon capture, in hydrogen, and in areas of industrial technology such as, you know, efficient asset management monitoring tools. And so, if you like, that’s the long-term opportunity for these guys; is that you balance out the declines in the hydrocarbon business by these new technologies, these new energies, and then you have this really attractive repeating revenue business from LNG in the middle.

JY: Well, thank you very much Will, that’s given us a really good feel for the portfolio, and you’re certainly doing something different. A lot of sustainable funds have really struggled over the last couple of years. You are off to a very strong start, and I’m sure we’ll catch up again in the future. So, thank you very much for joining us today.

WL: Thanks James. And hope the Good Money Week goes well, and everyone enjoys the content that’s being produced.

SW: The R&M Global Sustainable Opportunities fund is a multi-cap, multi-sector, benchmark-agnostic sustainable equity strategy with a value tilt. It maintains a high-conviction portfolio of around 50 holdings. To learn more about the R&M Global Sustainable Opportunities fund, visit FundCalibre.com — and don’t forget to subscribe to the ‘Investing on the go’ podcast, available wherever you get your podcasts.

*Source: The UN Global Compact is a voluntary initiative that seeks to advance universal principles on human rights, labour, environment and anti-corruption through the active engagement of the corporate community, in cooperation with civil society and representatives of organised labour.

**Source: TOPIX stands for the Tokyo Stock Price Index, which is an important stock market index for the Tokyo Stock Exchange in Japan, tracking all domestic companies of the exchange’s Prime market division.