Sustainable investing and valuation
This blog does not constitute Investment Research as defined in COBS 12.2.17 of the FCA’s Handbook of Rules and Guidance (“FCA Rules”). See the end of this blog for links to important information and disclaimers.
Sustainability investing – its still about delivering a financial return
“Prediction is very difficult, especially if it’s about the future!” attributed to both Niels Bohr and Yogi Berra
Sustainable investment must generate a financial return.
To keep global warming to only 1.5-2.0° (Net Zero 2050), we need to mobilise vast amounts of private sector capital – up to $120 trillion. This investment must be financially as well as socially viable. Popular tools such as ESG scoring, and measuring company exposures to the UN SDG’s, are largely silent on the key question … “does this make a good investment”. This is not to say that ESG analysis does not have a part to play in constructing investment cases – just that simple high-level analysis alone isn’t enough. This is a topic we will come back to in a later blog.
But traditional financial approaches also have weaknesses
Traditional financial analysis can be too myopic for sustainability. The focus of much of the equity analysis produced is on a relatively short time frame (the next two and sometimes three years). Implicit in this is the assumption that beyond the direct forecast period we have some form of steady state. And yet, in a world transitioning to net zero/green economy, the future is going to look very different from the past and the present. If the rise of tech giants like Microsoft, Amazon and Apple has taught us anything, its that true value is created well beyond the sell-sides’ traditional three year forecast period.
Building the world in a spreadsheet is getting tougher
The changes from the net zero transition are creating some incredibly interesting investment opportunities. But there will also be negative returns in many legacy industries and misallocated capital in new ventures. Vested interest, green washing, excessive hope, and simple “kicking the can down the road in the hope that the problem will go away” will create some blind investment alleys. You put all of this together with the complexity of the differing pathways to achieve net zero, and you can see why many analysts find it difficult to comfortably forecast.
Sustainability themes will drive longer-term investment analysis
In this environment of uncertainty, sensible decisions on fair value require us to think much longer term. This is not just a case of adding a few more years onto a DCF. Technological, political, social, and regulatory pressures are going to fundamentally change the competitive dynamic of many sectors. New entrants, new business models, new regulation, and the importance of getting to scale to reduce costs, will put pressure on financial return rates. Having high rates of demand growth is no protection if competitors are undercutting you on pricing. This means not all business models or technologies will prosper, or even survive. Plus, we have to assume that as 2030 approaches, the political pressure will ramp up. So, more regulation, more restrictions, and more pricing of currently free externalities.
Its better to be broadly correct than precisely wrong
In this world of uncertain outcomes, it’s easy to focus on a single scenario and to “over model” the future. Humans like certainty, and the ultimate praise for an analyst can be that they “show high conviction”. Instead, it’s better to stand back and ask “how will the net zero future likely impact this particular business model”? In thinking about how business models can be disrupted or enhanced, tools such as the SASB materiality map, can be a starting point. However, the reality is that different companies in the same sector will face often dramatically different risks, opportunities, and competitive environments. And some companies are better at responding to change, through innovation and flexibility.
There is no simple algorithm
As much as we would like to have a simple algorithm or investment approach that easily and cheaply scales, it doesn’t exist. Neither does the high, low, central case type of analysis make sense. All this tells us is that a wide range of possible futures, can lead to a large spread of financial outcomes. We focus instead on a detailed analysis of the interactions between the political, social, technological and regulatory dynamics, and how each company and its’ competitors, are likely to react to the changes this brings. In this process it’s important to be able to link the material sustainable investing factors, with a tangible impact on a company’s future financial performance. This in turn can be translated into an investment appraisal using just a handful of key KPIs: market size and how share is divided up (= sales growth), likely competitive advantage (= operating profitability and returns on capital), plus investment needs (not just capex but R&D, working capital etc).
It’s as much as art as it is a science.
Plus, we need to be explicit, there are many things we don’t know. Sustainable investing does not exist in a vacuum. Human investment decisions & thus share price moves can be driven as much by fear and greed as by “rational” analysis. Its one of the (many) reasons why Dan is such an important part of the team. What the market thinks and believes is very important if you want to understand if a share price is “right”. Our focus is unashamedly on investing in sustainability. If we cannot help in delivering a fair financial return, then we have not done our job properly.
Our approach will not suit everyone
Many investors will continue to seek out high conviction stock calls and use ESG scoring to construct overlays. We understand this. But, we can see a small but growing band of investors who take a longer term approach to their investing and who want to understand the uncertainty.
Sustainable Investing LLP is an appointed representative of Varramore Partners Limited which is authorised and regulated by the Financial Conduct Authority (“FCA”) in the United Kingdom (“UK”). Sustainable Investing’s FCA Firm Reference Number is 946165.