Don’t just stand there, do something!
Most people will be familiar with this phrase, often shouted when some unexpected event causes chaos or disruption in the world around them. At these times, it is seen to be proactive and wise to do something.
What exactly that ‘something’ is, is of course open for debate. But when the unexpected occurs, it is rarely seen to be wise or acceptable to sit quietly and observe.
To anyone observing geopolitics and economics, and their impact on equity and bond markets, chaos might seem a relevant description this year. The melt down in the bond market and melt up in commodities is right up there with any event in most people’s investment experience which has, understandably, led to us being challenged: don’t just stand there, do something!
Activity with respect to fund management is a much-debated topic. Often measured by portfolio turnover (the percentage of a portfolio which changes over the course of a year), the asset management industry offers a range of products with both high and low turnover. For our sustainable equity portfolios, our turnover was around 10% in 2021, implying that we maintain a holding in company on average for around 10 years – it has been higher and lower in the past, depending on the opportunities we have seen. Should we be active now?
Our last period of high turnover was during the pandemic when there was a once in a decade opportunity to buy great businesses at low prices. This was caused by a market panic as the global economy shut down. We do not believe what is occurring in markets today is a market panic yet, and don’t think that valuations are as attractive as they were back then when share prices were much lower. We think what is occurring today will take longer to understand compared to the pandemic, which was ultimately a problem of science.
Today we are facing inflation at levels unseen for decades, and a war whose conclusion looks uncertain. These circumstances may take time before their relevance to investment strategy becomes clear. As such, activity now is as likely to be incorrect as correct and observing what is occurring and waiting is as likely to be the right decision as being active.
An approach of relative inactivity does of course depend on the starting point of where our funds are invested now. We own established, profitable, and high quality businesses where we believe their products and services are likely to become more valuable to society as time goes on. If we do nothing, we expect these businesses to find their way through the challenges of today and become larger and more profitable in the future. To change these portfolios, we need to be sure the alternative is more attractive. As of today, we are not.
For anyone who has been in the presence of a fidgety child or investment manager, perhaps the inversion of the phrase noted above is sometimes more apt: don’t just do something, stand there! Of course, should events transpire that make it sensible to become more active, such as another market panic, we will act. Until then, we can learn a lot just by observing.
A year of two variables
This year has, so far, been a year of two variables: carbon and interest rates. Most of the investment performance within our sustainable funds has been a consequence of these two factors.
This is the first year for some time when being low carbon as an investment approach has been so overtly negative to investment performance. Carbon has its origins in oil, gas, and coal. These commodities were beginning to see an upward trend in pricing last year, as the global economy reopened following the pandemic. This upward trend was relatively modest however, reflecting there being ample supply to meet that rising demand. This allowed funds such as ours to replace this performance with cleaner, lower carbon investments elsewhere. We felt it seemed likely this would be the same again in 2022, until Ukraine was invaded.
Sanctions placed on Russia since have fundamentally changed the supply and demand equation for carbon across the world, and none more so than in Europe, where many countries are highly dependent on Russian oil and gas. This has created a significant spike in the price of carbon to the benefit of those companies who supply it. Our sustainable funds remain low carbon, and not invested in companies which extract oil, gas, and coal due to the environmental impact they have. This approach is one reason we have underperformed so far this year.
The second variable, interest rates, reflects the need for monetary policy to become more restrictive to offset the inflationary consequences of high carbon, and other commodity, prices. Higher interest rates will slow down economic activity and require less carbon and other commodities to be used, thereby reducing inflation. Central banks around the world have begun down the path of higher rates, but no one knows how far and how fast they will have to go to bring inflation back under control.
Higher interest rates also impact the price of all assets, some more than others. Longer duration assets which hold much of their value in the future, whether they be bonds or stocks, are impacted the most – sustainable investing is an inherently long duration strategy. We think the world looks a lot different 10 years from now, and investors would be wise to reflect that in their investments to make sure they are in the most profitable areas. For now, being a long duration strategy has not been helpful.
The correct investment strategy for this year therefore has been high carbon and short duration. This is why industries such as oil & gas and coal mining have performed so well. These are not areas we invest in. How long this will continue for is unknown, but we doubt the end point for investors has moved materially. At some point in the future the world will be much lower carbon (accelerated by recent events), more digital through the greater use of technology, and healthier as more diseases become treatable. These areas, and other similar ones, are what we continue to focus on.
The ebb and flow of investing
Although sustainable investing has become much more popular and widely known about recently, it isn’t a new idea. This is the 19th year of our sustainable investing journey, having enacted our existing philosophy and process at the start of 2004. This means we have a long track record which we can draw upon to understand and give context to current events.
Over the years, investing sustainably has allowed investors who care about how their money is invested to benefit from the attractive long-term returns from investing in equity and debt markets. Like many investment approaches, it is designed to maximise the likelihood of a successful outcome in the long term and accepts that not all market conditions will suit it.
The period that is perhaps most similar to the one currently is the commodity super cycle of the mid 2000s, when the rapid economic growth of China, allied with its desire to build a huge amount of new infrastructure, saw elevated commodity prices for a number of years. In time this proved not to be a new paradigm, or indeed a super cycle, as supply readjusted to meet demand and commodity prices fell, helped by the financial crisis of 2008/2009. It was a time of underperformance for sustainable strategies, but it passed, as longer-term and more powerful trends took over.
It is impossible to tell how long current market conditions will persist. Then, as now, it seemed clear that the future was a more sustainable one, and that ultimately those businesses helping the transition to a cleaner, healthier, safer, and more inclusive society would ultimately prosper. The companies we invest in do just this, and in time we are confident they will be good investments.
Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.