Investing in Sustainability

Published on 01/17/20 | Saurav Sen | 2,138 Words

The BuyGist:

  • There’s a lot of buzz around Sustainability Investing and “ESG” these days.
  • The latest newsflash is Blackrock CEO Larry Fink writing a very strong endorsement of Sustainability Investing.
  • People listen because Blackrock is an 800-pound gorilla in the game of investing.
  • While the letter was decisive,. But we wish it would be more precise.
  • We like what Fink wrote. He makes some good points more articulately than we could. He’s talkin’ the talk. Is Blackrock walkin’ the walk? We have been, for about 18 months already.
  • The Buylyst has been decisive and precise about how it executes Sustainability Investing.
  • This article delineates our thinking on the topic.
  • We hope that it both helps you and inspires you to follow suit and invest in PROGRESS.

The Blackrock letter is decisive but not precise.

I liked what Larry Fink wrote. He made some good points:

  1. The connection made between Climate Change and Finance – for example, how does an insurer price Risk in the future?
  2. The implicit reminder that stock and bond prices (or inversely – yields) factor in future risks and “bring them back” to the present. The underlying warning is that it’s hard to predict when these risks will be factored in with greater ferocity.
  3. Clearly stating that “Climate Risk is Investment Risk”.

#3 is what we, at The Buylyst, have believed from the start. We have a saying, “Investing is not divorced from reality”. We apply common sense to our investments, based on what we see, hear, read in the world around us – on “Main Street”. For us, the immediate Climate Risk is the risk of investing in the wrong sport – the 20th century thinking that involves fossil fuels and promotes environmental ignorance under the garb of profit maximization. That thinking will, sooner or later, see its day of reckoning. When will that happen? It will be on the day that someone invents a stronger, long-lasting battery that stores electricity reliably at an industrial scale. On that day, fossil-fuel investments will take a massive beating, and we don’t want any part of it.

Back to Fink’s letter: Overall, it wasn’t specific enough. He spends a lot of real estate in the letter about Accounting Standards. I appreciate the sentiment. But, in my view, accounting standards can be gamed. Any disclosure rules that involve ambiguous measurement standards – like total carbon footprint per dollar of revenue – can be gamed.

The problem with measuring carbon footprint is one of scale and scope. It’s tough to accurately measure the carbon footprint of my iPhone, for example. Apart from Apple and the store from which I bought it, one should factor in hundreds of suppliers of iPhone parts from all over the world. How does one total up all those carbon emissions? Maybe what Fink wants is for Apple to provide a number for its final product. At the moment, I think this kind of self-reporting is complicated and gameable. For starters, it requires a global coordination of carbon footprint reporting standards that each country’s regulatory body must enforce. This is ambitious, and sure, it can happen. But even if it does, I’m having a hard time believing the we’ll see reliable numbers.

To be fair to Fink, Blackrock did publish a more specific letter to its clients about investing in sustainability some time ago. One tangible move it mentioned in that letter was the introduction of more “sustainability” ETFs. So, people would have a choice of buying, for example, an S&P 500 ETF that excludes all fossil fuel companies. This is creditable. But, in my view, Blackrock would be decisive if it doesn’t offer ETFs with fossil-fuel companies at all. I don’t think that will happen.

According to me, the best way to practice sustainability investing now is to do the big, obvious things. In the investment world, it means:

  1. Staying away from all direct fossil fuel companies
  2. Investing in Renewable Energy companies
  3. Investing in companies that have taken decisive, unambiguous stands in favor of Renewable Energy
  4. Investing in companies whose business is to make our civilization cleaner, greener and more livable

In our personal lives, we can follow similar steps – use common sense and be less wasteful. I try to. But it’s not always easy given how addicted we are to conveniences like 2-day delivery. In investing, it’s a bit easier. Diverting money towards what I call PROGRESS is not that hard. Let’s start with that.

Our Buy List is already heavily skewed towards Sustainability.

We’ve been decisive from the start. In fact, our first investment – Vestas – is a Renewable Energy company. And if you scroll through our Worldview section, you’ll notice that we started with a clear take on our Energy investments. For us, there is no trade-off between returns and sustainability. In fact, we think they’re highly correlated.

We’re always trying to find ways to invest in:

  1. Electric Vehicles
  2. The Smart Grid
  3. Wind Power
  4. Solar Energy
  5. Smart Cities
  6. Technology that enables all of the above.

If you look at our Investment Themes, many of them converge to “Sustainability”. Specifically, 6 of our 10 themes are about investing in better, greener, more livable world in some degree:

  1. Renewable Energy
  2. AI & Big Data
  3. 5G and IoT
  4. Autonomous & Electric Vehicles
  5. Urbanization
  6. India

I’ll give you an example. You may be surprised to see that India is on the list above. It’s not exactly a bastion of sustainability and environmentalism. But one our investments related to the India theme is about environmentalism. India is a tough country to invest if you’re a foreigner, just because of regulations. At The Buylyst, we try to find “pure plays” in the India story as much as we can. We recently took a position in an Indian bank. But more often than not, we find “lateral” plays. These are companies that we think will see significant revenue and cash flow growth by virtue of their exposure to India.

One such investment of ours is a water purification company called Xylem. This company meets all our criteria for a “comfortable company” at a “comfortable price”, but what really excites us is the tremendous business opportunity in cleaning up India’s water sources and systems. India has a big water problem; Xylem is a world leader in providing solutions for that problem. In short, we expect this “sustainability” investment to generate good returns because it’s solving a real problem for 1/6th of humanity. Environmentalism and Returns, the two concepts are not mutually exclusive.

At the moment, we have 7 investments that have significant Sustainability brownie points (or should I say greenie points? Sorry.):

  1. 1 Wind Turbine manufacturer
  2. 1 Industrial company that makes Robots, Smart Grid systems, and Electric Car Charging Stations
  3. 1 Automobile manufacturer that’s taking decisive steps towards becoming predominantly Electric
  4. 1 Truck, Bus, and Construction Equipment manufacturer that’s spending most of its R&D on electrifying its entire fleet
  5. 1 Water Treatment & Purification company
  6. A Utilities company that has only Wind and Solar Power generators.
  7. 1 Solar Panel company

That’s 7 of our 20 holdings that are considerably exposed to renewable energy and environmental protection. These weren’t political decisions. They were economic ones.

Sustainability is not just a buzzword for us.

Okay, we admit that it’s a nebulous word. It could mean a lot of things. But at The Buylyst, we take it quite literally. It means lasting for a long, long time – possibly forever. It jives perfectly well with our view of investing – invest for the long-haul in companies that will thrive for a long time because:

  1. They’re playing the right sport.
  2. They’ve got a distinct competitive advantage.
  3. They’ve got a wide moat to protect that competitive advantage.
  4. They’ve got a good management team in place

When we analyze a company, we literally have the word “sustainable” in our valuation metrics. We always try to estimate a SUSTAINABLE Free Cash Flow number. This doesn’t mean cash flows attributable to green, hippie-dippie investments made by the company. It means the answer to the question, “what is a believable annual free cash flow estimate for this company, given the industry in which it plays, its competitive advantage, its moat, and its management team?” But for some of our investments, sustainable free cash flow is directly linked to playing a sustainable sport.

The correlation between “Sustainability Investing” and investment returns is clear and tangible at The Buylyst. In our view, Renewable Energy is a sustainable sport. And that plays a big role in our estimation of “sustainable free cash flow” when we try to value, say, a Wind Turbine company like Vestas. The attribution is simple:

  1. Revenue = Price X Volume.
  2. Pricing Power depends on a firm’s competitive advantage, whether product differentiation or cost competitiveness.
  3. Volume growth depends largely on whether the company is playing the right sport. That’s why we spend so much time articulating our Worldview.

Vestas doesn’t have much pricing power. But they are competitive on costs, so they can still generate free cash flow even if pricing has been decreasing, industry-wide. Vestas has also seen significant volume growth since we invested – largely because it’s playing the right sport.

Again, “Good for the world” and “good for our portfolio” are not mutually exclusive events. Sometimes, the two Venn circles intersect.

But we’re aware of the Risks.

The main risks with what some may accuse of “hippie investing” are essentially:

  1. When subsidies for Renewable Energy expire, what happens…?
  2. What if a better battery is never invented?

 On #1, our estimates show that subsidies are not necessary for Renewable Energy to be competitive. Relative to Natural Gas Power Plants in the US, Wind Power is now cheaper per MWh of electricity, even after including Construction and Servicing costs. That’s the economic reality. No wonder Renewable Energy sources are taking a greater share of the US power supply stack. Subsidies have helped. But they’re not the main cause of the upsurge in Wind and Solar Power in the US.

#2 is a legitimate risk. But the way we view our Renewable Energy investments is like a Call Option. As we mentioned, Renewable Energy sources are already economically competitive with the alternatives. The problem – compared to Natural Gas – is that sometimes the sun doesn’t shine, or wind doesn’t blow. Even if this problem remains, the mere fact that Wind Energy, for example, is economically competitive with Natural Gas power plants probably means that Wind Energy will keep taking “market share” from Natural Gas even without a good battery. BUT, if a better battery is invented, then lollapalooza! We think the downside – the probability X magnitude of it – is significantly lesser than the upside. In fossil fuel investments, we think the payoff profile is exactly the opposite – marginal upside, big downside. Needless to say, we’re not that excited about the Aramco IPO.

The point of this article is not to devalue what Larry Fink wrote in his letter by boasting about our process. The point is to remind you of 2 things:

  1. Think of Sustainability Investing as Sustainable Returns. Invest for the long-haul, not for the next month or year.
  2. If you want to know how, give us a shout. We’ve been doing it for a while, and it has worked out well for us. Use our experience.

Many Happy Returns.

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