In a complex investment environment, investors should get back to basics and focus on corporate cash flows, scarcity value and the impact of inflationary pressure on profits. Simplicity will serve investors well in the coming years.

When things get complicated it often helps to try and simplify them. Looking out on today’s complex investment landscape investors should focus on the key fundamentals that drive corporate cash flows, profitability and ultimately asset prices over the long term. It requires sight of a company’s revenues versus costs, ascertaining if it is producing something other corporates can’t and identifying the key profitability drivers in its wider industry.

“At the end of the day, it really comes down to the fact that asset prices are a function of future profit” says Robert Almeida, global investment strategist and portfolio manager at MFS Investment Management in an interview with Top1000funds.com from the firm’s Boston headquarters.

“The simpler we can make it, the better off we will be.”

Keeping it simple means playing down the importance of trends and avoiding grand predictions. Political insight, a view on GDP or where the next spike in the virus will hit isn’t going to help either.

And he warns that the past won’t throw any light on the future in a view shared by other strategists like Alliance Bernstein’s head of institutional solutions, Inigo Fraser Jenkins, who argues investors are entering new terrain. After decades of low inflation, the characteristics that have underpinned the investment dynamic of the last 30 years are set to change.

“We think that the pandemic has changed the investment environment and the policy framework within which investment decisions are made,” says Fraser Jenkins. “Investors are likely to have to get used to a higher level of inflation, and governments may need a higher level of inflation to deal with debt levels. The pendulum will swing away from favouring owners of capital to labour.”

In truth, says Almeida, nobody knows what is going to happen and unlike science, finance is not rooted in immutable rules like gravity. Ignore the hubris and concentrate on making as few mistakes as possible.

Deciding what is and isn’t material has become more complex. Central banks have intentionally crowded out the purpose of financial markets via extensive asset purchases, leading to significant asset price inflation. Now the pandemic and subsequent recovery make it even more difficult to gage corporate profitability. Strong GDP levels coming out of COVID resulted in double digit corporate revenues and surging stock prices, fuelled by companies ripping out costs.

“Government stimulus, followed by the vaccine, has led to an explosion in economic growth boosting corporate revenues,” he says.

Now the picture changed again.

“GDP growth is fading as the stimulus wears off, while old costs are coming back into companies’ bottom line,” he says, just back from his first business trip since the pandemic – an industry conference in Salt Lake City. Elsewhere, new corporate costs are appearing like the spike in energy prices and secular costs like integrating sustainability.

“If you mix all these things together, plus expectations around cash flows and profits, my worry is things will decelerate faster than what markets expect,” says Almeida.

Add in the fact supply chain disruption is proving less transitory, impacting companies in two ways. On one hand it is triggering a negative supply shock, reducing the number of goods companies can put on their shelves and hitting revenues. On the other, bottlenecks are increasing costs like labour and raw material inputs, especially electricity.

“Companies are burning the candle at both ends. Profits are a function of revenues versus costs and in my view, revenue growth is vulnerable while costs are likely to rise,” says Almeida.

Solutions in scarcity

Making sense of these myriad cross currents requires investors focus on identifying the factors that will drive corporate profitability going forward. They should pick companies that are offering products and services which people are prepared to pay more for and stocks that can offer different profit streams.

“Scarcity has value,” says Almeida, who believes a scarcity value or premium will result in fierce competition for high performing stocks and bonds down the line, surprising investors.

As well as creating winners, the dispersion in risk markets will create losers. Avoid companies that don’t have something unique or have derived income from, say, not paying employees properly and now can’t raise prices. These companies will underperform in the next cycle, he predicts.

A scarcity value or premium will result in fierce competition for high performing stocks and bonds

It’s a sentiment echoed by Jimmy Chang, chief investment officer of Rockefeller’s global family office, part of Rockefeller Capital Management which includes both the family office, private wealth management plus Rockefeller Asset Management and Rockefeller Strategic Advisory, responsible for a combined $85 billion of assets.

Chang counsels a similarly cautious approach focused on finding the best quality and most consistent names with the strongest balance sheets as the market’s macro backdrop becomes less supportive.

“Our stimulus-driven economy is transitioning to mid-cycle,” he says. “While November and December are historically stronger periods of the year for equities, waning fiscal and monetary stimuli coupled with still elevated inflation portend higher volatility after the turning of the calendar to 2022. Such an environment warrants some conservatism, and we believe investors should focus on higher quality stocks with a history of earnings consistency.”

Both Chang and Fraser Jenkins think investors should position for higher inflation. While Chang has suggested investors play this with exposure to inflation beneficiaries like financial services and commodities, Fraser Jenkins suggests higher equity exposure, a strategic exposure to the value factor and a reduction in the duration of portfolios. “We also think that investors need to consider using factors alongside traditional asset classes in asset allocation,” he suggests.

Sustainability

Sustainability, as well as scarcity, will be the other performance differentiator in the years ahead. Investors will increasingly reduce allocations to companies in their portfolios that don’t integrate sustainability. And many companies haven’t factored in the cost of the transition, says Almeida.

“Given the level of corporate indebtedness today, ESG strikes me as an underappreciated material risk, particularly by corporate bond investors.”

When it comes to making investment decisions, Almeida warns technology holds challenges and opportunities. Sure, investors have more information than ever before. But it requires carefully sifting through and does not equate to knowledge.

“To be clear, reaction time to a data point is not a differentiator. The differentiator is the ability to disregard what isn’t material and incorporate what is,” he says. “As you take in more data you must decipher what information does, and doesn’t, change the investment thesis.”

Don’t build portfolios based on past trends or try and predict what might happen in the future; views on central bank tapering and interest rate policy are important but shouldn’t be central. Rather, bond and equity investors should focus on corporate cash flows, scarcity premiums and the impact of inflationary pressure on profits.

“Profits are a function of revenues versus costs and in my view, revenue growth is vulnerable while costs are likely to rise,” he concludes.

Technologies that have decimated and transformed the retail and manufacturing sectors are finally ‘knocking at the doors’ of the services sector, and institutional investors need to build a higher level of technology education among in-house sector specialists to stay ahead of the curve, argues Taimur Hyat, chief operating officer at PGIM, the investment management business of Prudential based in New Jersey.

But Hyat said more incumbents in financial services would survive and thrive than was the case when retail and manufacturing were disrupted, as incumbents within this sector have stickier client bases, more complex regulatory structures, and at least winning incumbents are making the investments needed in cutting-edge technology, do technology-driven M&A, and are willing to cannibalise their own business models.

It is imperative for investors in financial services to observe which incumbents are making the transition and positioning themselves for the future, he said.

“The leading incumbent service firms have seen this movie before in other sectors,” Hyat said.

“They are embracing technologies and there are ways to empirically test whether they’re doing so. They’re willing to cannibalise their legacy models and it’s important to keep an eye on them and understand that bifurcation of incumbents into those evolving with the times and the dinosaurs who will be left behind.”

In an interview as part of the Market Narratives podcast Hyat raised the impact of key technological advances on healthcare, finance and logistics, drawing from the insights from PGIM’s recent paper, ‘Reshaping Services: The investment implications of technological disruption’.

Hyat gave the example of robo-advisers which were seen as a threat to wealth management businesses.

Large wealth managers have built digital user interfaces that drive down costs or have “simply acquired these robo-advisors and become more powerful themselves,” he said.

Also acting in favour of incumbents is the fact that customers are a lot more “sticky” in the financial services industry than in other industries. Customers are much less willing to switch health care providers or financial advisors than they are to try a new app for booking restaurants or ordering groceries.

Regulatory barriers and the risk of regulatory backlash also create tech inertia in these sectors, making it harder for new entrants to arrive and completely revolutionise the way things are done.

Institutional investors need to separate “breathless media hype” from the “investible reality today,” Hyat said, singling out public blockchain, automated vehicles and drones as technologies that may fall short of investor expectations.

The internal combustion engine will see a “long sunset”, he said, owing to regulatory uncertainty around AV, the enormous job of building new EV infrastructure, and concerns from some governments over potential job losses from automating truck driving.

“We think AVs will take longer than people expect beyond certain closed loops and certain… trucking circuits and a couple of emerging markets that are kind of making the bet there,” Hyat said.

But he does believe neo banks and fintech payment platforms are two areas where there is a strong opportunity for venture capital.

“We do think neo banks are actually not trying to steal the customers of the existing incumbents, which as I just said, is expensive and quite hard,” Hyat said. “But they’re trying to go after unbanked populations that were too expensive or didn’t have enough profit margins for old-fashioned bricks-and-mortar technology to serve them.”

On the topic of payment platforms, “the MasterCards and Visas of the world are ripe for disruption,” Hyat said, particularly in emerging markets without deeply entrenched legacy payment systems.

For the podcasts in this series see PGIM’s Harsh Parikh on getting the sensitivities right in real assets.

Investing in consumer finance portfolios – an untapped opportunity

The emergence of a specialty finance sector in Europe in recent years has opened up an opportunity for investors to gain exposure to a large, mature and resilient asset class – consumer finance – offering myriad of potential benefits, including diversification and higher risk-adjusted returns. Moreover, the opportunity to invest in performing residential mortgage and consumer loan portfolios appears compelling due to a unique confluence of factors, and in view of the supportive macroeconomic, regulatory and policy backdrop. This paper outlines the case for investing in consumer finance portfolios and how investors can gain access to the opportunity via both a specialty finance approach that utilises cost-effective financing to drive higher risk-adjusted returns, as well as an income-driven approach focused on cashflow generation.

Read the paper

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If the world is to achieve net zero, investors’ current approaches to allocating capital must change. We examine the flaws in asset managers’ and owners’ interpretation, which has led them to set portfolio-level carbon targets that will stymie global net zero ambitions.

Monitoring EM countries’ alignment with global climate goals: a new index to track EM climate performance.

The fast view

  • If the world is to achieve net zero at a speed compatible with the Paris Agreement’s goals, investors’ current approaches to allocating capital must change.
  • The approaches’ flaw lies in asset managers’ and owners’ interpretations of net zero, which has led them to set portfolio-level carbon targets that may actually stymie the world’s net-zero ambition.
  • The acute risk in these capital-allocation models is that emerging markets may be starved of the finance they need to transition to net zero. No net zero in some parts of the world means no net zero everywhere.
  • The first step is for investors to get better at assessing whether an investment or portfolio is aligned with a net-zero pathway that works for all the world. We believe core portfolios should move away from a myopic focus on carbon intensity and towards a focus on a transition. None of the current metrics offers a comprehensive tool.
  • The Net Zero Sovereign Index, introduced in this paper, provides, we believe, sovereign- debt investors with the best, independently verified assessment of Paris-alignment.
  • The next step is to create financial instruments that help capital allocators align with real-world decarbonisation. It is crucial that the developed world and global investor community increase funding to finance the transition in emerging markets. Asset owners must commit capital to a transition, and work with asset managers and policy makers to develop common usable standards for transition finance.
  • We hope that this paper and the Net Zero Sovereign Index encourage a deeper discussion about what capital allocators can do to help achieve a real and sustainable path to total net zero. Time is short.

Access No one left behind: Building an inclusive transition for emerging markets

Part 1: Why investors need better tools to assess net-zero alignment

Part 2: How to measure better — the Net Zero Sovereign Bond Index

Part 3: Financing an inclusive transition

Download the full PDF:

Download the PDF

Important Information

This communication is provided for general information only should not be construed as advice.

All the information in is believed to be reliable but may be inaccurate or incomplete. The views are those of the contributor at the time of publication and do not necessary reflect those of Ninety One.

Any opinions stated are honestly held but are not guaranteed and should not be relied upon.

All rights reserved. Issued by Ninety One.

David Blood, head of the portfolio alignment team and co-founder of Generation Investment Management argues that portfolio alignment metrics will be crucial catalyst of the transition to net zero. Here he argues, with Dominic Tighe and Tanguy Séné who are members of the portfolio alignment team, COP26 private finance hub that by establishing standards of best practice, the Portfolio Alignment Report helps these metrics to reach their potential.

The costs of inaction on climate change are catastrophic. With the last five years the warmest on record, the impact on our planet’s ecosystems is accelerating. To hold back this tide, the next eight years are critical. The IPPC’s ‘report on 1.5C’ indicates that the world needs to cut annual global emissions in half by 2030 to limit warming to 1.5C.

To rise to the challenge of climate change, financial institutions and the companies that they finance, need clear pathways to net zero, illustrating the efforts they need to make. Investors need to be able to differentiate from those sticking with the high carbon business model of the past and those delivering the low carbon solutions of the future.

Different sectors of the economy and regions of the world have different decarbonisation options open to them, and so the shape of their pathways to net zero are different. It’s also key that finance doesn’t just shift from today’s high emitters if they have a credible plan to transition to net zero: the success story from Orsted’s rapid reconversion – from an oil driller to offshore wind leader – wouldn’t have been possible without sustained financial backing.

While critical, knowing the pathways to net zero is only the first step. Financial institutions need tools to assess the performance of specific companies against these pathways. These tools, known as portfolio alignment metrics, enable us to distinguish the leaders from the laggards as our economies adjust to a net zero future. That way, financial institutions can both direct capital to the leaders and stimulate the laggards to raise their game with credible transition strategies.

One approach for metrics is to translate a degree of misalignment between a company’s emissions projected over time and its net zero pathway, into a temperature score. This answers the question: “If every company acted with the same level of ambition as my company, what could the resulting level of global warming be?”, giving an intuitive sense of alignment with the aim to limit warming to 1.5C.

Our ambition is that portfolio alignment metrics become for climate finance as mainstream as credit ratings are in the bond market.

The new TCFD-commissioned Portfolio Alignment Report, published on October 14, should strengthen the quality and usability of portfolio alignment metrics. In setting out best practice recommendations for constructing these tools, it improves comparability and consistency. Our ambition is that portfolio alignment metrics become for climate finance as mainstream as credit ratings are in the bond market. Different methodologies exist but there is broad agreement on the status of an individual asset. We are not there yet, and challenges remain to mainstreaming.

One of the workstreams under the Glasgow Financial Alliance for Net Zero (GFANZ), that brings together over 300 net zero committed financial institutions, will focus on developing the potential of portfolio alignment metrics further, driving consistency and adoption across the financial sector.

Our hope is that this ongoing work can unlock the full potential of portfolio alignment metrics, as a catalyst of the transition to net zero. Once mainstreamed, these metrics will reflect and drive real world decarbonisation and help us to avert catastrophic climate change.

 

David Blood (Head of the Portfolio Alignment Team, Generation IM), Dominic Tighe and Tanguy Séné (Members of the Portfolio Alignment Team, COP26 Private Finance Hub)

For asset owners wanting to know how to set interim targets for your net zero portfolios, here’s how to do it. Amanda White speaks with Deborah Ng from Ontario Teachers’ on their world-class approach.

Back in January, the C$227.7 billion Ontario Teachers’ Pension Plan made a commitment to a net zero portfolio by 2050. At the time it said it was aiming to set interim targets by the end of Q1 but the fund’s journey is a demonstrable reminder of the difficulty in setting targets for large complex global portfolios. Come September it has now released its interim targets.

Deborah Ng, head of responsible investing at Ontario Teachers’ says the delay reflects the fund’s complexity. OTPP took a collaborative approach with representatives at the most senior levels of the organisation having key buy-in, and it had to incorporate the intricacies of setting net zero targets in a large and growing allocation to private markets.

A net zero commitment was a corporate strategy initiative at Ontario Teachers’. The fund’s net zero taskforce was led by members of the investment executive team, as well as representatives from total fund management and global strategic relationships.

The idea was to get a broad group to work through the interim target setting and get buy-in from the entire organisation. There was a lot of interaction and meetings with the investment teams which Ng says was integral as “they are the most impacted”. It also worked with external consultants to help facilitate some of the work which included extensive interviews with peers.

“It was a collaborative approach that we took across the plan internally and externally. We did a landscape assessment of our peers to find best practice and mostly focused on asset owner peers who had set net zero targets as well as asset managers like Blackrock and Wellington,” Ng told Top1000funds.com in an interview.

“It varied quite a lot with where they were at with their plans, some were at very advanced stages and had targets. A lot of them were top down and we also took a tone from the top approach which unlocked resources and efforts to work towards it on a bottom up basis.”

Setting interim targets

The starting point for OTPP was the International Panel on Climate Change’s recommendation of reducing 2019 levels by 50 per cent by 2030.

The fund landed on interim targets that were a lot more ambitious than that, with a plan to reduce portfolio carbon emissions intensity by 45 per cent by 2025 and two-thirds by 2030, compared to its 2019 baseline.

“We did a lot of scenario analysis, we knew there would be emissions reduction because of the decarbonising world, and we wanted to capture that and add to it,” she says. “All of our businesses are buying electricity from somewhere and with this macro decarbonisation we looked at how much reduction was expected in each jurisdiction and applied that to our portfolio.”

The second step was to spend time with the investment teams and examine where the fund was already looking at opportunities, and what plans there where with the transition of assets.

“There was lots of discussion to understand from an investment strategy viewpoint how investments would evolve from now to 2030,” she says.

One of the nuances here was that the broad indices in public equities were very emissions intensive and driving a lot of the fund’s intensity exposure.

OTPP’s strategy overall is to invest more in private markets and high conviction positions in public companies so the portion of the portfolio that was high intensity, broad-based market investments, would be declining over time. In addition, Ng says, the sectors that were of interest to the deal teams were not the high emissions sectors.

“Understanding the investment strategy helped us to understand the targets,” she says.

More in private markets

Ontario Teachers’ currently has 50 per cent of the portfolio in private markets, and that is expected to grow by as much as $70 billion over the next five years as they lower their allocation to fixed income.

“From an investment standpoint we will be increasing private assets over time and our private equity portfolio is very low intensive compared to public equity,” Ng says. “Part of [net zero] strategy is as we pivot more to PE will be able to achieve some of those reductions.”

As a direct investor, the fund will also use its role as an owner of businesses to set portfolio companies on a clear path to implement Paris-aligned net-zero plans and meaningfully reduce emissions.

“We invest a lot directly, and sit on boards, so we can use that influence to help facilitate improved practices and decarbonisation,” she says.

Part of the net zero plan is to significantly grow investments in companies that generate clean energy, reduce demand for fossil fuels and build a sustainable economy.

Sections of the private equity team have been pivoting towards sustainable energy such as sustainable fuels, bio energy and battery storage.

The fund has also set up a team called VERT – the virtual, energy and renewables team – which is a cross-collaborative team made up of representatives from every asset class.

“This group is working to develop an over-arching total fund strategy for how we find investment in clean energy technology, so they are on the cutting edge,” Ng says. “We are trying to understand the areas of interest, our capabilities and what is most investable. We didn’t want to create a new standalone team, we already have the talent, this is a forum to accelerate that and look at opportunities.”

 

Green bonds and transition assets

OTPP has a debt issuance program as part of its total fund management program and has signalled its intention to grow its green asset base. It will issue green bonds and invest the proceeds in climate solutions and sustainable companies.

In addition it intends to address transition assets, recognising their importance in the net zero pathway.

“We can buy higher emissions investments and through our efforts help them to decarbonise faster than they planned or could before and that’s an important area for net zero. There is so much focus on emission reduction what we see happening is the easiest way to meet a target is to sell an asset. There will be times when our footprint doesn’t go down as much because we are taking on a high emissions investment, but we will be taking it down in future years. Most importantly, these efforts lead to real-world emissions reductions,” Ng says, adding it is developing a taxonomy to help define that.

OTPP is an anchor investor alongside Temasek in Brookfield’s global transition fund, co-led by Mark Carney, which will scale clean energy as well as invest capital to transform carbon-intensive businesses. PSP and IMCO are also investors.

 

Operational plans

Ng says a lot of the net zero steps are operational items. Things like how to allocate the targets across the organisation and asset classes, how to define transition assets and measure them in a meaningful way.

“Measuring our green investments is another definitional challenge. We are leveraging our green bond framework, but we also need to understand and measure our entire exposure to green assets and how much that is changing over time,” she says. “We also have to get the deal teams focused and working on private companies to help them moving. We have already done work with portfolio companies to measure their carbon footprint. The work ahead is now we’ve measured it what are the opportunities for reducing those emissions?”

While the fund has been working on the net zero interim targets for the past six months, Ng says the work has just began.

“2025 is not very far away and it will take support from the investment teams to reach these targets. They are aware of targets and are on side but sometimes they need help on getting started so we are working with them on things like how to have the conversation with your portfolio companies. We are looking at what we need to equip the team with to execute this.”

The last piece of the roadmap is on the policy advocacy level to work at the industry and regulatory level to promote policies that are conducive to a transition to net zero.

“As much as we are an influential investor there are much bigger pools of capital out there so standards and regulation also important lever that can create positive change across the entire market .”