This article is from The Good Investment Review, October 2022, which is available to download for free here.
With the last 12 months more challenging for ESG funds and our Sustainable Future investment process at Liontrust, it is worth reiterating exactly what we mean by a sustainable company and why we continue to believe there is alignment between doing good things and business success.
Several commentators have questioned whether sustainable investing has become a ‘punt on growth’ given so many funds have struggled in the value rotation, and whether underperformance indicates a previous bubble in these stocks. We feel both oversimplify what is going on.
The question of growth
Looking at the ‘growth’ question first, the trigger for the recent change in performance from many sustainable funds, including ours, has been macroeconomic, with central banks hiking interest rates to control inflation. By nature, many sustainable companies are focused on innovation and sit in the ‘growth’ category; they are long duration as more of their valuation is linked to future earnings, and therefore more susceptible to higher interest rates.
Over recent months, as rates have risen, this has led to a sell-off in growth assets in favour of defensive, value and inflation-aligned investments. We believe this has been indiscriminate and overdone in the case of many sustainable businesses.
A deeper question is whether progress towards a cleaner, healthier and safer future has stalled but again, despite concerns, our view remans that sustainable themes have persisted for decades and are embedded in the global economy.
The long-term case for innovative sustainable companies
If you examine how change happens, there tend to be three actors. First, understanding is developed around a particular issue and ways to resolve it (air pollution is harmful to health, for example), then society/government lay the groundwork for action – via regulations, taxes and other incentives – and finally companies develop and distribute solutions. What is interesting for investors is that these businesses tend to experience persistent demand growth and face less competition due to the novelty of what they are delivering. This suggests a long-term case for innovative sustainable companies to outperform.
It is reasonable, though, to ask whether this model will work for challenges like tackling climate change, biodiversity collapse or inequality. On climate change, successive reports have stressed the need to reduce emissions from human activity and yet we now have greenhouse gases (GHG) at record levels and are experiencing extreme weather-related impacts.
But with more than 80 per cent of global energy still from fossil fuels, is this a challenge too far? We believe not: change is rarely linear, and when a cheaper, better solution is developed, it can displace the old at an exponential rate. Progress has been slow but we are confident recent growth in renewables and adoption of electric vehicles signal one of these transitions.
The growth of renewables
For years, renewables were supported by regulation and subsidies, then there was a tipping point when it became the cheapest form of energy generation. Since 2010, solar has fallen by 90 per cent in price and onshore wind by 60 per cent – and cost deflation continues. The consequence is falling fossil fuel use, starting with coal.
Reducing emissions will impact the whole economy, including our energy system but also driving transformations in transport, industrial processes, agriculture and land use. This move to an ultra-low carbon economy will also have a massive impact on investment returns: companies contributing to this shift should prosper while those on the wrong side are at risk of secular decline.
Beyond climate change, we see a swathe of companies contributing towards making our world cleaner, healthier and safer. We have long recognised rising demand for more digital communications, for example, as we become more connected and aware of environmental impacts of travel.
UK company Helios Towers, held across our funds, is exposed to our Connecting people theme, owning and operating telecom towers in rapidly urbanising parts of Africa. This move to online life can only thrive, however, if people are confident their information is safe, and Softcat is a long-term holding that provides outsourced IT services to small and medium-sized UK businesses.
A more sustainable economy
Finally, while increased communication is important for a more sustainable economy, the challenge is to decouple growth from environmental impacts. Even before Covid supercharged these themes, we were considering the impact of the world’s digital footprint: figures from think tank The Shift Project show these technologies account for 4 per cent of GHG emissions, more than civil aviation, and this could double in coming years.
The US technology industry now emits more carbon than ever, so more efficient data centres are vital. Electricity used by these centres is expected to double approximately every five years and emissions are already comparable to small countries (back in 2016, global data centres used more than Britain’s total electricity consumption). Energy now represents around two-thirds of total data centre cost, greater than the hardware within them, mainly consumed by ancillary systems such as cooling and Uninterrupted Power Supplies (UPS).
Investing in companies finding solutions to the world’s problems is the central part of our process and we believe those enabling energy and carbon dioxide savings for these centres should benefit from growing demand. Held in our funds since 2011, US company Equinix stands out as the only global player in the co- location data centre market and its assets are almost impossible to copy. On top of this, the business is addressing environmental impacts of technology, with a goal of using 100% renewable energy.
Digital technologies have changed the way many of us conduct our lives and Moore’s law on the rate of technical advance suggests greater transitions to come. Providing access to these trends must be part of any sustainable world but it is vital – to quote the UN World Commission on Environment and Development – to ensure we are not compromising the future by meeting the needs of the present.
Risk warning: Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested.