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Five value chains driving the ‘transition winners’

The most promising global companies identify opportunities and sustain profitability using what we call ‘global sustainable equity’. Sustainable has three pillars:

  1. a durable competitive position
  2. do no harm
  3. adapt to change.

The most obvious sense of sustainability is in companies that do no harm. On environmental, social and governance (ESG), good performance and planning around those factors can have a direct relationship with a company’s broader financial performance.

But the sustainability of a business clearly overlaps with its durability. Companies must reinvest profits to sustain their core business and take advantage of attractive opportunities. The ability to adapt to change makes a company much more likely to sustain today’s profitability into tomorrow.

Transition winners come from value chains

We identify five value chains in the modern economy.

  1. Digitalisation of the economy (the Digital Enterprise value chain)
  2. Demand for renewable energy (the Energy Transition value chain)
  3. Lower-cost solutions for unmet or high-cost medical needs (the Access to Healthcare value chain)
  4. Products and services that recognise the increasing focus on ethics and convenience (the Conscious Consumer value chain), and
  5. Solutions in the rapid shift to digital payments and online access to finance (the Fintech and Financial Inclusion value chain).

Much investment management still tends to think in terms of industrial sectors, but the shift toward services and the growth of information technology has substantially blurred the lines between the traditional sectors.

For example, Amazon’s tools are the internet and logistics, but its impact has been felt in the retail sector. Today, the performance of a manufacturer in the industrials sector is less likely to be determined by what it has in common with other industrials stocks than by whether it makes things for, say, the renewable energy industry rather than the extractive commodity industry.

Look through a value chain lens

Value chains offer a more realistic view of what’s going on in today’s economy. We look for the companies that are best positioned to adapt to and take advantage of the major transitions identified by those value chains. These are ‘transition winners’.

To identify companies with durable competitive positions, look for businesses that can sustain high profits for an extended period by building ‘economic moats’, especially with intangible capital such as a lead in a particular technology, a unique consumer offering, protected intellectual property, an unassailable cost advantage or a hard-to-replicate platform, network or ability to scale.

As a starting point, we look for two important quantitative markers of a business that is compounding profits due to economic moats: Cash Flow Return on Investment (CFROI) and Asset Growth.

CFROI tells us how efficiently cash flow is generated from capital invested, and therefore the level of cash resources that are available for reinvestment. Asset Growth tells us whether or not a company is finding opportunities to invest that cash.

When both are relatively high, that indicates to us that a company is investing for growth while simultaneously guarding its profitability from potential competitors. When CFROI is high but Asset Growth is low, that suggests a company whose past investments remain profitable but which is struggling to find new opportunities. When CFROI is low and Asset Growth high, that may indicate an early-stage business that has not yet established the moat that will protect its profitability.

Companies with high CFROI and high Asset Growth are not always likely to be among the ‘transition winners’. Let’s take an example of one of our value chains, Energy Transition.

It is perhaps obvious that a lot companies working in this value chain with low CFROI and low Asset Growth are fossil-fuel producers threatened by cheaper and more sustainable alternatives and weighed down by stranded assets. It is clear why these companies struggle to adapt to change as they are massively geared to yesterday’s economy.

But how do you think a manufacturer of batteries, electric vehicles or solar panels looks, according to these metrics? Asset Growth tends to be high but CFROI does not follow, because these products are easily commoditised and competition is fierce. We tend to find high CFROI and high Asset Growth in the manufacturers of solar invertors, equipment for electricity grids and specialised home energy services. We think it is much harder to identify the obstacles that will prevent the best of them from emerging as transition winners generating sustainable, durable profits.

There is a simpler way in which high CFROI makes a business more likely to be a transition winner. Profitable businesses usually have established brands and reputations which they can bring to new markets, and their cash flows remove the necessity to borrow or sell more equity if they identify an opportunity to pivot and invest in new opportunities.

That opens the possibility for a mature, old economy business with high CFROI and low Asset Growth today to adapt to change and find new growth opportunities tomorrow— but in our experience, successful examples are rare.

A focus on ESG shows a focus on the future

A lot of ESG investing remains top-down and quantitative. These screens are useful for weeding out the very riskiest businesses, but they are much less useful for differentiating between businesses that pose similar levels of risk or identifying attractive opportunities.

Few companies have uniformly strong performance across all ESG factors, and this tends to make the aggregate ESG scores of many businesses bunch around the average regardless of how well or badly they perform on the factors that matter most to them.

Furthermore, the historical data that feeds into quantitative ESG scores does not fit well with our focus, as active investors, on businesses that are making marginal ESG improvements that are yet to be priced into securities. They offer no insight into a company’s sustainability action plans. They tell us nothing about the likelihood of changes in regulation or consumer attitudes, which could alter a company’s material ESG exposures. For us, low current ESG risk is a plus, but we see the most attractive alpha opportunities in active efforts both to manage and to change ESG exposures.

In addition, a forward-looking view on ESG helps both investors and company management teams to appreciate how societal change can make what were once non-material ESG risks into potentially material threats or opportunities. A forward-looking plan of action on ESG often indicates a general adaptability to new practices and changing circumstances, and therefore an enhanced ability to adapt to change to sustain profitability. We find that companies like these are more likely to be thinking ahead and taking a holistic view of their position in society, the economy and the wider environment and it’s no coincidence that this way of looking at the world overlaps considerably with the value-chain lens that we apply in our own research.

Bringing it all together

High Asset Growth suggests that a company has found a way to adapt to change happening in the economy. High profitability gives companies the reputational and financial means to adapt to change. Moreover, a greater reliance on intangible over tangible capital, which we often find associated with durable competitive positions, can also give companies the operational means to adapt quickly to change. It is often easier to change the productive focus of technology or knowledge than to change the productive focus of specialised machines and factories.


Hendrik-Jan Boer is Senior Portfolio Manager and Head of Global Equities Group at Neuberger Berman, a sponsor of Firstlinks. This material is general information and does not constitute investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. You should consult your accountant or tax adviser concerning your own circumstances.

For more articles and papers from Neuberger Berman, click here.



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