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Nathan Hughes on consistency in strange markets

Nathan Hughes is Portfolio Manager for the Ethical SRI Fund at Perpetual Investments.


GH: Nathan, how does the Ethical SRI portfolio differ from other Perpetual funds which no doubt have an ethical screen as well?

NH: Fundamentally, the Fund draws on the same philosophy and quality filters that we use across the broader equities team. However, a two-stage screening process is overlaid on top of that. The first stage excludes companies from the investable universe when their activities are deemed too ethically unacceptable, at a 5% revenue-materiality threshold. Some examples are the manufacture or retailing of alcohol and tobacco, and fossil fuel production.

The second stage looks more at how a company acts, and we score companies both positively and negatively on a range of SRI (Socially Responsible Investing) factors. A company must have a net positive score to be included in the ethical universe. I build my portfolio from there with additional filters.

GH: So how does Perpetual screen for responsible investing across all portfolios?

NH: ESG (Environment, Social, Governance) is incorporated into our decision-making process for all equity funds and we've been a long-standing signatory to the UNPRI. The overall process is about balancing out those risks and potential rewards for investments. My Fund is different in that it’s very explicit. Clients can invest in the Ethical SRI Fund knowing that it will not buy certain kinds of companies. There are hard and fast rules on what's in and out.

GH: Okay. Is there a committee process that you go through?

NH: Largely, the process relies on the objective, two-stage screening and filtering. We also have Richard Morris, who is Head of Responsible Investments, as the ultimate arbiter of the investment universe. As the Portfolio Manager, I’m given a list of companies I can invest in and I'm independent of the screening process so I’m not trying to squeeze companies in or out.

GH: Can you give an example of a company that's in the broader universe but not in yours?

NH: The easiest examples are the big resource companies which are excluded from the ethical universe on fossil fuel grounds. So for example, Woodside, Santos or BHP Billiton. A more topical example is Commonwealth Bank, which was excluded from the ethical universe over 12 months ago based on corporate misconduct. There was a pattern of behaviour and events over a period, but that assessment is reviewed on an ongoing basis.

GH: Fund managers often get criticised as custodians of capital for not doing enough to change companies for the better. Is your approach more speaking at AGMs or in the media or behind-the-scenes?

NH: It’s a range. Our preferred method is to talk to companies behind closed doors, and we certainly do engage with boards. But we have a history of going public as well, if we feel like our message is not being heard. Brickworks is the best example.

We are stewards of other people's capital and we have a fiduciary duty to look after it and grow their investment, to ensure that companies are acting responsibly and in a manner that can hopefully generate the kinds of returns we expect.

GH: Has ethical or sustainable investing moved beyond ‘coming of age’ to become part of the market noise and potentially investors are jaded by the story?

NH: Funny you should ask that. I wouldn’t say ‘jaded’ given its ongoing popularity, it's growing strongly and investors are more active, especially the younger ones. They want more data on how their money is invested and what the companies are actually doing.

But you are right, there is an enormous amount of noise in the market as well, particularly on the ESG factors. There's a lot of data and much of it is inconsistent and noisy, and some of the things that we're looking at are hard to measure. Some of the social elements can be fluffy and difficult to quantify whereas things like emissions and energy intensity are easy to understand.

It is tricky, but it's an area in the market that people are interested in. We must be transparent about our product and what we're trying to do, but we can't be all things to all people.

GH: The removal of resources companies from your portfolio obviously creates tracking error versus the index, and there’s an issue that some ethical themes will take 20 or 30 years to play out. But performance is judged every month. Is that a challenging communication issue?

NH: Not really. We demonstrate long-term thinking and we’re not trying to outperform the market every day, every week, every month, it's just impossible to do. We have a process and philosophy here which has been out of favour recently, but obviously we’re sticking to it. It doesn’t change.

GH: Are there any trends that you've identified that the market underappreciates?

NH: We’re not big on macro trends, our process is more bottom-up, research-driven. But any company that ignores sustainability, in my view, that behaviour just cannot go on. Most large companies are taking disclosure seriously. It’s become a key part of their business proposition, and that’s a trend some small companies must catch up with. Some of what we call ESG is simply good business practice, such as safety or employee engagement and culture.

GH: How do you feel about this market disconnect with interest rates at all-time lows suggesting economic slowdown, and equity markets at all-time highs, suggesting good trading conditions?

NH: Markets are in a very strange place. Even the Reserve Bank Governor can’t understand why rates imply a slowdown while equity investors and credit investors are complacent about risk. We believe lower risk-free rates can justify higher valuations but that’s only one part of the equation.

The other part of the equation is the outlook for earnings and margins, and according to companies we talk to, margins have probably peaked in the near term. And that is obviously negative for earnings and indicates lower growth in future. We also find puzzling some of the extreme valuations being paid for growth companies, which are now talked about in multiples of sales to justify their prices.

GH: It’s hard to have a P/E ratio when there’s no E.

NH: Yes. There are some companies where significant upfront investment costs such as customer acquitistion expenses are going through the P&L as opex (operational expenditure) whereas historically we may have seen these costs go through capex (capital expenditure). There are many examples, such as Xero and previously Aconex, and this accounting treatment can mask true profitability or earnings growth over time. However, we think people get lazy and apply that thinking to a range of stocks. There are stocks trading at 20 to 30 times sales with a great hope of profitability at some point in the future. Many of these stocks are set for disappointment, as growth expectations may not eventuate. There will be exceptions, but many expectations are just too high.

GH: So other than the WAAAX companies, are there other examples?

NH: There’s a company we used to own called Pro Medicus, PME, which is a fine business, strong growth, fixed cost leverage, high margins, but it’s priced at 50 times sales. It’s well-managed, but we can’t get there on valuation. Nearmap has a great narrative but the earnings delivered so far are quite small. In the US, many big listings carry a history of losses.

GH: On the subject of history, Perpetual has a long history of developing some of the highest-profile fund managers in Australia, going back to Peter Morgan, John Sevior, Matt Williams. Is there something about the culture or training that produces that sort of person?

NH: We think so. The philosophy and the process are critically important, and they stay consistent over time. One way we do that is by encouraging promotion from within. Our current Head of Equities, Paul Skamvougeras, worked externally for a period of time but his two stints here cover two decades. He started in the back office and got a job as a dealer for Peter Morgan. Many of the team have come through the ranks and it’s important that our process and culture are maintained. We add quality from external places where necessary. Our investing rules are not negotiable and they've stood the test of time.


Graham Hand is Managing Editor of Cuffelinks. Perpetual Investments is a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any investor.

For White Papers by Perpetual relating to Nathan’s portfolio, see The Perpetual Ethical SDRI Fund and Our Ethical SRI Screening Process.

For more articles and papers from Perpetual, please click here.



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