Investors are Embracing this Emerging Theme

A review of the oil and gas sector has led to the Alphinity Sustainable Share Fund rejecting all fossil fuels where clean and affordable solutions are available. Most notably, the review led the manager to exclude BHP (ASX: BHP) from its sustainable investment universe, although it notes the miner’s commitment to lowering emissions.

More broadly, Stephane Andre, principal and portfolio manager at Alphinity Investment Management, believes Australia is at a “tipping point” on sustainable investing with the momentum accelerating as more companies delivering integrated annual reports, which present sustainability outcomes alongside business outcomes.

Around 45% of ASX100 companies last year included sustainable development goals in their strategy and corporate reports, up from 25% in 2018.

Unfortunately there is still no agreed industry disclosure and evaluation approach to assess how companies perform compared to the goals, but there’s no doubt people increasingly want to work for a greater purpose and with companies that support their values.

I understand that you no longer invest in companies that produce fossil fuels. What prompted this decision?

The Alphinity Sustainable Share Fund aims to support companies that display good ESG practices and contribute to achieving the UN’s Sustainable Development Goals (SDGs). The fund had previously excluded most companies that produce what we referred to as “high-impact fuels” — those that were most damaging to the environment and/or social cohesion, such as thermal coal, arctic drilling, oil sands, fracked gas and uranium. This left only conventional oil and gas as allowable investments in the fossil fuel space.

As some of the conventional energy companies were still considering investing billions of dollars in new LNG plants that would produce for the next 20-25 years, we felt we needed to revisit the concept of gas as a transition fuel, a scenario where some fossil fuels were claiming to be part of the solution rather than the problem itself.

We embarked on a thorough review of all main usages of oil and gas, assessing for each whether a cleaner yet still affordable solution was available. To our surprise, the answer was “yes”. Our in-depth analysis concluded that not only is unabated fossil fuel production incompatible with the achievement of SDGs 7 (Affordable and Clean Energy) and SDG 13 (Climate Action Goal), and therefore inconsistent with the charter under which the Fund operates, but also that reducing GHG emissions of these fossil fuels to the point of carbon neutrality is already affordable today once the significant external costs of using fossil fuels, including climate risks, are taken into account.

We concluded that the fund should no longer invest in companies which have a material exposure (more than 10% of revenues) to oil and/or gas production.

The only exception to this is if we’re convinced they have clearly demonstrated a net zero emission commitment by 2050, backed by credible plans to reduce their Scope 1, Scope 2 and Scope 3 greenhouse gas emissions on a trajectory aligned with the Paris Agreement. No fossil fuel company currently meets those hurdles, so the fund is fossil fuel free.

The exception is companies that convince you they have credible plans to reduce their greenhouse gas emissions. Can you offer some examples of companies the fund can no longer invest in and those that qualify for the exemption?

We’re not aware of any ASX-listed mid- or large-cap oil and gas companies that have committed to a net zero emission target for scope 1, 2 and 3 by 2050, or that have credible plans aligned with a trajectory to meet the Paris Agreement. The closest to that mark is arguably BHP, whose oil and gas operations account for around 15% of revenues. We commend the company for its Scope 1 and 2 Science Based Targets and credible pathway to get there. But as their ambitions for Scope 3 have been contained to an aspiration rather than a target, they don’t meet our Sustainable Share Fund hurdles, which means we cannot re-introduce them into the fund.

In saying that, we recognise how challenging it is to set Scope 3 targets and BHP’s approach to focus on key areas of their footprint where they have some influence makes sense. They have committed to work with industry and their supply chain to develop technologies and pathways capable of 30 per cent emissions intensity reduction in integrated steel making, and to support a 40 per cent emission intensity reduction of BHP-chartered shipping of their products. BHP is one of the first large companies to set clear aspirations for Scope 3 emissions and given their influence we expect this has set a new exciting standard which we hope other companies will also follow.

I note BHP has dropped from an active weight of 2.2%, to -6.9% (no holding) over the last 6 months. Can you explain how you went about the decision to remove BHP from your portfolio?

Yes, it was a direct result of that change. The recent deep dive into the sustainability of oil and gas described above led us to exclude BHP from the Sustainable Investment Universe. Its oil & gas production is material and doesn’t meet the Scope 3 Net Zero emission commitment. We have managed to replace BHP with attractive investment alternatives that allow the Sustainable Fund to maintain exposure to some of the other commodities BHP produces for which we see upside. These alternatives are OZ Minerals (ASX: OZL) for copper and a combination of Fortescue Metals Group (ASX: FMG) and Iluka (ASX: ILU) for iron ore.

Are Australian investors more accepting of the sustainable investment universe now than five years ago? Where do you see this sector five years from now?

Absolutely, more and more investors are embracing the shift to sustainability and aligning their investments with their values. The space is changing through — five years ago it just meant avoiding exposure to certain industries like tobacco, alcohol or gambling. Today it is moving away from these negative screens to finding companies that have a positive contribution to society. The definition of what that means differs per investor and can be at times nebulous. For the Alphinity Sustainable Fund, the concept of positive contribution has been anchored around the Sustainable Development Goals. In five years, I hope that Sustainability will become closer to what ESG is for investment today, that is a fully integrated part of the assessment of a company investment proposition.

How would you rank the movement towards sustainability? Can you share a few comments or examples to back up your view?

It feels like we’re getting close to a tipping point, and the momentum is accelerating. We’re increasingly seeing companies focusing their reporting on sustainability and delivering integrated annual reports, which present sustainability outcomes alongside the business outcomes. A study published by the United Nations Association of Australian and RMIT, for instance, showed that the percentage of ASX 100 companies reporting the SDGs in their strategy and corporate reports lifted from 25% in 2018 to 45% in 2019. In a few years we could expect them to all report against SDGs, and eventually we might even reach a common notion of what that means. But for the moment there is still no agreed industry disclosure and evaluation approach to assess how companies perform compared to the goals, so the interpretation can be very arbitrary.

We’re also seeing increasing engagement, activism and disclosure on sustainability more generally. For example, a few of the larger companies now hold dedicated ESG and Sustainability investor briefings, which was something unheard of only a few years ago. Another example is the recent investor action over the Juukan Caves destruction and Rio Tinto (ASX: RIO). On our end, we can clearly see the changes in momentum through our interactions with clients, not only for the Sustainable Fund but for our other funds too. There has been a substantial increase in the number and depth of sustainability-related questions, especially around how we integrate and consider sustainability aspects in our investment decisions.

Our discussions with companies suggest that the UN SDG framework is not only compelling for the marketplace but also for employees. More and more people want to work for a greater purpose and with a company that supports their values.

How do you distinguish between stronger than expected earnings growth that’s driven by transient factors, and that which is driven by sustainable upgrades?

Earnings upgrades are driven by multiple factors across industries and companies. Some are company specific while others can be broader industry or economic trends. Key to understanding what those drivers are and how long they will persist is fundamental research. We know that earnings upgrades (or downgrades) are serially correlated so stocks already exhibiting upgrades are more likely than the average company to have another upgrade. Our quantitative factor research helps us keep track of those changes for individual companies as well as sectors and the overall market, and that’s a good start.

But to understand what is behind those upgrades, we need to do fundamental analysis of supply and demand, company productivity, pricing power, competitors and much more. That’s why the Alphinity team has had over 600 company and industry meetings this year alone, all virtual in the last six months, of course. That information is used in our proprietary financial models of company earnings to ascertain whether the market is over- or underestimating their earnings outlook. There is no one answer to what are transient earnings and more sustainable upgrades, but continuous pursuit of fundamental insights can go a long way to making the right call.

When you say you want to invest in companies that “do good, and do it well” what does that mean to you? Of the 17 SDGs, which are most central to your portfolio today?

Our Sustainable Share Fund invests in companies that “do good” (contribute towards achieving one or more of the Sustainable Development Goals) and companies that “do it well” (companies that have strong ESG practices). Of course, the companies we invest in are likely to outperform the market by surprising positively earnings wise, which is our core investment philosophy. We believe, and have demonstrated, that investing in companies that do ‘good’ does not have to come at the cost of investment performance. There is no compromise to be made.

The UN SDGs are 17 goals behind which sit 169 individual targets. These goals and targets set the global agenda for a sustainable future and are now being used by Government’s, private companies and investors to define sustainability strategies. We use this framework to define what ‘doing good’ means and for aligning company revenue and product’s contribution to one or more of these goals.

At this stage, our portfolio is most strongly aligned with SDG 3 Good Health and Wellbeing, SDG 1 No Poverty, SDG 9 Industry, innovation and Infrastructure, and SDG 11 Sustainable Cities and Communities. As our assessment focusses mainly on revenue contribution to the goals, some goals like 5 (Gender Equality) and 8 (Decent Employment) are underrepresented even though many of the companies we’ve invested in do good work in these areas. This is because measurement typically goes more towards operational practices and improvements rather than services, products or revenue. So that we can present a more complete picture of how companies align with the SDGs, we are currently working on metrics to integrate these in our overall alignment and scoring of companies against the UNSDGs.

We believe, and have demonstrated, that investing in companies that do ‘good’ does not have to come at the cost of investment performance. There is no compromise to be made.

Could you share an example of a specific company and how it’s helping to meet one or more of the SDGs?

Firstly, Lifestyle Communities (ASX: LIC) is a company that positively contributes to SDGs, displays robust ESG practices and offers a compelling earnings surprise investment case. The company develops and operates affordable housing communities for older people who can still care for themselves, mostly on the outskirts of Melbourne. It operates along the ‘land lease’ model whereby Lifestyle owns the land itself, provides on-site management and builds common facilities (such as a clubhouse, pool, bowling green, and other recreational amenities) to be shared between residents. Residents can buy compact and inexpensive self-contained houses built by Lifestyle, which charges a modest rent for the land; this is often covered by a pensioner’s rent supplement.

Lifestyle solves several needs often faced by older people. Often asset rich and cash poor, it enables someone to sell their family home, which is often ageing and requiring maintenance, to the next generation of owners and release a substantial amount of equity to help provide for their future needs. It provides modern and affordable housing specifically designed for people in their age group. Importantly, it also provides community for a class of people who often suffer from the problem of social isolation. Lifestyle Communities has also generated strong returns for the Fund over the period of its shareholding so far as its growth and earnings sustainability has positively surprised the market.

Secondly, Sonic Healthcare (ASX: SHL) is one of the world’s leading global providers of medical diagnostic services. The Group provides highly specialised pathology/clinical laboratory and diagnostic imaging services to clinicians (GPs and specialists), hospitals, community health services, and their patients. Headquartered in Sydney, Australia, Sonic has grown to become one of the world’s leading healthcare providers with operations in Australia, the USA, Germany, Switzerland, the United Kingdom, Belgium, Ireland and New Zealand.

Due to its extensive services in healthcare, including a clinician and patient focus, they are strongly aligned with SDG3 Good Health and Wellbeing which aims to ensure healthy lives and promote wellbeing for all at all ages. Sonic’s extensive pathology and diagnostic imaging businesses help diagnose patients rapidly to ensure they receive appropriate treatment. For these reasons pathology and diagnostic imaging services are key in any healthcare system and vital in delivering healthy lives and promoting wellbeing. These statements are particularly relevant today as Sonic’s global pathology operations cornerstone COVID-19 responses by various governments globally. Throughout the pandemic Sonic has supported governments through widespread COVID testing to help firstly understand the full extent of COVID-19’s spread, then help suppress further spread through effective containment. These efforts, where effectively implemented, have significantly reduced the spread of COVID-19 and consequently saved many lives.

The alignment with SDG3, at both the thematic and target level, is further strengthened by their work in some of the most impoverished areas in the world, including Ethiopia, Tanzania and the Democratic Republic of Congo. Its Catalyst program was established in 1996 and aims to improve the healthcare and lives of people in some of the world’s most disadvantaged areas, by establishing sustainable, modern pathology and imaging services that lead to local self-reliance. They also provide training and other services like medical supply deliveries and community support. Sonic’s work to support healthcare systems and professionals in developing countries makes this company a stand-out in the health sector and highly appropriate for inclusion in the Sustainable Share Fund’s portfolio.

From an investment perspective, we believe Sonic earnings growth is under-appreciated by the market. COVID testings are likely to stay at higher than expected levels for longer whilst Sonics other pathology testings are likely to come back to pre-COVID levels in 12-24 months. Sonic is therefore a good example of a company that does good not only to society but for our investors too.

How would you best describe the investment opportunity that you are pursuing?

We are in essence looking to invest in companies that contribute positively to society, the environment, and to our investors. These companies can be found in any type of market.

What excites you most about your role?

I am really excited about having the responsibility to properly allocate investor capital on the one hand, and on the other hand to actively engage with companies to lift their awareness and consciousness around what they do and how they operate. If we can do that and at the same time meet our investor return expectations, then all is good!