Ask A Fund Manager
The Motley Fool chats with fund managers so that you can get an insight into how the professionals think. In this edition, U Ethical portfolio manager Jon Fernie tells how you can make good money while not wrecking the environment or putting up with unethical executives.
Investment style
The Motley Fool: What's your fund's philosophy?
Jon Fernie: We're an ethical fund so we negatively screen out activities that we view as harmful to society or the environment such as gambling or fossil fuels. We also actively look for higher exposure to companies that have a positive impact so that includes healthcare or education.
From an investment philosophy perspective, we recognise that equity markets are cyclical and believe that the fundamentals will ultimately drive the performance of stocks. We also aim to deliver non-financial benefits so there's a focus there on active ownership and engagement with companies on key ethical and ESG [environmental, social and governance] issues.
From a style perspective, we definitely have a bias more towards quality and large-cap stocks and we aren't fixated in terms of value versus growth. We're a long-term focus and have relatively low turnover in the fund as well.
MF: What's the typical investment horizon?
JF: We're looking at 3 to 5 years as the typical investment horizon.
MF: A question some people might have about ethically driven funds is: Where do you get your morals from? Because there are grey areas where some parts of the population might think something's a bit off, and some parts of the population might think it's okay?
JF: It's a good question. We have an ethical investment policy and that really drives our ethical approach. And everyone will have different values, but it's becoming more commonly accepted that a lot of funds in the responsible investment space will screen out areas such as armaments, tobacco, et cetera.
We have a more stringent policy where we look at things that we deem as harmful to society or the environment. And that is a subjective notion, but we've got an investment committee which oversees these decisions, which is part of a subcommittee of our board. And we're also getting external experts to get their opinions as well.
MF: How has the fund performed in the past year?
JF: We've been really pleased with the performance over 2020. We were fortunate to be relatively defensively positioned coming into the pandemic and we didn't own any energy stocks due to our ethical exclusions. As a result, we performed better than the broader market on the initial sell-off.
The recovery was pretty rapid and we slightly lagged at the end, but overall we delivered a 5% total return for the year. And that was around about 3% ahead of our benchmark, which is the S&P/ASX 300 Index (ASX: XKO). We were really happy with that outcome, given the volatile conditions.
MF: Did you manage to free up some cash before everything went downwards in March last year?
JF: Yeah, we had slightly higher levels of cash coming into the sell-off.
And as I said, some of the stocks that we were holding were reasonably defensive in nature. I mean, we didn't anticipate the extent of what was going to happen clearly, but I think we were well positioned overall.
MF: Typically how much cash do you have in hand?
JF: It varies depending on our view of the market and what we see as the opportunities out there and also how we see valuations in the market. We've got a range of 0% to 10%, so it's not that large.
MF: What is it at the moment?
JF: At the moment we're around about 5%, so we're fairly neutral in terms of that allocation.
Buying and selling
MF: What do you look at closely when considering buying a stock?
JF: We look at a range of factors when looking at stocks.
Firstly from the ethical perspective, we have a negative screen and that is down to our investable universe. We also look at minimum ESG thresholds as well.
From there, we look at a range of financial metrics, including things like return on capital, earnings growth, cash flow, and also balance sheet strength. And then when we look in more detail at companies, we look at qualitative factors like the broader industry growth, macroeconomic conditions, and competitive position. Also, the experience and track record of management teams and boards.
MF: With the ESG side of things, do you try to give it a numerical score?
JF: We utilise external providers. So we use MSCI ESG to look at some of the numerical scores, but I guess we also do a qualitative assessment on some of the issues because we realise that you can't necessarily capture everything in a score.
And we do have certain thresholds. So we're trying to invest in companies that have better and improving ESG ratings. But we're also looking at issues, which might be a financial or reputational risk to companies, whether that's around the environment, labour management, or product safety.
MF: What triggers you to sell a share?
JF: Yes, similarly, there could be a number of triggers for the selling down holdings.
Our exposure in stocks is driven by a combination of the sort of internal rating that we give based on those metrics mentioned before, and also the share price relative to our valuation.
So I guess the triggers for selling a share could be a deterioration in the fundamentals of a company that either increases the risk of that stock or leads to us having expectations for lower future earnings cash flow. And/or we might sell down a stock based on valuation grounds — if it's run too hard, and we think that it's too expensive.
Finally, we may divest holdings based on ethical and ESG factors. If we think that behaviour has been particularly egregious and companies aren't taking the appropriate actions then we may divest, but generally, we try to engage with companies on these issues to drive better outcomes.
What's coming up?
MF: Where do you think the world is heading at the moment?
JF: We're cautiously optimistic on the outlook for markets, but we recognise that there's a lot of uncertainty given the risks of the economic recovery and the rollout of the vaccine.
We had had a really strong reporting season in Australia that was ahead of market expectations, but we've also got this fiscal stimulus that's rolling off in Australia. So we're cognisant to see what happens on that front.
We expect that the Reserve Bank will likely keep interest rates relatively low, but obviously the market's become more concerned about rising inflation. And I guess that is a risk that you can't ignore. There are also some risks around the level of debt that has been taken on in the global economy.
MF: In the past year people have really flocked to ESG-aware companies, like with clean energy and electric car stocks. It's been a good 12 months, hasn't it?
JF: Yeah, I think there have been good flows into ESG and responsible investment funds. I think that we've also seen a step up in terms of companies reporting on these issues and engaging with investors on these issues, and I think that we see that performance around a lot of these issues will ultimately be beneficial to stock performance. It often goes hand-in-hand with the good governance of the company and it can give us more faith in the management team.
Overrated and underrated shares
MF: What's your most underrated stock at the moment?
JF: The stock that we hold that we think looks attractive at the moment is Resmed CDI (ASX: RMD).
The stock's pulled back quite a lot over the last 3 months, but they did deliver a very strong half-year result. They continue to gain market share in their device segment. And I think we'll see improved sales with COVID restrictions easing as well. Longer term they made some large investments in terms of software solutions. That'll be a good opportunity to grow in earnings in that out-of-hospital care space.
MF: It would be a growth area, with an aging population?
JF: Definitely. And I think that they've got some good tailwinds and certainly that increase digitalisation of health. I think it's a longer-term trend as well.
MF: Has the pullback in the share price just following the general market or has there been a specific reason?
JF: We see it as unjustified, to the extent, over the last 3 months, it's down about 15%.
It's not a company that necessarily screams out 'cheap'. But we think that the valuation is justified given the strong growth outlook.
MF: What do you think is the most overrated stock at the moment?
JF: We have problems broadly with the buy now, pay later space, which is probably not an uncommon observation. There are some very good companies [in that sector], but there's going to be increased regulatory focus, we think.
There's also a lot of signs of increased competition, whether that's from overseas buy now, pay later companies like Klarna, or like Paypal Holdings Inc (NASDAQ: PYPL), [which] has signalled their intent to ramp up in this area.
MF: Do you have any views on the ESG side of that buy now, pay later sector?
JF: It's not an area that we would invest in. I think that we had previously invested in, but we've got some concerns over the consumer side and the consumer protections.
Looking back
MF: Which stock are you most proud of from a past purchase?
JF: We bought A2 Milk Company Ltd (ASX: A2M) back in 2016 at about $2. So that was a stock that we held and returned about 10 times on our initial investment.
It's recently had a large pull back, but we had taken a lot of profits along the way and sold down most of our holdings prior to the large pull backs.
MF: Back when it was $2, what sort of signs did you see that made you want to invest into it? Because you mentioned before that predominantly you focused on large cap companies?
JF: Yeah. Look, we do hold some sort of small and mid cap stocks where we see there are good opportunities. I think that what we liked about A2 Milk was that they had a strong, differentiated brand, they had a good balance sheet, and they were executing well in terms of growing that brand. Also, we saw a fairly strong tailwind, which obviously became more challenging over the last 12 months.
MF: Is there a move that you regret from the past? For example, a missed opportunity or buying a stock at the wrong timing or price.
JF: Good question. I think the one stock retreat where we got the timing wrong was investing into Challenger Ltd (ASX: CGF) several years ago when we thought that interest rates were going to move higher. We also thought that there were going to be regulatory changes that would drive underlying demand for annuities.
Unfortunately, both those things didn't happen. And that led to us ultimately exiting the stock at a lower level. So that was probably one investment decision that we regretted.
MF: You mentioned before you could exit a company because they've challenged the ESG side of the equation. Because you filter companies for their ESG values when you're buying into it, something dramatic must happen for you to exit for that reason — is that right?
JF: Yeah, generally speaking, it would be something big.
[But] as I said, for the most part, we're not exiting for that reason. We normally try to engage with companies and look to influence change by speaking to management and see that appropriate changes can be made within the company.
But I guess if a company bought into a business that we excluded, then that could be a reason. So if someone bought into a large oil and gas business and that hadn't been their existing business or if there was a major scandal within an organisation, then that might be something that we review. And we want to make sure that, as I said, appropriate changes are made.
MF: Do you have an example where you had to engage with the company or even exited your holding for an ESG reason?
JF: We're regularly engaging with companies. Probably a good example would be that we engaged with Cleanaway Waste Management Ltd (ASX: CWY) by some of the revelations around the CEO's behaviour.
We still hold Cleanaway. There's obviously been a management change there as well, but we are looking to ensure that they put into place changes around the side of the CEO — certain behaviours that we didn't like.
So we will regularly engage with other companies on issues ranging from environmental issues to modern slavery, also looking at climate action and what companies are doing in terms of reducing their emissions.
MF: Personally, for yourself, what led you into the ethical investment area?
JF: It's an area that aligns well with my beliefs and I think that it's also an exciting growth area. I think more people are looking at investing through the values lens and want to ensure that they're not only missing spike returns, but also that they're not having a negative impact on society or the environment when they're doing that.
It's an exciting space and I'm sure that we'll grow further over the next few years.
MF: I gather the ultimate aim would be for people not to use the term 'ethical investing' and it would just be 'investing'.
JF: Exactly. Yeah. Ultimately that would be great. As we said, people will have different opinions and different values. So it's always a little bit subjective.
