Schroders tells BENCHMARK how it is finding investment opportunities through a focus on climate change.
Simon Webber (SW): Schroder ISF Global Climate Change Equity is an actively managed thematic global equity fund investing in companies that are positively impacted or likely to benefit from the issues surrounding climate change. The strategy’s approach is intentionally broad, recognizing that the effects of climate change will be far-reaching and affect most companies across most industries. Stocks are selected from a proprietary universe of companies that, in our opinion, will be beneficiaries of efforts to mitigate or adapt to climate change. Within the broad theme we have identified five sub-themes within which climate change opportunities are most apparent: energy efficiency, sustainable transport, environmental resources, clean energy and low carbon fossil fuels.
The effects of climate change can be seen globally. Temperatures are rising, rainfall patterns and sea levels are changing, and extreme weather is becoming more common. Climate change will have large financial consequences for many companies. The impact of climate change affects most companies in most industries and is set to herald the next industrial revolution. Global environmental regulations and energy policy will continue to grow and become increasingly exacting. Expenditure on mitigation and adaptation will continue to rise. The financial implications of climate change policy and regulation will only increase, with implications for companies’ sales, margins, earnings and, ultimately, valuations. These impacts are poorly understood, creating an attractive investment opportunity today.
BM: Does the fund use a bottom-up approach? How are investments selected and valued?
SW: The fund adopts a bottom-up, fundamental research-driven approach. Stocks are selected from a proprietary universe which has been developed by Schroders’ Climate Change Team. The universe comprises of over 700 companies from both developed and developing countries whose long-term investment outlook, in our opinion, is significantly impacted by efforts to mitigate or adapt to climate change. Multi-stage discounted cash flow (DCF) analysis based on forward earnings estimates is the primary stock valuation model used for deriving fair value for each stock. This is supported by other valuation metrics which are most relevant to the particular sector.
BM: What is your sector allocation policy, if any, and which sectors seem to have contributed most to performance last year?
SW: Sector positioning is broadly a residual of our bottom-up stock selection approach. While efforts are made to ensure the portfolio is well-diversified from a sector perspective, the theme ensures a structural bias towards areas of the market which are more impacted by climate change. These tend to be the more cyclical areas of the market. For example, the fund has exhibited a persistent structural bias towards industrials, IT, materials and consumer discretionary, although it also favors the more defensive utilities sector. Areas of the market less impacted by climate change include financials, healthcare and staples.
The fund comfortably outperformed the wider market over the past year, with performance primarily being driven by positive stock selection in many of the sectors most impacted by climate change, especially in materials, industrials and utilities. This was marginally offset by the negative impact of sector allocation, especially our overweight in materials and our zero exposure to healthcare.
BM: What is the minimum market capitalization of these holdings, given the fund is more linked to mid-caps?
SW: We tend to invest in securities where minimum market cap for inclusion in the investment universe is US$200 million. Stocks are selected based on an assessment of four key characteristics: attractive medium-term growth with the presence of a “growth gap” (where Schroders’ assessment of medium to long-term growth is higher than consensus), attractive valuation, quality and sustainable competitive advantage.
BM: When looking at potential stock ideas, what does the team target as a potential upside of a firm’s growth? What is your process for relative screening, macroeconomic views and fundamental research?
SW: Fundamental stock-level research carried out by local regional analysts and supported by a global sector specialist and/or portfolio manager on the team drives our stock selection process. Stocks are selected based on upside potential, downside risk and the level of conviction in the investment thesis. Stock weights reflect these considerations and also reflect them in the context of the characteristics of the portfolio in aggregate. The strategy is characterized by its concentrated nature which ensures a healthy competition for capital within the portfolio. Stocks are therefore traded on the basis of their merits relative to stocks within the portfolio. Macroeconomic information, including information which helps ascertain the effects of climate change on company fortunes, is used as an input at individual stock research level, rather than as a top-down overlay.
BM: Does the team implement and conduct ESG assessments to make sure potential investments meet the fund’s SRI criteria?
SW: Our investment approach includes analysis of ESG factors which are integrated into our fundamental stock analysis to identify future earnings growth of companies and the entire range of factors which may influence that growth. ESG research is conducted at the local analyst level and by portfolio managers and global sector specialists who contribute to idea generation for the fund. This research effort is supported by a team of dedicated ESG specialists who are responsible for ESG analysis, engagement, voting and integration into the investment process. ESG specialists engage directly with companies, prioritizing companies with exposure to higher ESG risks and low ESG rated companies.
BM: Is any sustainability rating used and what is its influence on how you determine fair value?
SW: We do not employ the use of formal sustainability ratings when determining fair market value. However, analysis of ESG factors is a central part of our stock analysis process. Further, our process of investing in stocks which are positioned to benefit from efforts to mitigate or adapt to climate change is, in our opinion, a material medium to long-term investment trend which provides companies with a sustainable source of earnings growth.
BM: Is there a holding const
raint for positions’ sizes and/or sectors? How is currency being played in the fund and what is your current exposure?
SW: The portfolio is benchmark unconstrained. There are no formal constraints on sector allocation. At stock level, we seek to manage the maximum contribution to stock-specific risk which is limited to 8%. Currency exposure is a residual of our bottom-up stock selection approach and is not used as a primary source of added value within the fund. Anticipated currency movements are factored into analyst earnings forecasts and are ultimately captured within a stock’s rating. Currently, the fund has a large exposure to the US dollar, as well as meaningful exposures to the yen, sterling and the euro.
BM: How is a sale triggered and what is the sell discipline of the fund?
SW: Sell decisions occur when the team considers a stock to be no longer cheap, the team has better ideas, the fundamental case deteriorates and our view changes or if climate change ceases to be a significant driver of the investment case. Any of these factors could precipitate a sell decision, but for this strategy, the only “mandatory” sell signal is if climate change ceases to be a driver of the investment case.
BM: What is your outlook for this sector for 2014 and which countries are likely to benefit from this theme?
SW: 2014 has scope to be a reasonable year for equities. Equity market rises in 2013 were largely driven by factors other than company earnings. In contrast, we believe earnings growth will be a more important driver of equity returns in 2014. Equities offer good value relative to bonds. With increasing signs that the euro zone is finally tackling its structural problems, and that the US economy is gradually recovering from the imbalances of the last decade, there are encouraging signs for the more cyclical areas of the market across all regions, where the climate change strategy is focused.
As the dominance of macroeconomic factors on equities recedes, markets should focus more on company fundamentals to the benefit of stock-pickers. Furthermore, market leadership should begin to transition towards companies able to thrive in a more normal economic and monetary policy environment and we think this is a very positive backdrop for climate change equities.
Global GDP growth is likely to pick up and, as corporate confidence gradually improves, capital spending should recover, benefitting the capital goods and investment-related sectors where we focus.
Ultimately, we believe that the structural growth trends created by climate change will remain a powerful underlying driver to performance in global equities with huge, compelling returns on energy efficiency investments, making this the most powerful theme in the short term. Consequently, around half of the holdings in the portfolio are exposed to this heterogeneous trend, with lighting, materials, housing and industrial efficiency technologies all well represented. BM