Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
‘Profitability collapses almost instantaneously’: beware ‘The Second Wave’
A time of great change is upon global markets – and the ‘winners’ that everybody is backing might not be the winners at all.
It’s essentially an orthodox view among fund managers that the incumbents in any industry will “win” the transition to green energy. After all, they already have the infrastructure in place, stable cash flows, and, potentially, lucrative subsidies that will allow them to do just that.
But to Tom King, chief investment officer of Nanuk Asset Management, the equation is pretty simple: as volume growth in particular industries slows or goes negative, the profitability of those industries generally collapses “almost instantaneously”. The existing business will decline at the same time they’re trying to develop the sustainable alternative. One imagines a plate spinner in a circus sideshow.
“The auto component manufacturer who makes internal combustion engine components that now needs to start making electric drive chain components; when volumes in internal combustion engine components go into decline, the profitability of that business is going to be awful… It’s a pretty challenging dynamic,” King says.
“Some of those businesses are well positioned to be leaders in supplying the new technologies, but it does make the challenge of managing the profits and economic value of their business through that transition very difficult.”
Some of this stems from what Nanuk and King call “the second wave”; the belief that the global economy will go through large structural changes similar to the Industrial and Digital Revolutions. The “first wave” saw the price of technologies like LED lighting, solar and wind energy generation, lithium-ion batteries, and to some extent electric vehicles, drop precipitously as a result of government mandates and economic incentives.
“We’re going to see that repeated in a really broad range of sustainable technologies that address environmental issues – climate change and decarbonisation being some of them – across the whole global economy over the next couple of decades,” King says.
“The most prominent one is probably green hydrogen… A good chunk of (global carbon emissions) come from using fossil fuels for heating or as a feed stock within industrial processes. The logical alternative is hydrogen – but it’s an order of magnitude more expensive to use hydrogen generated from solar energy or other renewable sources today than to use petrochemicals or fossil fuels in those applications.”
Which is not to say that newcomers will automatically be better off. The global share market’s latest “top indicator” is Rivian, an electric vehicle manufacturer that has somehow managed a valuation greater than that of Volkswagen and just behind that of Toyota despite having zero revenue and few actual cars. Its ability to challenge an incumbent will be pretty limited. The industry “is not standing still”, and all the existing auto manufacturers will likely be able to produce competitive and commercially attractive electric vehicles.
“That doesn’t necessarily make them good investments or attractive investments, because they’re in the bucket of losers who need to spend lots of money and invest new capital in changing their businesses to be relevant in the Second Wave,” King says.
“But the dynamics in the industry are such that with twice as many competitors and twice as much capital being thrown at the industry, and likely no more total number of vehicles being sold, that you see across the board auto manufacturers generating twice the margins that they have historically on a sustained level – and that’s what the market’s pricing in today.”
The other problem, as others have noted, is that many renewables technologies are still in their nascent stages, and investors are being forced to pick winners when there is little information about the forces these technologies will benefit from and how they will be adopted. Part of Nanuk’s process is not betting on companies where commercialisation is uncertain (Rivian is out); the other is examining the whole of the value chain.
“If you look at the solar industry, you’ve got poly-silicon manufacturers, people making aluminium frames, glass, silver paste, capital equipment manufacturers,” King says. “There’s a whole series of bits of the value chain, and a lot of those businesses are already proven businesses that stand to benefit from that kind of growth over time.
“There’s this paradox in what we do, in that it’s pretty easy for me to sit here today and give a set of predictions about elements of the global economy and where they’ll be in 20 years’ time… There are things that are quite certain over that timeframe, but that certainty doesn’t accrue to the companies doing those things today.”
King probably has more visibility over the changes than some others. He started his finance career at Rothschild – after winning a gold medal in sailing at the Sydney Olympics – before a stint doing private equity work at Consolidated Press Holdings, the Packer family’s investment company. He helped set up Nanuk in the immediate aftermath of the Global Financial Crisis. Its focus from the start was on environmentally sustainable investing – perhaps a tough sell when investors were staring down a more immediate catastrophe than climate change.
“We were describing a set of future investment dynamics that not many people ascribed to. There was a minority that understood the implications of climate change… but not many people really grasped how significant that was likely to be,” King says,
“We were looking at setting up a niche business in an area where most of the people who’d tried that in the previous five or ten years had failed… It was an interesting experience. The challenge was that we had a lot of conviction in the merits of what we were pursuing but it was much harder to convince other people of that back then than it is today.”
King believes that the consequences of the “second wave” translate to a 30 per cent lower return after 15 years for global equities, with the outcome for Australian equities – weighted heavily towards polluting industries and the companies that supply them – even worse. It’s a high conviction view, and King isn’t sure there’s any risks to it.
“It’s maybe a bit facetious, but the big risk is that someone proves that climate change isn’t a real phenomenon,” King says. “That’s the one that’ll kill me.”
