We no longer live in an era of short-lived industrial cycles driven by the dynamics of manufacturing and the management of tangible capital. Today, we live in an era of long-term transitions in the key value chains of the modern economy, usually starting with a disruption that has an impact across several different industries.
We think that means investors need to look across traditional industry boundaries to identify the potential “transition winners” in modern value chains. We also believe transition winners are likely to be characterised by strengths built on intangible rather than tangible capital. They will be companies that have:
- A durable competitive position in their markets;
- Do little to no harm to society or the environment; and
- Adapt to change.
FOCUS ON DISRUPTION AND FAR-REACHING TRANSITIONS IN BROAD VALUE CHAINS
This approach is quite different from traditional investment management, which tends to think in terms of industrial sectors and investment styles. Most foundational investment theory was developed during the age of industrial and manufacturing cycles, and identified the major determinants of performance as asset, sector and style allocation through those cycles.
Over the past 30 years, however, the growth of information technology and services has reduced the relative importance of heavy industry, manufacturing and tangible assets in the economy, and all but smoothed out the traditional industrial cycles.
That is why we believe a focus on disruptions and far-reaching transitions in broad value chains offers a more realistic view of what’s going on in today’s economy.
For example, Amazon would look like an internet and logistics company, but its disruption has so far mainly been felt in the bricks-and-mortar retail sector. Food-delivery apps would look like technology companies, but they are changing the restaurant sector. And nowadays, the performance of an industrials-sector stock is more likely to be determined by its differentiating exposures to transitions in its value chains, rather than what it has in common with other industrials stocks: in simple terms, is it making things for the renewable energy industry or the extractive commodity industry?
It is this understanding of the modern economy that informs our search for potential transition winners that have a durable competitive position in a key value chain, do little to no harm to society and the environment, and can adapt to change. Let’s consider these characteristics and the way they reinforce one another in more detail.
Maintain High Profits Through ‘Economic Moats’
We think the most socially sustainable way to maintain high profits is through ‘economic moats’. These moats can be built from tangible capital—Amazon has expanded its warehouses at a pace that competitors are unable to match, for example. Nowadays, however, moats are more likely to be built from intangible capital: a lead in a particular technology, a unique consumer offering, protected intellectual property, an unassailable cost advantage or a hard-to-replicate platform, network or ability to scale. The moat around Netflix, for example, is its huge, hard-to-replicate content library.
In our view, the two most important indicators of quality companies with durable competitive positions are cash flow return on investment (our preferred indicator of economic profitability) and asset growth (our preferred indicator of life-cycle phase and competitive position).
Cash flow return on investment (CFROI) is a ratio that compares a company’s cash flows with its operational capital base. It tells us how efficiently a company generates cashflow from the capital invested in its business compared with its peers. It denotes economic returns, primarily—but also the level of cash a company generates for reinvestment or to strengthen its current position.
Asset growth tells us whether or not a company is operating in a growing addressable market and finding opportunities to invest. A new company, or a company that is trying to take advantage of a new market, will often exhibit high asset growth—it will be building new factories or wind farms, buying new machines, adding computer processing power. But in our view, the long-term success of those investments depends largely on economic moats: a company that builds them quickly and wide is much more capable of achieving the compounding effect of high, stable CFROI reinvested for persistent asset growth over a sustained period.
DO LITTLE TO NO HARM
In addition to screening for the financial metrics that describe a company’s competitive position, it is also important to filter out negative outliers on environmental, social and governance (ESG) criteria. These are companies that we regard as having a substantial ESG tail risk against their valuation or business model: they may have a competitive position today, but if it is not sustainable, we do not believe it can be durable.
This means the exclusion of certain businesses, for example nuclear and thermal coal-based energy generators, weapons manufacturers and military contractors, tobacco manufacturers, private prison operators and gambling businesses. In addition, we set aside any companies that are or have in recent years been involved in major controversies or are in breach of UN Global Compact principles.
We believe exclusion based on ESG scores alone is not enough. A basic, top-down, quantitative ESG assessment is a blunt instrument, however, and, in our view, only useful for weeding out the very riskiest businesses. We see it as much less useful for differentiating between businesses that pose similar levels of risk, or identifying the most attractive investment opportunities, for two reasons: it is unable to assess the materiality of certain factors to specific companies; and it is backward-looking.
Historical data series can tell us a little about “ESG momentum” by showing how certain metrics have improved. But they offer no insight into a company’s sustainability action plans, let alone the credibility of those plans. They tell us nothing about the likelihood of changes in regulation or consumer attitudes, which could alter a company’s material exposure to certain ESG risks and opportunities.
For us, high forward-looking ESG momentum is more significant: we see the most attractive opportunities to generate alpha in companies’ active efforts to manage their existing and potential ESG exposures. We believe top-down ESG scores are no substitute for bottom-up analysis and the proprietary insights that come from company dialogue and engagement.
We have seen that ‘doing little to no harm’ and ‘doing good’ can have a direct relationship with sales, margins, cost of capital and ultimately risk and return—but only when the ESG-related questions we ask are materially relevant to specific businesses, and relevant to their future rather than their past.
TRANSITION WINNERS IN AN AGE OF DISRUPTION
At the start of this paper, we mentioned how we think about companies as potential winners and losers from disruptions and long-term transitions in the key value chains of the modern economy
We currently identify five value chain lenses as particularly important. They are shown in Chart 2, together with the business areas in each one where we believe transition winners are most likely to be found.
We believe the ability to adapt is linked to the ability to generate high CFROI. Businesses with high CFROI are profitable, which usually means that they have established brands and reputations which they can bring to new markets. High CFROI also enables them to be self-financing: it removes the necessity to borrow or sell more equity, which means they can likely continue to invest even in a downturn, or when competitors are retrenching due to external disruption.
In our view, when identifying transition winners of tomorrow, a combination of high CFROI, persistent asset growth and good performance on material ESG metrics can be markers of a successful company. We believe that positive momentum in these three metrics can be just as important as current performance, as a marker of a company that is successfully adapting to change.
We also conclude that the traditional industry lens does not focus in the right place: disruptions to industries increasingly come from outside those industries; and the relative strength of competitors’ intangible capital is becoming a more important determinant of stock performance than common industry characteristics.
We think that forward-looking analysis of this combination of quality markers, ESG factors and idiosyncratic characteristics is key to identifying the likely transition winners of the new economy. In our view, that also suggests that bottom-up, fundamental insights, including proprietary insights gleaned from dialogue and engagement with company management teams, will continue to gain importance as a key driver of potential excess returns.
Hendrik-Jan Boer is senior portfolio manager and managing director at Neuberger Berman.