One thing that unites “capital destructive” businesses, and how to avoid it

This article was published on Livewire Markets, 28 April 2022

Only around half of the 200 companies in the ASX Small Ords have revealed how they plan to reach “Net Zero” emissions by 2050. But this number will likely tick up quickly in the weeks and months ahead – partly because, in case you haven’t heard, there’s a Federal Election looming. A change of government could mean a shorter timeframe and tighter regulations around the disclosure of emissions targets, as is currently happening in the US.

“At this point, there’s not much pressure to have a target, but I’d imagine there will be a step up in a couple of months’ time,” says Liam Donohue, a co-portfolio manager at Lennox Capital. He and co-portfolio manager James Dougherty recently spoke to Livewire Markets as part of our Decarbonisation Series.

The incentive to publish decarbonisation plans will also ramp up as the full-year earnings season approaches, say Donohue and Dougherty.

They’re not explicitly ESG-focused, but say their analysis of a 10-year period shows a high correlation between poor ESG practices and underperformance. So it’s key to the way they sift the Aussie small-cap universe.

“That gives us confidence that having ESG as part of your process, and using screens to eliminate businesses that don’t meet minimum ESG hurdles, will minimise that risk of investing in capital destructive businesses,” Dougherty says.

In the following interview, Dougherty and Donohue discuss how they decide what’s investable, including a three-step process of elimination that also requires the right answers to around 50 questions. They also detail two Aussie small caps – one a fuel distributor, the other an “edu-tech” firm – that tick their boxes and why they believe these companies are set to outperform.

Edited transcript

How has the Aussie small caps space changed in the decade since you launched the strategy?

James Dougherty: It’s a bit over a decade since the last resources boom, which, at its peak, saw mining and energy companies comprise about 40% of the Small Ordinaries index, which is our benchmark, before the boom rolled over and those businesses, as a percentage of the total index, started to subside. Since then, we’ve seen technology and high growth companies start to fill that space, where we’ve seen enormous growth in the number of companies listing over the last decade. And then interestingly, we saw commodity prices start to surge again about two years ago and we’re, arguably, in a resources boom again, where resources companies again comprise about 40% of the index. So, they’re all making a lot of money or, at least, their market caps are growing significantly.

And conversely, the technology businesses that have been a big part of our universe for the last decade have all seen a lot of their valuations compress on an expectation of rate increases.

Outside of that, undoubtedly, ESG considerations and investing has probably been the most dominant thematic to appear over the last decade, as its acceptance has accelerated during this time period

How are you currently positioned in terms of the number of stocks and cash allocation?

James Dougherty:

We’re currently at 32 stocks and that number hasn’t changed much. And our cash level has been pretty stable. But in talking about that compression in the valuation of technology stocks, which has been rapid over the last six months, there are some good opportunities starting to appear. On that basis, over the next calendar year, I think the cash will probably start to trend down because we’re seeing a lot of opportunities, which is exciting.

You don’t define yourselves as an ESG fund manager but it’s an integral part of your stock selection. How do you manage the interplay between the E, S and G?

James Dougherty: There are three ways we incorporate ESG into our process.

  • screen out industries that have poor ESG outcomes,
  • assess businesses on their quality, which includes ESG, and eliminate those that don’t pass minimum hurdles,
  • then finally we target improved ESG outcomes through our portfolio construction.

We consider each of the E, S and G as equally valuable. For example, a business may have excellent governance, but if it’s a high carbon emitter and has no plan to reduce this over time, that business is “uninvestable” for us. Similarly, we might find a business with very low carbon intensity that’s doing well. But if it has poor governance, it wouldn’t pass through that quality screen.

Liam Donohue: There are around 50 questions that we need to answer and we spend time with businesses understanding each of those answers, and a big chunk of those questions relate to ESG. And ultimately, it’s how we assess whether a business is of a high enough quality for us to consider it as an investment.

Those questions can be answered through a combination of both publicly available information and engagement with management and the board. And we also employ external data providers and consultants to help us.

In terms of the ESG data that’s provided, even over the last 12 months, it’s almost been a step-change in the small-cap part of the market. ASX 100 stocks were always quite well covered from that perspective, from big data providers such as MSCI, but we’ve seen the small caps really start to catch up.

In the past, maybe 20% or 30% of our portfolio would be captured by that data but now it’s the vast majority. So, it has become much more powerful and insightful in terms of identifying where the focus should be.

How does the lack of renewable energy projects in Australia, versus other markets, affect your stock selection?

Liam Donohue: When we think about renewable projects in Australia, there aren’t that many of them. That’s not to say there are none, but it’s an emerging space. There are some great ideas – solar farms, wind farms, and even some in hydro power in relation to some unused mining pits ­– but nothing that’s yet moved to commercialisation.

Being in the small cap space, we tend to see those opportunities before other parts of the market – that’s just how small caps work. They tend to be a testing ground for some of these newer technologies and thematics. We’re ready and able to allocate capital to those projects that are in appropriate areas, once they reach a point that we would deem investible. But they haven’t yet reached that critical mass.

You invest solely in Australian companies and potentially some in New Zealand, but what other countries are your stock holdings most exposed to?

Outside of Australia and New Zealand, in terms of the operations, the biggest general regions would be North America and then Asia and Europe. But in terms of the percentage of the portfolio that have their revenue coming from those regions, it still quite minimal. The overwhelming majority of earnings for our companies are from Australia. For some technology businesses it’s often the success they can get from these offshore markets that can make them much bigger businesses.

Can you talk us through an example of a recent stock addition and how it passed your selection process?

Liam DonohueViva Energy (ASX: VEA) is somewhat on the fringe in terms of ESG – it’s in a part of the energy value chain, owning a refinery, without being a resource owner itself. Management has been quite public about its ESG stance. A fuel distribution company, Viva is best known for owning a majority stake of the Shell-branded service stations around Australia, along with the associated network that supplies fuel to those. They’re really a fuel distribution network – you can almost think of it as a fuel infrastructure owner.

But they also own a refinery in Geelong, Victoria – which is one of only two such refineries left in Australia. So, from an ESG perspective, it does raise questions. Where we distinguish between Viva and some of the oil producers is that Viva doesn’t own fossil fuel assets. They’re not generating revenue and profits from digging stuff out of the ground.

And management recognises their important role in reaching zero carbon. For example, assisting in developing hydrogen as an alternative energy source for trucks and rolling that out across parts of their network. Viva’s also beginning to install charging stations throughout that network, to facilitate the shift to electric vehicles, both trucks and cars, corporate and private. That shows the company’s actively leading the charge towards decarbonisation. Additionally, the company has targeted 2030 as their timeframe for going net zero carbon excluding their refinery, which in itself is quite an aggressive target, and even including the refinery they have committed to a 2050 timeframe. Yes, 2050 is still quite a way off and we don’t expect things to happen tomorrow but we expect corporates to acknowledge the fact that there is a transition happening and they need to play their role.

How many companies have committed to an earlier target, given that the 2050 deadline could change, especially after the upcoming Federal Election?

Liam Donohue: From what we’ve seen, only about half of the companies in the ASX Small Ords have committed to anything yet, so that’s something that will change day by day or week by week. But 2050 is the baseline and there’s a big chunk of companies that haven’t even committed to that yet. So, coming out with a 2030 target for the majority of your business like Viva has is pretty “fair dinkum” in terms of putting your hand up and saying “we’re actually going to transform our business.”

But that number of companies that have committed to a target will probably increase a fair bit as corporates come out with their full-year results, which I think will be a big prompt for targets to be published. At this point, there’s not much pressure to have a target, but I’d imagine there will be a step up in a couple of months’ time.

How do you judge when it’s time to reduce company holdings or to exit a position?

James Dougherty: Over the last decade, more than 500 companies have either moved into or out of the small ordinaries index. And there have been probably around 100 that have been seriously capital destructive and have cost investors more than 70% of their capital. We’ve spent some time looking at those businesses, and found some commonalities. We generally find that there are generally significant deficiencies either in ESG or in their financials. That gives us confidence that having ESG as part of your process, and using screens to eliminate businesses that don’t have minimum ESG hurdles, will minimise the risk of investing in capital destructive businesses.

It’s very black and white for us. There’s obviously valuation, and ideally, that’s a good news story, that hopefully means a business’s growth thesis is playing out. In those cases, we need to take profits and allocate that capital to an opportunity that has better returns. But as far as ESG goes, it’s either a pass or fail – that’s the end of the story. And if it’s an investment that we hold and something structurally has changed within that business, in either E or S or G, that moves it into what we would consider sub-investment grade and we’ll sell the position immediately.

We have three categories that we use when we finish that quality assessment of a business. So there’s sub-investment grade, investment grade, and in between that there’s what we call “investment grade – engagement”. These are businesses that meet those minimum hurdles, but there’s an improvement we’d like to see in some areas. That’s our job as shareholders, to engage with the board and with directors to get comfort that there’s a path for them to improve whatever metric we’re concerned about, over the next three, five, or 10 years.

About 30% of the portfolio is “investment grade – engagement” – these are the businesses that we think could be great investments and where we’re spending time with the board to improve those metrics we think need it.

What’s another company you’d highlight as a good example of what you look for in a business?

Liam Donohue: The main thing we look for when assessing the ESG credentials of a business is that management acknowledges they have a role to play. Keypath (ASX: KED), which we’ve owned for around six months, is effectively a technology business, which provides the tech that sits behind online tertiary education courses. There are obviously many smaller players in that segment but Keypath is one of the larger players globally and is listed on the ASX. It has global exposure and management is very forthright in acknowledging its role in terms of ESG.

On the environmental front, one of the ways it passes our hurdle there is in energy consumption, which is primarily through its data centres through which it transfers, stores and consumes a lot of data. KED uses AWS for its data storage, with that service provider having committed to using 100% renewable energy by 2025, which is obviously a pretty aggressive target. And then in terms of the company themselves, the business is pretty carbon-light but they do things like ensuring all of their travel is offset with carbon credits. So, it’s doing what it can on the “E” front.

In terms of the social side, the business is part of the democratisation of education in that the online channel opens up the potential for education to a much broader market than traditional on-campus methods. And that hopefully promotes social mobility in terms of opening up the opportunities for education to a much broader market than otherwise has been the case.

And in the G, governance, there are no issues. As a tech business in the education space, where they handle a lot of data, the management and security of that data could be a problem – but in their case, it’s hosting all data via AWS on a private cloud. And they are pursuing various certifications including SOC2 certification, which is an independent certification that verifies the security of the services they provide. And outside of that, its valuation looks cheap, there’s a huge market opportunity and they’re growing – all of the things we want to see for a compelling investment opportunity.