Commentary

For the month ending 31 August 2020, the Fund returned 1.3% compared to the MSCI World Net TR Index (AUD unhedged) which returned 3.5%.

The bull market continued strongly in August. Our benchmark MSCI World Index has delivered an overall positive return for the five months since the onset of the COVID-19 outbreak. Both the S&P 500 and the Dow Jones Industrial Average had their best August return in more than 30 years. Much of the strength was due to the optimism of finding vaccines and treatments for the COVID-19 pandemic.

While the Fund did generate strong positive returns this month, it was behind the rapid growth of the benchmark. This is not surprising when one considers that the 10 largest companies in the benchmark include many of the mega-cap tech companies that form FAMANG (e.g., Facebook, Apple, Microsoft, Amazon, and Google’s Alphabet) as well as high growth companies (e.g., Tesla) which do not fit into our requirement of companies that are providing solutions to sustainability challenges, or which do not meet our valuation or governance criteria. These 10 companies generated an average return of 16.8% over August and accounted for 18.3% of the index.

Our Safety and Cleaner Energy themes performed strongly, but this was outweighed by underperformance in the two largest themes, Resource Efficiency, and Health.

Safety was the best performing theme in the month with Intertek the major positive contributor. The company provides testing, inspection, and certification services to the consumer goods industry. It also tests the safety and regulatory conformity of food and beverages, healthcare products, and electrical goods. COVID-19 is forcing businesses and regulators to take more care to ensure safer operations and more resilient supply chains. This in turn is driving demand for Intertek’s services and is expected to increase the size of the company’s addressable market.

Our Cleaner Energy theme was another major positive contributor. This was largely due to the strong performance of TPI Composites which is an outsourced designer and manufacturer of turbine blades for wind turbine manufacturers. The company also produces innovative lightweight truck body parts to reduce greenhouse gas emissions. The recent extension of two supply agreements with GE gave investors confidence over its long-term growth prospects.

This strong performance was offset by underperformance in the Resource Efficiency theme. Daifuku performed poorly within the theme. It supplies warehouse material handling systems including storage systems, conveyors, and automatic sorters. These products enable the automation of warehousing and manufacturing and reduce energy and resource use in these activities. The company has meaningfully outperformed the local market since the beginning of the pandemic. It gave up some gains this month despite having reported slightly positive quarterly results.

The Health theme also performed poorly during August. HMS was the major culprit. The company provides services to insurers and government programs to help recover costs that are incorrectly levied against healthcare policies. Their poor quarterly results were largely due to lower hospital utilisation and some clients delaying projects as a result of COVID-19.

Another poor performer in the month was Premier. Premier is a group purchasing organisation (“GPO”) in the US that helps hospitals to reduce the cost of procurement. The company has been playing a critical role in helping to secure supplies of personal protective equipment (PPE) as well as critical drugs for treating patients with COVID-19. The need to rapidly scale up the supply of these products resulted in a weaker margin at the company over the last quarter. This along with some changes to their contracts with hospital networks meant the company’s share price was weak during August.

Results season is now largely over. While some of the strategy’s holdings were negatively affected by the global pandemic in the short term, overall, the tone from the management is still positive. In particular, there is still clear evidence that some critical sustainability trends continued to drive demand notwithstanding the pandemic. These trends were more prominent in areas such as logistics automation, renewable energy, and food safety.

“This world… belongs to the strong, my friend!”

It was the American actor William Redfield playing Dale Harding in the Oscar-winning film ‘One Flew Over the Cuckoo’s Nest’ who put it best. ‘This world… belongs to the strong, my friend! The ritual of our existence is based on the strong getting stronger by devouring the weak.’

The market consequences of the COVID-19 pandemic and its aftermath may still be in flux, but one aspect is unavoidable. Strong companies are very likely to get stronger still. Meanwhile, the position of weaker businesses will deteriorate further.

In part, this effect is likely to result from the stresses imposed by the pandemic. This has revealed and exacerbated existing weaknesses in businesses across the market. Indebted companies have become more vulnerable through weaker order books and cash flows. The pandemic has accelerated existing trends towards on-line commerce and manufacturing automation. Companies that were already struggling to adjust to this new world have suffered as a consequence.

The result is that the gap in performance between the top performers and everyone else has widened dramatically. According to McKinsey ‘Between December 2018 and May 2020, the top quintile of companies [as measured by economic profit] grew its total market-implied annual economic profit by $335 billion, while companies in the bottom quintile lost a staggering $303 billion’. This pattern has been evident since 2010. The COVID-19 pandemic is pushing it to entirely new levels.

This widening gap is also visible between different sectors. Sectors that were already generating above-average levels of economic profit, such as semiconductors and pharmaceuticals, have jumped further ahead. Banks and utilities have fallen further behind. The McKinsey authors point out that the Global Financial Crisis had a similar effect. Leading companies were able to deleverage, sell underperforming assets, and buy more promising ones faster than weaker rivals.

This greater flexibility may be one reason that strong companies get stronger. But another paper published in August suggests that there may be other forces at work. Economists at Princeton University and the University of Chicago Booth School of Business suggest that the long-term decline in interest rates has served to supercharge the ability of market leaders to pull ahead of their competitors. The authors observe that ‘market leaders have a stronger investment response to lower interest rates relative to followers’ in a low-interest-rate environment. This in turn leads to stronger productivity growth and greater market share.

As investors, we have identified a similar dynamic in many of the markets that we invest in. Companies with strong balance sheets and competitive products like Ansys in technology, Hikma in healthcare, and Kingspan in building materials are gaining market share and targeting their next acquisitions. To a large degree, this is healthy and welcome. Yet the Princeton and Chicago economists urge caution. More concentrated markets become less competitive. This eventually leads to falling productivity growth. For the authors, the world at large is not best served by a small number of very large companies. Regulators should enact ‘more aggressive anti-trust policy during times of low-interest rates’.

Poor Dale Harding was one of the ‘weak’ ones in the Oregon psychiatric hospital where One Flew Over the Cuckoo’s Nest was set. He had no option but to accept the complete supremacy of the ‘stronger’ characters (notably the loathsome Nurse Ratched). Thankfully the analogy ends there. The market is clearly not the equivalent of an abusive psychiatric hospital. We should expect regulators to ensure that markets work in the interests of society as a whole, and not only for the strongest.