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Roman Cassini

Roman Cassini

Head of ESG

To question the obvious and the given is an essential element of the maxim 'de omnibus dubitandum' [All is to be doubted].” 

Christopher Hitchens

"Those who have knowledge, don't predict. Those who predict, don't have knowledge. "

Lao Tzu

Introduction

As we discussed in last quarter’s AOR, confusion around the role and meaning of ‘ESG’ is leading to confusion, oversimplification, and the misallocation of capital. At the heart of the problem lie two different views on what the incorporation of ESG into investment actually means in practice. For some, ESG investing requires a fundamental shift in the way we think about the creation of wealth and value, and accordingly the way asset managers define the fiduciary duty they owe their clients. Under this interpretation, the simple pursuit of financial returns is deemed too narrow a mandate to incentivise investors to contribute proactively to solving the problems caused by negative externalities such as climate change. Instead, asset managers should incorporate supplementary mandates designed to deliver outcomes beyond simply performance. Managers who explicitly design investment approaches in this way are called impact funds.

For others, ESG investing simply means getting better at incorporating consideration of long-term, often intangible and hard-to-quantify value drivers into investment analysis. Under this interpretation, asset managers remain focused on a single mandate – to earn the best risk-adjusted return for their clients – but acknowledge that to do so with requisite care and due diligence demands a holistic approach to valuation that considers a wider range of inputs than merely the basic metrics derived from published financial statements. Key to this interpretation is active ownership, through which a manager levers its shareholding to encourage positive change at an investee company.

Neither interpretation is wrong. But there are fundamental differences in the degree of agency different types of investment have to affect each approach. This is underappreciated and often misunderstood, and has led to the confusion of one type of approach with the other. Increasingly, managers with a focused mandate are being encouraged – by both regulators and the public – to behave and market themselves as if they are an impact fund. Consequently, managers who resist this pressure find themselves at a disadvantage, as do real impact funds whose opportunity set and therefore profit incentive is being squeezed by pretenders.


Different ESG approaches, supportive asset classes, and possible outputs (1)


At Hosking Partners we believe that the manner in which a manager incorporates ESG should emerge organically from that manager’s underlying investment philosophy. Without the natural alignment of philosophy, mandate, and process, ESG is doomed to be something peripheral and discrete which can be dialled up or down depending on market sentiment and fashion. Accordingly, the interests of asset owners, investment managers, corporates and governments shift in importance, and the likelihood that capital allocation occurs in the optimal way – whatever that may be – is diminished.

This piece describes how Hosking Partners’ approach to ESG complements our capital cycle philosophy. This is a story about how our unconstrained, contrarian style encourages a nuanced and pragmatic approach to ESG which helps rather than hinders our search for opportunity amidst complexity.

Our people and process

Hosking Partners’ investment team consists of four multi-counsellor portfolio managers and three analysts, supported by the Head of ESG. Unlike many of our peers, we are not a collection of specialists with siloed areas of responsibility. Instead, each member of the team is a generalist with an unconstrained global remit. A team member might well find themselves speaking to a Chilean copper miner in the morning before analysing a Japanese financial services company in the afternoon, and the absence of asset allocation means that portfolio construction could be understood as the outcome of an almost infinite number of relative judgements. The key to unlocking this challenge is our capital cycle led investment approach, which applies as readily to one sector or geography as it does to another. The language of the capital cycle helps describe how flows of capital into and out of an industry affects competitive behaviour. Consideration of this provides us an insight into the future direction of returns on capital, and by extension market pricing or mispricing. This investment approach encourages cross-disciplinary, qualitative, and contrarian thinking. Furthermore, the capital cycle approach means we have a naturally long-term mindset, with an average holding period currently over 10 years. 

Such an investment ecosystem is predisposed to consider long-term, intangible drivers of value. We are sympathetic to those proponents of ESG investing who claim that companies with sustainable business models are more successful at creating long-term value and therefore better investments. In fact, it seems self-evident that those executive teams that are better at managing risk, allocating capital, incorporating fair but dynamic governance regimes, and maintaining a societal license to operate should justify a premium in investors’ assessments of the companies they lead, and thus make for better investments. Within the context of the capital cycle, they are more likely to be able to sustain higher returns on capital for longer at the top of the cycle and deliver improvement more quickly at the bottom. 

Perhaps more fundamentally, our investment approach makes us predisposed to contrarianism, which provides an interesting overlay to the more conventional ESG integration described above. This contrarianism comes naturally to those who think and speak in the language of the capital cycle, and should enable the avoidance of market groupthink and the asset price bubbles that often result. Recent years have seen oversimplified approaches to complex problems – including the energy transition and ESG – distort the flow of worldwide capital in unusual ways, an effect that has been magnified by a decade of ultra-low interest rates. The result is that at Hosking Partners we have tended to find ourselves on the ‘other side’ of the consensus ESG trade, as necessary but out-of-favour old economy sectors including energy, materials and industrials are starved of capital and consolidate, just as asset-light growth sectors like IT attract it and incentivise overcapacity. This suggests that the future direction of returns on capital is up in the case of the former and down in the case of the latter. The capital cycle provides us with an approach that both encourages the evaluation of long-term, intangible drivers of valuation, while simultaneously exposing attractive opportunities created by the actions of market participants who adopt a more superficial or short-term perspective. 

The tangibility of supply

This ‘ESG contrarianism’ can be seen most clearly where the withdrawal of primary investment from an industry is mimicked by secondary market participants via divestment. An obvious example is coal. Here, regulatory pressure on financial institutions including banks and insurers has made it increasingly difficult for coal mining companies to secure financing, which raises the cost of capital and lowers returns on it. Concurrently, secondary market participants, who hear only the voices of declining demand and stranded assets – or sometimes due to simplistic ESG strategies – divest their shares, valuations fall, and the index reweights. The industry responds by cutting capex and consolidating. Readers familiar with the capital cycle lens will know that this set of circumstances is an attractive set-up, as falling levels of invested capital combine with consolidating supply to cause return on capital to increase, and valuations follow. This is not simply the natural oscillation of the business cycle. Rather, pressure is being applied to constrict supply ahead of demand, in the hope that other sources of supply are readily viable, affordable, and available. But this may not be the case, at least in the here and now. In the case of hydrocarbons, the situation is made worse by the material failure to invest enough in potential substitutes such as nuclear, renewables or decarbonised natural gas.

Required vs actual investment in primary energy (2)


At Hosking Partners, our supply-focused, qualitative, long-term outlook – combined with the wider consideration of ESG issues – lends us the confidence to go against the crowd. In the secondary market, we recognise that the decision to buy or sell shares only indirectly results in real-world impact. In many cases, change may be better marshalled by continuing to hold shares and using the tools of active ownership – voting and engagement – to nudge the company towards decisions that will protect the creation of long-term value. This is particularly the case in industries where supply has been curtailed and capital is scarce. In those circumstances, as the short-term, survival-driven incentive for misbehaviour rises, the long-run rewards for those companies that instead implement the most responsible, long-term strategies grow. The Canadian oil sands producers – discussed in more detail elsewhere in this report – may represent a present-day example of this dynamic. Structurally contrarian, the Hosking Partners portfolio swims against today’s current in anticipation of tomorrow’s reversion. As such, it is a naturally diversifying bedfellow to allocations to impact funds and sustainable strategies, and should be viewed as their complement rather than adversary.

Prediction is difficult, especially about the future

A theme in ESG investing is the idea that portfolio alignment equates to sustainable impact. The idea is that if a manager fills their portfolio with renewable energy stocks, they are supporting the energy transition. We believe this concept is flawed. Nevertheless, selective divestment remains the most popular form of ESG strategy. Why? Part of the answer may be related to the forecasting of demand.

As interest rates approached zero over the last decade, future cash flows became an increasingly important component of asset valuations. The lower the discount rate, the more future cashflows inflate the present value of an asset. The further a cashflow in the future, the more speculative its amplitude. While evaluating supply is a somewhat dry affair, forecasting demand is an emotional business. Fundamentally, this is because supply is tangible – but demand is storytelling. A portfolio of growth stocks, which rely on seductive stories about future demand to justify elevated valuations, therefore also tells a bigger story about what its creator thinks the future will look like. When you buy that portfolio, you are buying into that story. You are saying, “I agree with you – I believe in your vision of the future.” 

Difficulties arise when measures are taken to restrict today’s supply today to shape tomorrow’s demand.  Without due consideration of reflexivity, or the second-order consequences of what might happen if there is insufficient appropriate alternative supply to meet sticker-than-expected demand, this sort of engineering invites the risk of shortages and capital misallocation. And yet it is commonplace: If the EU bans the sale of internal combustion engines by 2030, then demand for electric vehicles will be at least X; if green hydrogen becomes the fuel of choice in US passenger cars by 2040, then demand for electrolysers will be Y; if the world is to limit warming to 1.5 degrees, then demand for object A must be at least level B. Here, forecasting is replaced with a sort of fatalism, especially when it is taken in isolation from the realities involved in supplying that demand (capital, time, the laws of physics, and so on). The more ‘if… then’ statements that are required to justify a demand forecast, the more removed from reality that forecast is likely to be. Examples in the energy transition abound. Exponential demand growth for grossly inefficient and expensive technologies like blue ammonia, green hydrogen, and direct air capture is pitched as inevitable. “If the world stops producing fossil fuels, and if we achieve net zero, and if we avoid using offsets to do so, and if, and if, and if…” In an era of near-zero interest rates, today’s insurmountable problems can be wished away with assumptions about future technological progress, and speculative revenue that only exists in an unlikely future is reflected in valuations today.

Historical useful energy consumption and various forecasts out to 2050 (3)


This type of demand fatalism is engineered even by respected international organisations such as the International Energy Agency. As we discussed in ‘The Maze to Net Zero’, the IEA’s proposed pathway to net zero requires global energy demand to fall from today’s level by an amount necessary to make its supply numbers work. This ‘backsolving’ requires an unprecedented breakdown in the correlation between energy usage and prosperity that has been the case for at least the last five hundred years. This is the reverse of the demand fatalism described above. “If demand for oil and gas must be near zero in 2050, then these assets must become stranded, and so valuations must fall”. Again, we would question this logic and seize the opportunities it throws up.

Because we want to see the world reach net zero, we are emotionally invested in the stories which describe that outcome being successfully achieved. At Hosking Partners, our supply-side capital cycle approach means we are naturally resistant to both scenario-specific demand stories, and the excessive valuations that emotional crowding encourages. We avoid those areas of the market where we believe capital is being (mis-)allocated against speculative demand forecasts, because we expect lower returns on capital to materialise than the market expects. On the other hand, the emotional dynamics of the energy transition and desire to disassociate from carbon-intensive industries is causing capital underinvestment to run ahead of declines in demand, inviting the sort of supply shortages and consolidation that the capital cycle approach suggests will deliver rich returns for investors over coming years. Our confidence in making these calls is supported by our ongoing study of ESG-related trends, integration of long-term intangibles into our investment analysis, and active ownership of investee companies.

Conclusion

We abide by Charlie Munger’s aphorism that investors should try to be consistently not stupid rather than very intelligent. Over-simplistic approaches to ESG – such as the demand-driven alignment strategies described above – have crowded capital into a narrow range of assets whose returns looks set to disappoint as the singular future version of the world they rely upon fails to materialise precisely in the manner anticipated. The more concentrated the bet, the greater the risk. In this context, given that even the IPCC questions the likelihood of keeping warming below 1.5 degrees, one must question the wisdom – in risk-reward terms – of bodies such as the Net Zero Asset Manager’s Initiative, which requires members to align their portfolios to the emergence of an increasingly unlikely future. Surely effort would be better spent directing capital to impact funds that can actually evidence a secondary mandate? At Hosking Partners, we want to see the energy transition succeed as smoothly and efficiently as possible – but we also recognise that a diversified portfolio should account for the possibility that it does not. In a sad irony, it seems to us that the misallocation of capital driven by ESG oversimplification is working against the transition it claims to facilitate.  

The way an asset manager ‘does’ ESG should naturally complement its investment approach. This should be true both in terms of the philosophy and process that underly that approach. At Hosking Partners, our willingness to invest in unfashionable areas of the market is underwritten by two convictions – both of which are informed by our approach to ESG. First and foremost is the conviction that these ideas will generate long-term outperformance for our clients. Second, that the bottom-up integration of both financial and non-financial analysis helps us discern long-term valuation opportunities that the market misses. Fundamental to both convictions is our capital cycle investment approach, which helps us study companies – and the industries they operate within – in a holistic manner that considers the interaction of financial, behavioural, and systemic factors. As a diversified manager that invests overwhelmingly in secondary equities, we recognise that owning or not owning a particular part of the market may have little real-world impact. And while active ownership and engagement are essential elements of diligent stewardship that we practice on a day-to-day basis, their purpose should always be tied integrally to the creation of value for our clients’ benefit. The urge to silo ESG and apply it without thorough, holistic integration should be resisted. In the context of an energy transition that even in the best case will be hugely expensive, we simply cannot afford the misallocation of capital that will result.

1 – Hosking Partners

2 – Thunder Said Energy

3 – IEA, Thunder Said Energy, Hosking Partners

30 March 2023

Only dead fish swim with the stream

How our integration of ESG complements the capital cycle approach

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