347. Sustainability is a journey, not a clear destination

20 February 2025 (pre-recorded 17 February 2025)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. Sustainable investing has evolved dramatically over the past two decades and today we’re focusing on companies that make the world cleaner, healthier and safer.

Chris Salih (CS): I’m Chris Salih and today we’re joined by Peter Michaelis, manager of the Liontrust Sustainable Future Managed fund. A multi-asset fund investing in global equities and bonds. Peter, thank you very much for joining us today.

Peter Michaelis (PM): My pleasure Chris, great to be here.

[INTERVIEW]

CS: I just wanted to start with a bit of an intro on the fund. Obviously, you and your team are sort of one of the longest standing members in the sustainable space in the industry. Maybe just give us a bit of an intro on the fund, and maybe we can go into performance a bit as well. Talk to me about the long term and maybe some of the challenges that have been going on in the sort of past couple of years.

PM: Yeah, with pleasure, so the Sustainable Future Managed Fund is one of the funds in our range of Sustainable Future funds. It’s our largest fund. It’s about two and a half billion of assets on the management. And as with all of our funds, what we’re aiming to do is to deliver to our clients a strong returns by investing in sustainable companies. And these sustainable companies are companies that, through the products they sell, or the services they offer, are helping to make our world cleaner, healthier, or safer. And the reason why we think as an investment advantage in that is that generally we believe that the market tends to underestimate the growth prospects of companies linked to those themes. And that gives us an edge. And it’s why, you know, over the longer term we feel we’ve done a pretty good job at delivering those stronger returns for clients.

CS: I mean, we talked a couple of weeks ago about this, and you sort of summed up quite nicely. You said, if anyone who’s invested in this fund for the long term would be very, very happy with the performance past couple of years, been a bit more challenging, maybe just talk to us about some of those challenges that you face and sort of the opportunity that you see right now.

PM: Yeah, yeah. So, I mean, I was kind of looking at the numbers before this call, and actually over 10 years, if you’d invested in this strategy, it would’ve given you 130% return. If you’d invested in the average fund in the peer group, it would’ve been 73%. And that’s really the same picture of a 5, 10, 15, and 20 years. So, as you say, longer term you know, I think clearly happy clients over three years, though the numbers are less compelling. So it is a return of 11% versus 15% for the peer group. So we’re sort of behind that peer group average, which is obviously not where we want to be, and it’s not where you know, our clients should expect us to be longer term.

So, why? Well, principally in 2022 and 2023 and a bit 2024, we’ve had three things happening. The first is inflation. So after a really, really long period of zero interest rates very modest inflation, you had the second aspect, which is geopolitics and UK politics the geopolitics caused the Ukraine war caused this sort of inflation shock, but there were supply chain issues in there as well from China too. So those are two areas.

And then subsequently it’s been a really unusual market in global equities, particularly. We’ve had this narrowness of leadership, which is really in 2023 and 2024 is really focused on those Magnificent Seven, the sort of AI mega-cap leadership. And that narrowness has been something which hasn’t helped our strategy relatively overall. So there’s three factors coming together with the rise in interest rates with, you know, everyone focused on, you know, what’s Nvidia gonna do next? Has meant that the companies we’ve invested in have not performed as well as we, I guess, would’ve hoped for them.

Now as to the future we do think well, first of all, that the themes we invest behind remain very strong. And I’m sure we’ll get a question about Trump later, but we think that they’re structurally very strong themes, and so they should continue to perform or to deliver good growth prospects for companies linked to them.

The second thing we believe is the markets will broaden. We can’t consist persistently have you know, the market is performing well only because half a dozen companies are performing well. It just can’t happen mathematically. So we think the markets will broaden and the mid-cap area of the market where we’re invested in should be well positioned to benefit from that.

CS: Okay. I want talk about sort of the universe of companies available to you. Obviously, you’ve been doing this for, what, 25 years now or so. Maybe just talk to me about how that universe looks now versus then, and have you had to make changes to your sort of process to sort of account for that? You know, I don’t know, 20 years ago there might be one company doing one thing and now there’s probably 200. Just gimme an idea of how you had to evolve your process as the sort of universe of companies has evolved.

PM: I mean, there’s definitely had to be evolution. I think when I started in this job, I had to look at the sort of environmental reports of companies in the FTSE 100. And there were probably less than a dozen were producing even, you know, bothering to produce a report. Now that that has improved dramatically, and I think almost every company does. So the sort of issues around sustainability are much more at the forefront of company’s thinking. So in that way there’s been progress. I think there’s been developments in, I mean, I guess it is a hard, hard question to answer because you are right our criteria have changed as, I guess what’s possible has changed as well.

So one concrete example of how the sort of universe has changed has been that back in 2001 when we launched the funds, natural gas was seen as a cleaner fuel. So substitute and coal for natural gas cleaned up our air reduced carbon emissions unit of electricity. And it was, if you like, it was the best available practical solution. Now, the best available practical solution is solar and wind. And so you’ve seen you know, that natural gas aspect of our strategy be retired, so we don’t invest in any fossil fuels now because there’s a viable alternative. And you can see that by the fact that UK electricity generation has gone from less than 1% in renewables back in 2001 to over 30% and climbing in as we speak today. So, yeah, it’s an evolving process and the criteria gets tighter, but you know, companies improve as well. And I guess you’d expect that because sustainable development is a journey that you know, not a clear destination, if you like.

CS: Okay. I wanted to talk about the portfolio in general. So you’ve got these sort of three mega themes and then the 22 underlying themes. I’m actually gonna take the mega themes first. So you, you’ve got the likes of better resource and efficiency, improve healthcare, general safety and resilience. Maybe just take a minute on each and just give us a bit explanation of what you’re looking for within each and maybe an example if possible.

PM: Yeah. So in better resource efficiency when you think about it, what we try to do as human beings is kind of get more out of fewer resources. I guess whereas that demonstrated is in you know, your smartphone, and your smartphone using, I dunno, 1980s technology would’ve taken up an entire building. You know, they had those craves, supercomputers and massive cooling. The energy efficiency per unit computation has gone up million folds. You know, Moore’s Law, energy efficiency has gone with Moore’s Law and a company that fits with that is ASML. So ASML help make chips. They do the equipment which makes chips finer and finer and finer dimensions, which means we can do more and more and more with them. So that’s an example of what’s happening in terms of resource efficiency, energy efficiency.

It also covers water. It covers circular use of materials then under improved health or, you know, improving quality of life within that. If you look at, you know, structural trends around child mortality, the turn of the 20th century is 1 in 5 children died before their 5th birthday. Now that’s more in, you know, in the UK or developed markets, more like 1 in 300, 1 in 500. So some massive improvements, and we don’t expect that to stop. Indeed, I think we’re in the midst of a real revolution in how we treat disease. So how we understand and treat disease, and this is where we investing in companies that are I guess we invest in companies that provide the tools to help with bioscience of a company like Thermo Fisher or Oxford Bio Medical, for instance would be benefiting from that.

And then under the mega theme around kind of greater resilience and safety I guess an emerging areas has been the fact that more and more of our information, our data and our finances are now held digitally and online. And for that reason, our online security is becoming more and more and more important. And so that whole digital security market is one which we think is gonna continue to grow very fast. And Palo Alto Networks is a company which we hold in our global funds, which have been benefiting from helping to make companies and corporations and individuals much more secure in an online world.

CS: It is an industry I think we talked, and you mentioned it was almost recession proof because the hackers never stop. So the development has to keep going as well, regardless of what’s happening in the market, in the wider market as well.

PM: That’s exactly right, the phrase was “you never know if you spent enough on digital security. You only know if you haven’t spent enough.”

CS: There we go. I wanted to touch on one of the underlying themes. Now the listeners can’t see us, but you can see me. So you might be surprised while I’m asking this question, but it’s about London Fashion Week this week. So a bit more around delivering a circular materials economy and the idea that, you know, fast fashion can continues to sort of grow and grow. Maybe tell me why is that a theme and what sort of mega trend that links to above those ones you’ve just mentioned, and how do you go about investing in companies in that sort of space?

PM: Yeah, it’s linked to the theme around sort of a circular materials economy because if you think about how we use most of our materials, we spend a lot of energy and time and labour making the product, we then wear it or use it for a certain amount of time, and then we throw it away. You know, it’s insane. And I think that the fashion industry is where probably the insanity is greatest because you’ve got this kind of wage difference. So in the UK you know, wage is about £12/an hour, in Bangladesh it’s 40p/an hour. So from a company’s point of view, you think, okay, well we can make lots of stuff in Bangladesh. We’re quite a long way from the market in, you know, the UK or wherever, and it takes several weeks to get there. We don’t know quite how much of it we’re gonna sell. So what will we do? We’ll, overproduce. We’ll produce 50% more than we think we might need because it’s so cheap to make you ship it over, over to the UK or wherever else in the world. And then you work out that, you know pink sweatshirts are not all the rage you thought they were gonna be, and you’ve only sold 20% of what you produce, but you don’t care because the markup is so high. So what do you do with the rest of the product? You try and sell it to TK Maxx, you try and get rid of it, or yeah, it goes charity shops or it ends up in landfills in Ghana, from a materials point of view, it’s absolutely crazy, but you can see the economic logic behind it.

But the fashion industry is, you know, apparently responsible for about 10% of greenhouse gas emissions. Now we think greenhouse gas emissions is all, you know, cement making or steel making, but actually the clothes we wear because of the way they’re made, it’s not inherent, but because of the way they’re made and used are contributing a huge amount to the resource inefficiencies in our system and carbon emissions, as well as all the other aspects around long supply chains. So that’s the problem.

Is there any solution? Well, we think there’s solutions around resale. So, you know, once you’ve used your lovely pink sweatshirt, you you kind of can then resell it so someone else can enjoy it. There’s also fashions around resilience, so making things that are inherently, you’re gonna use them for longer. Or rental, particularly in workwear rental seems to be a big growing market.

But there’s one interesting, I think area, which is to use AI and automation. So the idea is that they would scan Peter or they’d scan Chris, and they would say, this is exactly your size. These are the types of things you like to wear, which would look good on you, and we can make them locally to fit you properly. And using AI and AI automation, you suddenly get a much, much better product and a much shorter supply chain. And so I think that’s kind of the model that I’ve heard, which I think actually no, that could really solve this whole dilemma around fashion.

So in terms of where we have investments, we have an investment in a company called On Holdings. They make trainers on cloud. They’ve been at the forefront around resale, around subscription models. So if you’ve enjoyed your trainers for a bit, you can then sell them on. There’s another interesting company which we hold in our US fund, which is called Winmark. Winmark is a kind of franchise system where they have companies like Plato’s Closet, it’s big in the US. And essentially you go there and you bring your clothes and then you get credits to buy clothes. And they’re very good at if you like curating the clothes they get. And it’s a franchise model, so it’s growing very fast around the US as people realise that you can get great clothes, update your wardrobe as often as you like, but for much, much less than buying it new.

CS: Just quickly on the back of that, you mentioned a few companies there. How easy is it to sort of pinpoint those companies? Or is there concerns about barriers to entry? Because that sounds quite early stage. Some of those could there be quite a lot of disruption in areas like that?

PM: So Winmark is $1.3 billion market cap company. These aren’t sort of speculative things. They’re up and running and we think they’ve got great growth prospects ahead of them. So yeah, we think we can see kind of, good long term growth from these companies. You are right though, we do want companies where there are barriers to entry where they kind of bring a new model and say, actually this is a better way of doing things. I mean, maybe your question was around displacing the incumbents. Is that…

CS: Yeah. Just thinking you’ve got these themes. Some of them are further, you know, you’ve got 22 of these underlying themes. Obviously some are further along than others. Are there some where you have to be thinking, you know, this company’s great, but the barriers to entry mean another company could come in and perhaps it’s not so great in 12 months time is that’s quite a big issue in your part?

PM: I guess we’re always thinking about that, but actually what we’re trying to find are the companies that are, if you like, the digital camera to Kodak. They’re the companies that will be the displacers that will say, actually, look, the way we’re currently doing this doesn’t make sense from an energy point of view or materials point of view, a labour point of view. So let’s find a better solution. And once you get a solution that’s cheaper and better, it actually displaces the incumbent technology much, much quicker than most people expect. Those are the ideal sort of companies we’re trying to find and back.

CS: While we’re on companies and before we sort of look at broader picture to finish this off a couple of recent additions, Berkeley and Advantis. Maybe just give me a couple of lines on why you’ve added those fairly recently to the portfolio.

PM: Yeah. Berkeley Group is a UK house builder. It’s about $3.5 billion market cap then build about 4,000 homes a year. What we like about it is they are focused on the southeastern London, where there’s the biggest gap between demand and supply. They are about 90% on brownfield to urban regeneration. So, you know, we think it fits the bill of what we need. And suddenly I think what the new government is trying to push for, which is, you know, more supply of homes into the areas that need it most. And they’ve got a great track record of delivery in a sector, the house building sector, which is I guess patchy at best.

Advantis, it’s a Japanese company. It’s about $46 billion market cap. And what they do that they operate in the semiconductor production area, and essentially they test the quality of kind of wafers before they go through the really intense manufacturing phase. So you, you want, you basically wanna reduce the failure rate of semiconductor chips. And so you wanna catch any defects early and that’s essentially what they do. So they’re as we kind of continue to develop more powerful chips in all areas, so you’ll need more services from the likes of Advantis. So we think it’s got good growth prospects ahead.

CS: Okay. I just wanted to finish with a couple of questions that sort of challenge the perception around sustainability and ESG in the current environment. The first one is, I mean, pessimists would point to the challenges, but you’ve said broadly that the companies you invest in are doing broadly what you want them to do. How attractive are the valuations in the market at the moment for you?

PM: I mean, we invest on a five year view, so we’re looking you, we essentially looking to buy and hold companies for as long as we can. And many companies we’ve held for, you know, 20 years within our portfolios. On that basis, the main thing we are looking for are companies that can deliver on their earnings growth. Now, I would say that at the moment, because so much money has been sucked into the sort of Nvidia and mega caps of the Magnificent Seven as well, we see gray opportunities in that sort of smallest end of the market.

So the mid-cap in globally and within the UK, which mean that we’re kind of really comfortable investing in in our growth companies at these levels. So yeah, so we think we’re well set. And certainly you’re right, the actual delivery that we’ve seen from companies for the most part has been very strong. There’s always the exception where it has a little wrinkle. But generally if the investment thesis still holds, we will you know, continue to hold those businesses. It’s only when something goes very badly wrong that we exit.

CS: Speaking when things go very badly wrong. Some might say that about what’s happened and you are right. I’m gonna ask about Trump now to go in there. The perception is he is not good for ESG and sustainability, drill, drill, drill, that sort of thing. But again, there’s actually benefits to a fund like yours and there’s all companies you hold. I mean, you talked about, I think we mentioned before that in his first term as President was some of the strongest performance of the fund coincided with when he was right during his first term as as president. I mean, there are cases where Trump’s policies actually improve the outlook for a number of your companies, aren’t there?

PM: Yeah, I mean, I guess the benefit of having managed the strategy for so many years is that we’ve seen sort of, I guess all flavours a politician or maybe there hasn’t been a flavour quite like yeah, the second coming of Donald Trump, but the structural trends behind a cleaner, healthier, safer world, they don’t seem to change. And you’re right. When Trump was last in power, coal fired generation in the US fell more than under any other president. If you think as well, many of our investments are about improving infrastructure. So we have companies involved in managing water. So, you know, water pipes and things in the US, all of that kind of, and companies involved in the construction in the US, all of that is gonna benefit from kind of reassuring America’s sort of policies.

So yeah, it is not straightforward that his actions are gonna be negative for sustainable investment. And that said, obviously would be better for all reasons to have a president in the White House that was, you know, cared a bit more about climate change and wanted to be more progressive on social issues than we’re seeing. But we always drill it down to an individual company level and say, how is this gonna affect the outlook for this company? And there are very few companies where we’re thinking, oh, you know, this is really a risk from some policy emerging out of the White House. I think it important to say that so much around energy in particular is done at a state level. So Texas has seen in the last, you know, five or six years an eightfold increase in renewable energy. I mean, it’s phenomenal. Texas is Republican. It’s oil. It’s the last place where you’d think they’d be doing something. It’s not just politics, it’s just a cheaper solution. It’s a cheaper, better technology. And that’s you know, that’s what’s driving it.

CS: On that note, Peter, so thank you very much for joining us today.

PM: Thanks a lot Chris.

SW: The Liontrust Sustainable Future Managed fund is backed by one of the most experienced and well-resourced teams around. The fund has a well-defined process focusing on the three mega trends we’ve discussed in today’s interview. To learn more about the Liontrust Sustainable Future Managed fund, visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.