In part three of our Balancing Act series, the managers of Brown Advisory’s Large-Cap Sustainable Growth strategy discuss how their sustainable investing approach has helped them preserve capital during down markets.
“Sustainable investing” means different things to different people. Some sustainable investors want to make a positive impact on the world, others want to align their portfolio with a specific mission or set of values, and still others simply want to screen out businesses and behaviors from the portfolio that they find objectionable. None of these goals are “right” or “wrong,” and those who work in sustainable investing generally embrace the different goals, viewpoints and methodologies that have evolved over the years.
In our work managing Brown Advisory’s Large-Cap Sustainable Growth strategy, sustainable investing is first and foremost about performance. For nearly a decade, we have combined fundamental and sustainable research to build a portfolio that has outperformed its benchmark, the Russell 1000® Growth Index. Our risk-adjusted results are particularly important to us, and as of Dec. 31, 2017, the strategy’s annualized alpha and Sharpe ratio (two commonly cited measures of risk-adjusted performance) since inception were both ranked in the top 3% of eVestment’s large-growth manager universe.
A major driver of our performance has been our consistent ability to perform well during down markets. Over the last three years, we achieved down-market capture of just 78%; this ratio measures the strategy’s return vs. its benchmark during periods of market decline. That result places us among the top 2% of our large-growth peers, according to eVestment. Our five-year results were just shy of a top-decile ranking.
Many investors are concerned about the aging bull market, and as a result want to understand how their investments might perform in a downturn. We are not making a prediction about the market’s near-term path, but we believe that our holdings can weather a downturn relatively well. Our experience has taught us that there is a strong link between the sustainable characteristics of our portfolio companies, and their resilience during difficult market periods. Here, we will discuss some of the reasons why we think that link is so strong, and provide a number of examples of portfolio companies whose sustainable business models have directly contributed to their strength in declining markets.
Sustainable Investing and Downside Protection
Every sustainable business is somewhat unique, but we tend to look for a variety of factors that, in our view, contribute to steady, consistent growth and profitability in both healthy and challenging markets. We cover three of these factors below.
Companies that offer their customers a compelling “sustainable return on investment.” Many of our portfolio companies help their customers address sustainability challenges like climate risk, energy reliability, water management, commodity price volatility and many other issues.
These businesses often hold up well in down markets. One reason is that many sustainability challenges represent real and meaningful costs: Energy costs money, materials cost money, and, increasingly, water and its use cost money. Many of our portfolio companies help their customers save money in these areas. This tends to foster strong customer retention—even during low points in the business cycle when these customers are looking for ways to cut spending.
A good example is Ecolab, which offers water, energy and sanitation solutions to customers in many different sectors of the economy. In 2016 alone, Ecolab reported that it had helped customers conserve 161 billion gallons of water, 52 million pounds of waste, and 11 trillion BTUs of energy. Because it delivers clear and measurable payback to its customers, Ecolab has generally navigated tougher periods without losing much business. Coming out of the global financial crisis, the company’s revenue declined only 4% in 2009, and it was able to improve its gross margins and EBIT during that period. In the years after the recession, Ecolab delivered double-digit top-line growth. Its revenue mix includes a healthy base of consumables that generate recurring revenue, which contributes to its revenue visibility and stability from year to year.
Danaher’s environmental businesses offer similar “sustainable ROI” to clients—helping customers to reduce operating costs, materials waste, and environmental impact—and these businesses also held up well in the wake of the credit crisis. Danaher’s overall business suffered double-digit year-over-year declines in all four quarters of 2009, but its environmental portfolio held relatively steady, and several of its water treatment businesses generated positive growth. Danaher’s environmental businesses gradually have become a more meaningful part of the company’s diverse business mix, especially after its recent acquisition of Pall Corp.
Companies that use sustainability to build supply chain advantages. As companies mature and gain leadership in their markets, supply chain mastery becomes critical to their efforts to improve or even maintain their margins. A number of our companies use sustainable thinking as they select suppliers, and go several steps further, developing clear operational standards rooted in sustainability and then helping their suppliers achieve those standards. By cementing their vendor relationships in this manner, companies can make their supply chains more reliable, reduce the volatility of their costs, and, in some cases, enhance their overall brand.
Starbucks has done an exceptional job of infusing sustainability into its supply chain, in our view. Sustainability is a key pillar of Starbucks’ premium brand, but in the past, the company was criticized for insufficiently supporting fair-trade and organic certification in its supply chain. While it is a major purchaser of third-party certified coffee beans, the company could not limit itself to only certified suppliers—it simply buys too much coffee. So it invested heavily in developing its own C.A.F.E. (Coffee and Farmer Equity) standards for coffee growers. It started multiple programs to support growers’ efforts to comply with C.A.F.E., including an expansive loan program that has made a huge difference for growers needing a working capital bridge between the start and end of their growing seasons. Although many were initially skeptical about Starbucks’ commitment in this area, the company has earned a great deal of respect over the years for its consistent and substantial efforts. In the end, this effort has supported Starbucks’ premium brand—and premium prices—and helped it stabilize its coffee supply and prices in a broadly volatile coffee bean market.
Companies that use sustainability to inform long-term capital allocation decisions. Every management team claims a long-term focus, yet many run their businesses with a “don’t fix what isn’t broken” mentality and avoid taking the bold steps that could redirect capital toward a more profitable path. Environmental and social challenges are creating huge markets all over the world, and we have been attracted to a number of companies based on their smart and substantial investments to embrace those markets. Of course, our evaluation of a company’s strategy is based on many different factors, but we take note when companies link capital allocation to opportunities stemming from long-term, sustainable trends.
Shifting capital from a mature business to a newer opportunity may seem riskier than standing pat. But we find that companies that make these decisions wisely are the ones that are built to last. Conversely, there is often a good deal of embedded downside risk in a company that remains focused on declining industries that face slowing growth, shrinking margins or competitive disruption.
A. O. Smith is a prime example of a firm whose capital allocation decisions consistently loop back to sustainable, long-term thinking. The company had a lot of foresight regarding rising middle-class populations that need hot, clean water; this opportunity motivated the sale of its electric motor business (which produced roughly one-third of company revenue at the time), so it could focus on its water treatment product lines. We believe that the company’s growth would have been much slower in recent years if it had retained its motor business. A. O. Smith has invested strategically in China for more than 20 years, seeking to serve China’s burgeoning middle class with solutions for water safety and comfort. It now generates more than 30% of its revenue in China; its share of the Chinese water heater market has grown from 10% to 25% in the past decade, and it owns a 20% share of the Chinese water purifier market as well.
The Bottom Line: Sustainable = Resilient
As noted earlier, investing in companies with these sustainable characteristics has helped us generate top-decile risk-adjusted returns and down-market capture. Of course, other factors have contributed to these results as well: We are disciplined about capping exposure to any single company, we emphasize consistency of growth over absolute growth rates, and we proactively optimize position sizes across the portfolio as prices change and conditions for each portfolio company evolve. In our view, all of these factors have helped our portfolio hold up relatively well when the market has stumbled.
Brown Advisory Institutional claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Brown Advisory Institutional has been independently verified for the periods from January 1, 1993 through December 31, 2016. The Verification reports are available upon request. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Verification does not ensure the accuracy of any specific composite presentation. GIPS® is a registered trademark owned by CFA Institute.
1. For the purpose of complying with the GIPS standards, the firm is defined as Brown Advisory Institutional, the Institutional and Balanced Institutional asset management divisions of Brown Advisory. As of July 1, 2016, the firm was redefined to exclude the Brown Advisory Private Client division, due to an evolution of the three distinct business lines.
2. The Large-Cap Sustainable Growth Composite includes all discretionary portfolios invested in the Sustainable Large Cap Strategy. The strategy invests primarily in large market capitalization companies with financially and environmentally sustainable business models. The minimum account market value required for composite inclusion is $1.5 million. Prior to 2012, the minimum was $100,000.
3. This composite was created in 2010. Prior to 3/31/13, the strategy was named Large-Cap Sustainability. Prior to 12/31/2011 the strategy was named Winslow Green Large Cap. No changes have been made to the strategy since inception.
4. The benchmark is the Russell 1000® Growth Index. The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000® Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000® Growth Index is constructed to provide a comprehensive and unbiased barometer for the large-cap growth segment. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics. The Russell 1000® Growth index and Russell® are trademarks/service marks of the London Stock Exchange Group companies. An investor cannot invest directly into an index. Benchmark returns are not covered by the report of the independent verifiers.
5. The dispersion of annual returns is measured by the equal weighted standard deviation of portfolio returns. The composite dispersion is not applicable (N/A) for periods where there were five or fewer accounts in the composite for the entire period.
6. Gross-of-fees performance returns are presented before management fees but after all trading commissions, and gross of foreign withholding taxes (if applicable). Net-of-fee performance returns reflect the deduction of actual management fees and all trading commissions. Other expenses can reduce returns to investors. The standard management fee schedule is as follows: 0.80% on the first $10 million; 0.65% on the next $15 million; 0.50% on the next $25 million; and 0.40% on the balance over $50 million. Further information regarding investment advisory fees is described in Part II A of the firm’s form ADV. Actual fees paid by accounts in the composite may differ from the current fee schedule.
7. The three-year annualized ex-post standard deviation measures the variability of the composite (using gross returns) and the benchmark for the 36-month period ended on December 31. The 3 year annualized standard deviation is not presented as of December 31, 2010 and December 31, 2011 because 36 monthly returns for the composite were not available (NA).
8. Valuations and performance returns are computed and stated in U.S. Dollars. All returns reflect the reinvestment of income and other earnings.
9. A complete list of composite descriptions, policies for valuing portfolios, calculating performance, and preparing compliant presentations are available upon request.
10. Past performance does not indicate future results.
11. This piece is provided for informational purposes only and should not be construed as a research report, a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy , including whether or not to buy, sell or hold any of the securities mentioned, including any mutual fund managed by Brown Advisory.
The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.
The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities or asset classes mentioned. It should not be assumed that investments in such securities or asset classes have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client. Private investments mentioned in this article may only be available for qualified purchasers and accredited investors. All charts, economic and market forecasts presented herein are for illustrative purposes only. Note that this data does not represent any Brown Advisory investment offerings.
The eVestment U.S. Large-Cap Growth Equity universe classification (“universe”) includes U.S. equity strategies that invest primarily in large capitalization stocks with fundamental growth characteristics or products that invest in growth stocks/sectors. The expected benchmarks for this universe would include the Russell 1000®, or S&P 500. Managers in this category will typically indicate a “Primary Capitalization Emphasis” equal to Large-Cap and a “Primary Style Emphasis” equal to Growth. The minimum criteria necessary for inclusion in an eVestment Universe are 1) minimum of one year of performance history, and 2) updated portfolio characteristics for the product. All products meeting the criteria are evaluated for inclusion. Managers voluntarily populate performance data into the database for inclusion, and the number of managers in each period consists only of managers that provided that data point and were in the universe for that entire period. For example, the number of managers that provided turnover and active share statistics as of 12/31/2011 differed from 262 to 25, respectively, despite representing the same eVestment U.S. large-cap growth equity universe. Historical manager data for active share, which has become more widely used since 2009, is notably limited prior to 2014.
Return on Investment (ROI) is the ratio between the net profit and cost of investment resulting from an investment of some resource. A high ROI means the investment’s gains compare favorably to its cost.
The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000® Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000® Growth Index is constructed to provide a comprehensive and unbiased barometer for the large-cap growth segment. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics.
“FTSE®”, “Russell®”, “MTS®”, “FTSE TMX®” and “FTSE Russell” and other service marks and trademarks related to the FTSE or Russell indexes are trademarks of the London Stock Exchange Group companies.