As crucial as sustainability may be to investors and companies alike, gauging the long term resilience of their business model is just as important. Sustainable International Leaders views resilience as a crucial lens through which to analyze businesses.

Only Time Will Tell

While the old adage “only time will tell” generally refers to a future outcome, it is apropos of our belief that a truly sustainable portfolio must consist of businesses that have proven to be resilient under a variety of macroeconomic circumstances. Short-lived businesses, after all, no matter how admirable their sustainability metrics may be, cannot contribute to the long-term sustainability goals of investors and society at large.

That is why the Sustainable International Leaders (SIL) strategy seeks to invest in companies that have withstood the test of time in their own right and have clear and measurable sustainability strategies. Although the median age of the portfolio is 68 years, the dispersion is wide: The youngest company we own, Dutch payments company Adyen, is only 16 years old, while French luxury goods firm LVMH is by far the oldest, having incorporated at the end of the 16th Century (Figure 1).

Figure 1. Time is the ultimate measure of resilience: Over 85% of Sustainable International Leader’s holdings have been in business for at least 25 years.
Portfolio Holdings by Age (Years)

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A primary assumption of any business is that the company in question will be operational well into the future. But just how far into the future the management is focused is where we pay close attention. Portfolio holdings such as Swiss pharma and diagnostic giant Roche Holding, Finnish elevator engineering company, Kone, LVMH, and Swedish multinational industrial company Atlas Copco are businesses where the founding families are still involved in the business, and that operate on a multi-generational time line, far beyond the investment horizon of most investors. We believe this is what allows them to create enduring businesses with sustainable competitive advantages and attractive capital deployment opportunities. While we do own a handful of relatively newer businesses, over 85% of Sustainable International Leaders’ holdings have been around for at least 25 years. This means that an overwhelming majority have withstood the early 2000s recession in developed markets, the 2008 to 2009 Global Financial Crisis, and the Covid-19 global pandemic. Indeed, these businesses have not only endured such events, but in most cases have emerged stronger and thrived in the periods that followed, all while building and improving their sustainability profile.

The concept of gauging a business’ resilience largely by how long it has already been in existence might seem odd in an era when newer companies with more contemporary business models and product ideas often garner more investor attention than the overgrown dinosaur companies of yesteryear. Indeed, there are certainly examples of this being a sound approach. But more often than not, it is the companies that have endured through a multitude of cycles — i.e. market, business, geopolitical, and so on — that we believe are more likely to exist in the years and even decades ahead. In fact, there’s even a coined theory of this concept known as The Lindy Effect.2 In short, the theory holds that the future life expectancy of some non-perishable things like a technology or an idea is proportional to their current age such that every additional period of survival implies a longer remaining life expectancy.

Identifying Resilience

A key source of our portfolio holdings’ resilience comes from the durability of their competitive advantages, structural growth tailwinds, and a proven ability to execute their plans over time. Additionally, we believe these businesses face low risk of permanent loss of capital caused by excessive leverage, obsolescence, or exposure to significant ESG risks and hidden liabilities. While some of Sustainable International Leaders’ more cyclical areas will not be immune to macroeconomic fluctuations, we nonetheless think they have unique qualities that will help them over time.

Even when the best company fundamentals are combined with the most capable management teams, the success of such companies can be highly dependent upon industry structure. Thus, Sustainable International Leaders places a strong emphasis on competitive positioning of companies within their sector and also evaluates the long-term prospects of these sectors.

In financial services, for example, we have stayed away from investing in large commoditized banks and instead sought to invest in companies that we believe have a differentiated positioning that is hard to replicate and which also benefit from secular tailwinds toward new financial market penetration, such as Hong Kong-based general insurance services company AIA Group, Ltd, Indonesian microlender Bank Rakyat, and India’s HDFC Bank.

In the industrials space, we tend to shy away from deeply cyclical commoditized businesses and see resilience in companies that typically benefit from a meaningful after-market component or subscription-like revenues from maintenance or service contracts, e.g. Atlas, French Aerospace manufacturer Safran Group, and Kone (Figure 2.) Others such as U.S. waste services company Waste Connections and British pest-control firm Rentokil Initial are traditionally defensive businesses that typically benefit from local economies of scale in distribution, which can be incredibly hard for smaller players to compete with.

With resilience as a key principle guiding Sustainable International Leader’s portfolio construction, our focus inherently points toward high quality, free-cash-flow generative companies that we believe have attractive business risk dynamics.
 

Figure 2. Selling past the sale: cash flows from equipment servicing contracts
Original equipmet revenues vs aftermarket revenues.

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In the technology sector — which is a double-edged sword of huge capacity for innovation and huge potential for disruption — our areas of focus are competitively advantaged businesses within consolidated, rational industries. While the semiconductor business has seen violent cycles in the past, the industry is more consolidated today and benefits from strong cyclical upturn with digitalization of the economy. We are able gain exposure to companies with strong competitive positions in these sectors via holdings such as Taiwanese semiconductor manufacturer Taiwan Semicondutor Manufacturing Company, ltd. (TSMC), Dutch semiconductor supplier ASML Holdings, and Dutch semiconductor manufacturer NXP Semiconductors. Other stocks we own in this space include providers of mission-critical solutions such as Wolters Kluwer, a Dutch a provider of information solutions for professionals such as health care practitioners, lawyers and accountants that they would typically be loath to cut down on even in a downturn and Adyen, which enables payments for e-commerce and other large enterprises and benefits from superior technology and execution that has been hard for its legacy peers to replicate.

Finally, our holdings in the consumer discretionary sector include businesses that have a history of not only rebounding quickly, such as the luxury conglomerate LVMH, online travel agent Booking.com, and Compass, Inc. While these businesses will likely be impacted by short-term cyclical headwinds, we think their long-term prospects remain attractive.

Riding the Macro Wave via a Bottom-Up Approach

Looking beyond sector dynamics, another key source of resilience across our holdings is their ability to withstand the prevailing macro environment, especially the current inflationary cycle and supply chain challenges. Indeed, while some portfolio holdings are managing well, others are able to capitalize and even benefit.

Due to a combination of strong structural growth tailwinds in their sectors and supply chain shortages, our semiconductor holdings such as TSMC and NXP are benefitting from strong pricing power, versus the price deflation that we have historically seen in this sector. Meanwhile, Deutsche Boerse has benefitted from strong cyclical growth across their asset classes and the impact from inflation has been limited: their operating costs during the first half of 2022 saw an inflationary impact of 3-4% compared to 8% for businesses overall.3 Others that have been able to pass on inflation or have even benefitted from it include luxury conglomerate LVMH, food services provider Compass, pest control business Rentokil, and information solutions company Wolters Kluwer, which have all been able to fully offset the impact of inflation. Our view is that this due to operating in a good industry with favorable competitive company dynamics. At the same time, we believe it is reassuring to see that pricing actions have been taken with integrity and none of these companies mentioned here are looking to exploit what is no doubt a tough operating environment for their customers.

Others have been able to simply absorb some of the inflation and withstand some margin compression, such as British consumer goods producer Unilever, Atlas Copco and Kone. However, over time we think they should be able to recover this either through a mix of driven innovation — in the case of Unilever and Atlas — or improved pricing in the aftermarket for Kone.

Today’s Environment a Prime Entry Point for Long- Term Sustainability Investors

Our focus is inherently toward high quality, free-cash-flow generative companies that have compelling business risk dynamics. The soundness of our investment strategy and the rational for the businesses we hold is not predicated on narrow predictions of the future. As such, we believe these businesses not only represent good long-term sustainable investments, but also attractive opportunities in the current market environment of global uncertainty. Going forward, we see meaningful long-term potential and attractive portfolio characteristics that are reflected in 18.7% ROIC, 8.6% three-year sales growth and a 3.9% free-cash-flow yield as of August 31, 2022.4

The Sustainable International Leaders portfolio was launched with some of our highest conviction ideas in international markets, which we view as a collection of high-quality compounders — i.e. businesses that can grow their intrinsic value at high rates of return over long periods of time. The portfolio is an outcome of bottom-up, fundamental and ESG analysis of individual companies, and conviction on internal rates of return, all while incorporating behavioral rules in to the investment process. We believe our investment process can deliver value for our investors over the long-run.


2 The Lindy concept was first floated by comedic commentator and author Albert Goldman in a 1964 article in The New Republic. The idea has since been refined more quantitatively, first by Benoit Mandelbrot in his 1982 book, The Fractal Geometry, and more recently by Nassim Nicolas Taleb in his 2007 book, The Black Swan: The Impact of the Highly Improbable, and then again in his 2012 book, Antifragile: Things That Gain from Disorder.
3 Source: Deutsche Boerse’s second quarter of 2022 company earnings call.
4 Source: FactSet® and Brown Advisory calculations. Portfolio information is based on a representative Sustainable International Leaders account and is provided as Supplemental Information. Portfolio attributes and performance characteristics exclude cash and cash equivalents which was 3.0% as of 08/31/2022 and are subject to change. Portfolio attributes show the median returns. Numbers may not total 100% due to rounding. ROIC is a measure of determining a company’s financial performance. It is calculated as NOPAT/IC; where NOPAT (net operating profit after tax) is (EBIT + Operating Leases Due 1-Yr)*(1-Cash Tax Rate) and IC (invested capital) is Total Debt + Total Equity + Total Unfunded Pension + (Operating Leases Due 1-Yr * 8) – Excess Cash. ROIC calculations presented use LFY (last fiscal year) and exclude financial services. FCF yield is a measure of financial performance calculated as operating cash flow minus capital expenditures. FCF yield calculations presented use NTM and exclude financial services.


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 mentioned. It should not be assumed that investments in such securities 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 timelines s o r 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.

ESG considerations are one of multiple informational inputs into the investment process, alongside data on traditional financial factors, and so are not the sole driver of decision-making. ESG analysis may not be performed for every holding in the strategy. The strategy intends to invest in companies with measurable ESG outcomes, as determined by Brown Advisory, and seeks to screen out particular companies and industries. Brown Advisory relies on third parties to provide data and screening tools. There is no assurance that this information will be accurate or complete or that it will properly exclude all applicable securities. Investments selected using these tools may perform differently than as forecasted due to the factors incorporated into the screening process, changes from historical trends, and issues in the construction and implementation of the screens (including, but not limited to, software issues and other technological issues). There is no guarantee that Brown Advisory’s use of these tools will result in effective investment decisions. The strategy intends to invest in companies with measurable ESG outcomes, as determined by Brown Advisory, and seeks to screen out particular companies and industries. Brown Advisory relies on third parties to provide data and screening tools. There is no assurance that this information will be accurate or complete or that it will properly exclude all applicable securities. Investments selected using these tools may perform differently than as forecasted due to the factors incorporated into the screening process, changes from historical trends, and issues in the construction and implementation of the screens (including, but not limited to, software issues and other technological issues). There is no guarantee that Brown Advisory’s use of these tools will result in effective investment decisions.

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