Ethical Investing: The wrong approach to achieve the right results

Ethical investing has been around a long time – since the 18th century when the morality of slave-trading and workers’ rights were up for debate. It is, in my opinion, a very good idea. The problem is the approach is off track and not driving corporate behaviour in the way that is desired. This post is not here to extoll the virtues of ethical investing and to encourage people down that route; that is the choice of the individual. My aim is to challenge the conventional wisdom, critically evaluate the status quo and encourage people to think about whether their actions are achieving their goals.

According to USSIF - USSIF: The Forum for Sustainable and Responsible Investment – Formerly the Social Investment Forum (SIF) there are three main pillars of social responsibly investing (SRI):

Screening – That is essentially the selection of ethical companies and the avoidance of unethical companies in the investment portfolio

Shareholder advocacy – This is discussing with executives issues and putting pressure on them to adopt measure to help prevent adverse contributions towards them such as climate change or discrimination

Community Investing – The practice of investing in initiatives that help a community that ordinarily would not be able to raise funds

All of these make sense with a cursory examination, invest in companies you want to encourage, harass their CEOs to avoid help those who cannot raise capital with their worthwhile projects. In fact, community investing is a solid concept and I can see no issues with it in its current form. However, it does not seem like it will produce very good returns as there is a good reason these projects are struggling to obtain funding, so perhaps not the best choice for an investor that wants to have a social impact with their decisions but still requires a solid ROI. So let’s move on to the first two pillars.

Shareholder advocacy is a good idea, after all the executive management’s job is to represent the interests of the shareholders. If those shareholders are demanding specific social targets rather than solely focussed on financial targets then they will have to change their companies behaviour. Combine this with stock screening and you have a disaster.

Almost every ethical fund carries out the practice of stock screening – it seems to be the main determinant of whether you can put ‘socially responsible’ all over your marketing materials. The theory is by investing in the ‘good’ companies you are encouraging them, but does this hold up?

Take two hypothetical companies:

Angel PLC – A wind power company that takes social responsibility very seriously

Devil PLC – Provides coal power using child labour, unsound waste management and lots of generally unethical things

 These two stocks have very similar fundamentals and their stock prices are identical at £5.00 per share. Our protagonist, SRI Investments, will think; ‘Excellent, easy decision to make for my energy stock, buy Angel and sell Devil’. Now if this fund was very large it could potentially have an impact of the share price by buying a significant stake pushing Angel up to £6.50. What has this achieved? Great! We’ve rewarded the good company with a higher share price. A week later, a standard fund manager is considering his energy stock selection. His investors have not specified a preference so he will choose the cheaper stock on fundamentals. So now you’ve rewarded investors that are ethically neutral for investing in a company you didn’t want to support. If you believe in efficient markets, any ethically neutral investors will switch investments and very quickly reverse any stock price impact anyway.

The AGM’s for both companies come around. The SRI fund manager will perhaps raise a few issue beforehand and then turn up to Angel PLC’s and vote on all issues as to encourage socially responsible behaviour. Of course Angel PLC is already best in class, so all this shareholder advocacy will have very little real world impact. Those decisions would have most likely been made by management anyway.

At Devil PLC’s AGM, management can announce their results and generally continue business as usual. The investors are interested in the earnings and have little incentive to look too closely at what is really happening behind the scenes as long at the profits are good. There is no reason why their management should change their behaviour.

Overall the only think that has been achieved is that the investors can feel good with themselves for ‘supporting’ good companies. Shareholder support is de facto standard for the vast majority of companies it is shareholder dissent that will raise eyebrows.

Following that train of thought now let’s explore the opposite scenario:

SRI Investments buys a significant stake in Devil PLC. Neutral investors are now encouraged to buy Angel PLC aligning them with the cause of wind power over coal. However the real impact is at the AGM. The executives at Devil PLC are not going to be sitting very comfortably knowing that a significant shareholder is clamouring for change in their working policies and practices. Suddenly they are forced to consider issues other than profits and this will begin to drive a change in behaviour.

With enough capital an SRI fund could potential buying a controlling stake in a company and force either a change in management or a change in policies. Rather than hoping that these companies will improve you are making it happen! This is what I would describe as bringing the private equity approach to SRI and almost completely absent in the world of fund management.

The current approach is at best ineffective burying your head in the sand, and the easy way. At worst it is actively detrimental to its own goals encouraging those neutral on ethical issue to align themselves with corporations seen negatively. Socially responsible investing should be seeking out the worst corporations, buying significant stakes and using this control to force management to change. Boycotting only works as a customer,  it does not work as a shareholder.

To close, I finish with a quote from Albert Einstein: “The world is a dangerous place. Not because of the people who are evil; but because of the people who don't do anything about it.”

January Outperformance

It's that time of year again, with New Year's resolutions already seeming an impossible target and the cold winters nights setting in with no Christmas break to look forward to... However investors are traditionally very happy this month with December and January traditional outperformers. So I thought I would have a look to see whether I could explain how such a seemingly predictable phenomenon can persist.

Before we have a look at the data I’m going to analyse some of the potential explanations so we know what we’re patterns we’re looking for that could confirm or contradict them. The business year is cyclical with most trading being done in the fourth quarter thanks to the commercialisation of Christmas. However analysts are well aware of this, and their forecasts represent this and their predictions should be as accurate as every other time of the year, so what are the common explanations? A good example is the recent announcements of the quarterly results of various supermarkets with Tesco undershooting their forecast and rival Sainsbury’s over-performing causing their share prices to go through similar negative and positive shocks respectively.
A major reason often cited is that investment/fund managers report their end of year figures December/January time and like to show that they have been holding the big winners of the year. This could potentially lead an uplift in the best performing shares of the year and of the wider market stimulated by the increased buying activity (a similar but opposite and milder than the panic effect in market crash conditions). The knock-on effect I would expect to see if this did happen would be for February to be a poor month. Why? Because once the reporting window is past the fund managers need to redistribute their portfolio, taking positions for the new year and this should unwind any effects on the surge in December.

Another potential explanation, and in my opinion a more likely scenario, is that CEO’s of businesses downplaying expectations before Q4 comes around. It is in management’s interest to make sure that analysts and investors underestimate the value of their stock to help preserve their jobs and increase their potential bonuses when the upside surprise kicks in at the end of year. After all it’s much better to deliver bad news when people are just getting back from their holidays in the summer rather than the time that you are expected to be delivering your headline results. If this theory holds merit I would expect to see underperformance in the months preceding December as executive level management employ techniques to reduce expectations.

So now that we know what we’re looking for, let’s have a look at the data. I’ve selected some of  the world's most important indices to look at: DJIA, NASDAQ composite, ASX, FTSE 100, and the NIKKEI 225. I’ve taken the monthly performance data over the last 40 years to produce the graph below:

The graph clearly shows that December, January and surprisingly April have consistently outperformed over the last 40 years.

Revisiting my earlier predictions it is interesting to see that February is a very ‘average’ month performing at 0.57% compared to the average of 0.68% which indicates that investment managers window dressing their portfolio does not hold too much sway. November is a relatively strong month however the preceding months are typically poor performers with September being particularly bad. Which suggest that there is some merit to the lowering expectation theory.

Although the data agrees with the original predictions I made about performance I’m not entirely sure that’s the whole story. Firstly analysts compare like for like quarters, so it would be difficult to bamboozle through off their predictions with poor results in Q2/Q3. Secondly while this effect would make sense if you anticipate a small tenure at your company, it would be next to impossible to pull off year after year.

So the question still remains, why do we see out performance in the months of December, January and April but poor returns in the summer/late autumn? My answer is in two parts and perhaps controversial  for economists but I believe it is credible. Firstly, news flow is not random. This may fly in the face of the efficient market hypothesis which is accepted by many, however I believe companies’ management are much more likely to release bad news around the summer as there is weaker trading for most companies in the summer (obvious exceptions such as airlines aside). If such a cyclical company is struggling to stay afloat, it is much more likely to enter administration when cashflow is tight in the summer months.

Positive news flow is more likely in the winter. Management want to take credit for their good actions and results when the markets are paying full attention and not on their summer holidays! More exciting announcements/forecasts are reserved for year-end (both calendar and tax year).

Finally, significant negative events have a habit of occurring in the summer. Looking down the listof stock market crashes over the time period I examined these events have coincided with. Using the data to estimate this; I have calculated that this accounts for between 20 - 25% of the overall deviation so while not the full story it is definitely a contributing factor.

Diversifying the Portfolio: Lithium

Every month I'm going to be running a feature looking alternative investments called 'Diversifying the Portolio'. This first post I will be looking at the commodity lithium.

Background:

Why have I chosen to look into lithium? If you’re reading this article then you’re almost certainly using a device powered by a Li-ion battery on a daily basis. Often used in watches and calculators the digital age is proving to be very hungry for these power sources especially as laptop and cellphone usage has increased. The real potential growth market revolves around the adoption of  lithium as a major component in other types of battery such as in automobiles.

Demand:

Lithium has a very wide range of applications, according to the USGS global end-use markets are estimated as follows: ceramics and glass, 31%; batteries, 23%; lubricating greases, 9%; air treatment, 6%; primary aluminum production, 6%; continuous casting, 4%; rubber and thermoplastics, 4%; pharmaceuticals, 2%; and other uses, 15%. It’s interesting to note that batteries are not yet the main use for lithium and it has many suitable substitutes in these other applications. Examples are calcium and aluminum soaps as substitutes for stearates in greases and sodic / potassic fluxes in ceramics and glass manufacture. Lithium carbonate is not considered to be an essential ingredient in aluminum potlines.

Although there are alternatives in the battery market, the properties of Li-ion batteries make them by far the most attractive for secondary (rechargeable) applications. Their high energy density makes them by far the most attractive option despite a premium price. See a comprehensive list of their pros and cons here. Despite this the growth in battery use is frequently touted to be around 20-25% per annum  mostly from the growth in laptops and smartphones. What makes lithium particularly exciting is its prospects to be adopted as the energy storage medium of choice for electric/hybrid vehicles. Researching into what the car manufacturing companies shows a clear bias towards Li-ion technology: General Motors have used it for their ‘Volt’ line, Nissan for their ‘Leaf’ vehicle. Now the Toyota Prius, which initially was using a Nickel-hydride battery has adopted the Li-ion battery.

Here is an interesting piece demonstrating the amount of Lithium actually required to produce a car battery. Combing through the detail I believe the author has been overly conservative and is overestimating how much lithium is required. For example they state that; ‘EV batteries will be 25% larger than the nominal or useable stated capacity to allow for capacity fade’. However the 16kWh assumption is based on the Chevrolet Volt which already includes this 25% over capacity in the 16kWh figure (the cell actually delivers 10.4kWh).

Supply:

There are two main methods to extract lithium from the Earth. The first method is hard rock mining. This method has declined significantly over the last 15 years as a cheaper alternative developed: Brine production. The world’s lithium production is focused in South America as it is one of the few places that has a high enough density of Lithium for economic extraction. With global production concentrated in a relatively small part of the globe.

There are reports that China may emerge as a significant producer of brine-sourced Lithium carbonate. There are brine production facilities in the Qinghai province and Tibet, however it is difficult to procure reliable up-to-date estimates on the figures behind these projects. Overall it seems they contribute around 25% of the global supply, however it is difficult to gauge whether this will be made available to the market with China’s propensity to hoard its resources.

Overall, the various sources I’ve used to investigate lithium supply conclude that feasibly extractable Lithium is not plentiful relative to the potentially increasing industrial appetite.

Forecast:

In summary it is safe to conclude that there will be no significant downward movements in the price of lithium. The price has been increasing consistently over the last few years  and I believe it holds solid potential. The question remaining is whether the growth in supply can keep up with the demand to keep prices relatively stable (and probably nominally above inflation), or whether demand outstrips supply causing a large increase in the price over the medium term?

The prices are likely to take quickly if hybrid/electric cars become a hit as it appears they are becoming so (2million Prius sales worldwide over the last 3 years) although it may take a few years for the latest models to be price competitive with their petrol powered alternatives.

How and where to invest in Lithium:

The key players in the Lithium market are Chemetall (owned by Rockwood Holdings Inc.) , SQM in Chile and FMC Lithium in Argentina. The most obvious is to invest directly in the equity of these companies but both are diversified and would require a significant amount more research before I would be happy to recommend them.

A more direct way would be to invest in a Lithium ETF such as: Global X Lithium ETF (NYSE:LIT). Conveniently our friends over at Seeking Alpha have done the due diligence on this equity based ETF so for the details take a look here.

Another option would be to look at exploration companies. Possible include: Canada Lithium Corp. (TSE:CLQ), Galaxy Resources (ASX:GXY), Lithium Americas Corp. (TSE:LAC), Orocobre Limited (ASX:ORE) and Western Lithium USA (TSE:WLC). My pick of them would be Lithium Americas Corp. for its very economically feasible discoveries in Argentina. Close second Western Lithium USA after its recent news in on its (slightly less economical) prospects in Nevada given the US is likely to be the largest market and its development is less prone to political barriers.

One final note. Linking back to what I said at the beginning of the article, the thought has occurred to me that there are perhaps better ways to tap into the potentially explosive market of electric vehicles by investing in small companies that stand to profit. This has the advantages of less incidental diversification and potentially higher returns however, it also carries out a significantly more downside. Unfortunately a more detailed analysis will take considerable time so that will have to a post for the future!

A cashless society?

An off topic start to a blog that will be about investment management, but working as a management consultant we do a lot of work in the retail banking sector so I decided to share my thoughts on the future of cash, and the overall strategy to make it superfluous.

Brainstorming around this idea I came up with the major obstacles that need to be overcome and looked at the best solutions for doing so. I see four major barriers preventing a comprehensive move to a ‘cashless’ society:

• Reliability
• Late adopters
• Security
• Cost

The first of these barriers is reliability. As Alex Knappfrom Forbes points out our debit and credit cards are reliant on electricity for the readers, telephone networks to be functioning, their bank to be operational, and the readers themselves to be functioning correctly. Very few of us would consider those to be 100% reliable and that isn’t something that looks like it will change over the next few years. In Africa mobile payments are touted as the way forward, and whilst they require less infrastructure than the card readers we are used to seeing they still require a working phone signal at the time of the transaction.

The second factor: Technophobia is naturally being addressed simply through immersion and familiarity, however there will always be plenty of late adopters that need a bit of extra encouragement to cross the finishing line. This is likely to be addressed by a government rather than the banks. South Korea have led the way by giving preferential VAT rates to non-cash transactions. The government has something to gain from pushing us towards electronic transactions – lower tax avoidance.

Another factor is security. In Britain we’re a little bit more security conscious than our American cousins,  who have already readily begun adopting touchcard technology. We are happy to use Oyster cards that act as credit cards, but give someone access to our bank account and you’ve crossed an invisible line. The way to address this is either by limiting transaction amounts or the balance available on a card at any given moment

Finally we have cost. For large businesses such as national supermarkets, they welcome cards and don’t enjoy handling cash. It costs them money to employ people to collect the cash from each of their tills, re-stock them with a standard amount of change ready for the next day’s trading, securely transfer their assets to the bank. Small start-up shops have the opposite problem though. By default they have to accept cash and you see many small business limiting the cards they accept as they can't really afford to pay a transaction fee on every other sale. The industry average transaction fee is 1.9pc. If the banks want to complete the move away from cash then they need to encourage small business where margins are tight to start with electronic payment collection rather than fee-free physical payment.

I believe a solution to most of these issues requires an intermediary technology. We’ve recently seen developments such as square mobile payments that allow users to read cards but this still relies on a phone connection to work. A ‘cash card’ that is not directly connected to bank accounts but allows users to top it up (similar to an Oyster card) seems like a logical step to fill this void. Combine this with a simple interface, capped transaction amounts, and a simpler 'batch' transaction messaging system that is chearper to maintain (resulting in lower fees). Both Barclaycard and Visa have experimented with this technology but it hasn’t caught on yet. However  it is only a matter of time before we swap our coins and notes for plastic with chips.