1 big investment idea, 3 ways to attack it

You can watch the panel session by clicking on the video player or read an edited transcript below.

James Marlay: Hello, and welcome to Livewire's inaugural Megatrend Series. 62% of Livewire readers intend to add decarbonisation to their portfolios in 2022, so we’re here with some of Australia's foremost investment minds to talk about why decarbonisation is a theme you can't overlook, how they're tackling the investment opportunity, and a few specific investment ideas they're putting into their portfolios.

I'm joined today by:

• Jonathan Shead from State Street Global Advisors,
• Dave Allen from Plato, and
• Dan Sullivan from Janus Henderson.

Welcome, all, and thanks for your time.

James Marlay: Jon, let's start from the top and get the rationale for investing in decarbonisation. Why is it an area that investors should be paying attention to?

Jonathan Shead: Look, James, I think your title for this series summarises it. It's a megatrend. A lot of people think it's a new fad, but it's actually not. The first World Climate Conference where global warming was called out was 1979, 43 years ago. The IPCC, the UN umbrella body covering science for climate, was established in 1988. So this is something that is a megatrend that has been going on and will continue. It's not something new. And the global response is going to have financial consequences, which is why it matters to investors.

What’s a tonne of carbon cost?

Perhaps the easiest way to think about that is in carbon pricing mechanisms. If you look at how the world needs to respond, it's through carbon pricing mechanisms like emissions trading schemes or carbon taxes and so on.

And the World Bank estimates that already around 20% of greenhouse gas emissions globally are covered by some kind of pricing scheme. But the associated price is around $20 a tonne, the median of that 20%, and most modelling suggests this needs to be much higher than that. The International Energy Agency says it needs to be $200 a tonne, 10 times the current price, by 2040.

So, you've got this 80% of emissions still not covered, and you've got a price that's way too low. That has dramatic potential financial consequences that I don't think investors can ignore. And on the flip side, consistent with this kind of megatrend, you've got that cost driving innovation, and this isn't innovation in five years’ time or 10 years’ time, this is innovation that started happening 10 to 15 years ago. It's such a megatrend, I just don't think it's something investors can ignore.

James Marlay: Dave, Jonathan alluded to the fact that people have been talking about this megatrend for a long time, which seems to have grabbed the attention of markets and investors. But that also creates a lot of noise. What are the underlying fundamentals of this megatrend that make you think it's sustainable and needs to be taken seriously?

David Allen: I completely agree that we see it as the greatest investment thematic over the next 30 years, just as the digital revolution over the last 25 or so years totally reshaped markets, industries and consumer behaviour. We see this as no different. It really touches every part of our lives. It touches how we power our homes, how we power industry, how we build our homes, how we grow our food, how we commute, how we travel. Nothing is left untouched by this thematic.

When you look at a McKinsey report saying that $9 trillion is needed per year to enable us to get to that net zero by 2050, that represents around 7% of global GDP. We're talking massive numbers of historic proportions that are going to drive wholesale changes in everything we do.

What's exciting for us three as investors is, something of that scale and breadth is going to create winners and losers in the investment sphere. If you’re an index manager, this isn't the type of trend or thematic that's going to benefit you. This is very much playing into the wheelhouse of active management.

James Marlay: Is there anything that you want to call out as the compelling reason for people to pay attention to this?

Daniel Sullivan: We really grappled with it about five years ago and felt that it really was going to impact the prices of the shares we owned. There was going to be negative consequences for certain industries and good innovation and new things coming for others. We've been working on that for a while, and that's led to a much lower exposure to petroleum, which is one of the hardest industries to get away from carbon.

But it has opened up great opportunities in agriculture as well, with a lot of agricultural issues around greenhouse gas and methane, so those companies also have to do a lot of work and use their supplies to figure out how to remove methane. And then at the back end, we're going to end up with brand new industries in carbon capture and storage. I mean, they already exist, but they're very small. And as carbon pricing comes up, we should see commercial sectors and companies in that area expand quite rapidly.

James Marlay: What are the challenges of investing in decarbonisation – because there's technology that's not commercially viable, and there are companies that will almost inevitably go bust?

Daniel Sullivan: Absolutely. The first way is to diversify, because we're never going to get everything right. We try to grapple with this across around five different ways, and two of the main ones is the electric vehicles and getting the electrification of the global economy, so copper, lithium, and nickel, and things like that. That seems like a commercial path now and those uptake rates are coming up pretty quickly. Some economies and regions still need to get a kick along and progress, but it seems like a pretty clear pathway now.

And the others, wind power and renewable energy. These things used to be sort of hobby farmer things and now they're global commercial scale and such a simple technology now to know what you're going to get for what you pay for. And you can see that activity's ramping up massively. Europe's been leading the way and they're having another round now of really ramping that up again.

Vestas and Ørsted are probably two of the leaders. Ørsted is a renewable wind power generator, and Vestas is the turbine producer. Those two companies have been around for a long time now. And as you say, in terms of even for incumbents, when this theme really got bid up about a year and a half ago, those stocks went to around 60 times earnings. You've still got to be cautious of evaluation and look for where the quiet spots so you can move back downstream into people actually making the turbine blades or making copper cable. There are all sorts of different ways of getting access to this thematic without necessarily paying for the favourite of the month.

David Allen: I think that's a good point. And to your original question, picking the winners and losers in an emerging megatrend is exceedingly difficult. If you think back to the turn of the 19th century, there were 2,000 automakers making 3,000 different makes of all shapes and sizes. Virtually all of them disappeared, went bankrupt. So, picking, as fund managers, we all like to think we've got perfect foresight, crystal balls, but diversification is obviously key.

But to your point, capturing some of the inputs downstream is, I think is a smarter way of capitalising on this trend. In the case of EVs, great trends, you've got three or four times the growth of internal combustion engines. You've got by 2030, they're saying the majority of cars will be fully electrical, have an electrical component, Volkswagen putting 50 billion into EVs. But picking the winners and losers is tough.

So, the way that we prefer, or one of the ways that we prefer, is through lithium, et cetera, but also through semiconductors. If you look at semis, I think it's a really interesting case at the moment, where EVs have three or four times the semiconductor intensity as a traditional car. So they've got this absolute insatiable thirst, and that's coupled with chronic underinvestment in semis over the last five, maybe 10 years. And what that means is that companies like a company we're a big fan of, STMicro, that I've invested in for over a decade, is very well placed in that space. It's at a 2023 PE of just 13 times and got great tailwinds. So yeah, very much agree, diversification and investing in some of the upstream contributors is key.

Jonathan Shead: I'd take a slightly different view. You referred, David, to the megatrend in the digital economy, and I think that's an excellent example. But if you wind the clock back to 2000 and pull up an investment report about Myspace or all the kinds of digital names that were going to be winners, it can be very difficult to pick winners on a 20-to-30-year time horizon. I completely agree on the diversity side. For me, one of the challenges is that you can be right in the long run and you can win the argument, but lose investors on the way.

Diversity is very important for the industry, because if you get this complete rollercoaster ride, investors give up. They have a really bad year and they move on, and they miss out on the megatrend.

If you look at what's happened to energy stocks and the oil price just in the last six to 12 months, that’s an example of that. The way we've tried to tackle that problem is by taking as many small positions as possible across very diversified industries and sectors to deliver that thematic, and deliver it in a way that is least likely to disappoint investors in the short term.

We've managed to do that in such a way that we've steered clear of the high carbon emitters. And we've done it with a portfolio that looks and feels quite a lot like a low-cost index kind of portfolio. One of the great things about innovation in funds management is that you can tackle this problem from different standpoints. Some of your investors are going to be looking to have a much more actively managed play in climate that is maybe a satellite or a part of their portfolio, whereas other investors will say, "No, I just want the core to be climate sensitive, and I don't want that core to blow up." That's how we've tried to tackle that problem of diversity, performance, and exposures.

James Marlay: Moving into investment ideas, I've asked each of you to bring along a statistic that you think screams loud and clear the opportunity in decarbonisation that investors can't ignore. I want you to briefly explain that statistic and provide some detail around how it feeds into the investment opportunity in the universe that you are pursuing. Dan, why don't we start with you?

Daniel Sullivan: As mentioned, UK and Europe are way ahead of us in what we experience in Australia in terms of renewable energy and things like that. They've got a program to increase the offshore wind power from around 12 gigawatts to 60 gigawatts, and that's only the first step. And now with their renewable energy plan of last week from Boris Johnson, that's going to be accelerated to another level.

The China-based, consumption-driven super cycle, that was very exciting and lasted for perhaps four to 10 years, depending on what period you want to count. This is out to 2050 now with net zero targeting, and it's been heavily driven by the Europeans, and those targets are being pulled forward to 2030 now, so that's very, very close, really. Capital is being allocated, and we're seeing the money flow.

Money is flowing to renewables at a much faster rate than to other sectors, so we're very excited about that type of progression. We can access that through wind farmers, equipment providers, cable makers, and then down through to the mines that actually mine that copper and things that are needed.

James Marlay: You’ve talked about some recent news events. Obviously, the energy security situation in Europe's pretty volatile at the moment. Have you made specific changes on the back of these developments in the past few weeks?

Daniel Sullivan:

It’s been a very challenging time, because I don't think anyone really expected we'd get into a full-blown war. A lot of actions are happening very quickly, and I think for me, the real trigger events actually were seeing BP abandon its Russian assets, and Exxon. These are two of the biggest oil companies in the world. They've been in those countries as good partners for 20 and 30 years. 

And that's signalling to me, this war of whatever kind it is, is going to continue for quite a long period. If they felt there was a diplomatic solution that was going to resolve all this next week, there's no way they'd walk away from 30-year assets. 

So, I think they've stood by their home governments, and they've decided they will go in with this strategy.

That’s pushing Germany really hard to get off the Russian gas. I think that's a massive thing for them to try to do, and it'll create all sorts of difficulties and opportunities for others to try and supply into them. It is hugely complex now, for us in particular.

We run a very, very low oil and gas weight in our fund. The benchmark index is about a third, a third, a third across mining, energy, and agriculture, and that works well in the long term for that diversification reason. But we're probably running 25% underweight, traditional oil and gas. I think we've bought about 6% to partially hedge the risk that oil goes to $200 a barrel. Now, that's possibly already abated, at least in the short term. It went to $113 then came back, but I think there's still a chance that can happen.

Jonathan Shead:

It's an interesting mind exercise, just coming back to the original megatrend theme. When you sit down with your economist that's the first question they ask, “What's the oil price going to be?” In 30 years' time, no one's going to care. Trying to wrap your head around doing your economic updates when no one cares what the oil price is, that's the kind of trend we're talking about.

James Marlay: Jonathan, what's your statistic and why should people care about it?

Jonathan Shead: Mine's 17 million, and Dave alluded to this. When you get technological change, the way it usually plays out historically is you get this slow adoption, and it's really slow for a long time, and then it starts to ramp up and all of a sudden production goes up, costs come down. Because costs come down, more people buy. You get this positive reinforcement loop. Now, 10 years ago, electric vehicles, there were 60,000, 65,000 on the planet. That's it. There are now 17 million, last count from the IEA. Only a couple of years ago, one in every 40 new sales was an electric vehicle. Now it's down to one in every 10 to 12 globally.

My point is not so much about “go long electric vehicles,” it's more about the speed of change and being exposed to that change now. Whether it's lithium ion, whether it's solar, whether it's heat pumps, whether it's green buildings, the change is happening really quickly. What we’re trying to do is get exposure, in lots of small positions, across as many of those thematics and opportunities as we can.

James Marlay: Dave, what's the incredible stat you've got?

David Allen: Mine is one hour, and it's one hour because in one hour, enough energy from sunlight hits the earth to power all of the world's needs for over a year. The thing that makes that, I suppose, particularly interesting is, 10 years ago, when you spoke about solar and you compared it to geothermal, nuclear, coal, wind, it was the highest per unit cost, so it wasn't really in the ball game, absent massive government subsidies. But now through the virtuous circle that we've been speaking about, costs have been coming down, to the extent that it's 90% cheaper than it was just a decade ago and still falling. It is now the cheapest single energy source. And for countries like Australia, where we have abundant sun, absent the last three or four months, there are huge opportunities.

James Marlay: We're going to get into some investment ideas. David, can you pitch me both a long and a short idea to demonstrate how Plato is thinking about this shift towards decarbonisation?

David Allen: This is a long-short fund, 150% long, so 50% more exposed to the long ideas that we like and the ability to generate alpha on the short side by betting against those that are going to really suffer in this new world where we're moving into. On the long side, a name that we're long and we like is Zoom. It managed to dislodge Skype virtually overnight with some superior technology. With the network effects that are in place, once you're an incumbent, it is very hard to get dislodged. But once you're an incumbent and people talk about Zoom and “Zooming” in the same way we talk about “Googling,” then you're in quite a strong position. And why has that occurred? That's obviously been pandemic-driven, to a large extent.

But Zoom isn't like a technology company that's not making any money. It has increased the free cashflow generation 50% in the last three years. Coupled with that, there was this overexuberance with Zoom at the height of the pandemic, and the stock is off 80% since its peak. So, we think that's overdone, and there's big future for the name. Particularly in business circles, the ability and the willingness to travel in the same way we once did is totally changing. I don't think that's something that's going to go away.

And that leads into the short name, which is the other side of the same coin. Business travel, the most lucrative segment of the airline industry, I'm not sure will ever recover. It's always, historically after recessions, the slowest segment to recover. After 9/11, it took four years. After the Global Financial Crisis, it never actually attained its pre-GFC level.

This time I think it's even worse, because there's been almost an irrevocable change in people's habits, in that it's so much more efficient from the business perspective. The elephant in the room, of course, is companies like Qantas, they've committed to net zero by 2050, but we all know there's no technologically viable pathway at this time. Hopefully they can get there but there are strong headwinds, and as a result, we're short several airlines.

We're short Singapore Airlines. We're short easyJet, if anyone's been unlucky enough to have to fly easyJet in their lives. And several other European names. I think the opportunities from this decarbonisation thematic are really very exciting on both the long side and the short side.

James Marlay: Jonathan, what are the hurdles a stock needs to pass to be included in your portfolio in the Climate ESG International Equity Fund, and can you share a couple of company names?

Jonathan Shead: It’s a three-part process. First of all, we're avoiding high carbon emissions, fossil fuel reserves, extractive industries sort of more generally, so we're biassing away from those. Next, we favour companies that are exposed to what you might call the green economy. That's not just renewable energy but also water, transport, and agriculture. There are a whole stack of areas and companies that are well positioned for climate change.

But just as important is finding that balance. If you are going to deliver something that looks and feels a bit like a low cost index portfolio, you have to build balance into the portfolio.

We don't think in terms of massive winners and massive losers, because we don't build the portfolio that way. To give you an example of how we might position and get that balance, the worst offenders in terms of direct emissions are obviously the utility companies, who burn fossil fuels to generate electricity. We tend to be underweight those. And there are some renewable energy generators, EDP Renewables in Europe or Meridian Energy in New Zealand and so on, where we might have small overweights.

But if you think about the financial balancing exercise, what is an energy generator? It's a regulated entity, and the financial characteristics are regulated prices, a tendency for really long duration, stable-type cashflows. That's a kind of financial characteristics, and you can get that financial exposure through water utilities, which are much more closely aligned to the green economy. So American Waterworks in the US or Savern Trent in the UK or United Utilities in the UK.

James Marlay: Can you please rank your top one or two resources exposures, with an explanation? And then pitch a high conviction idea in each of those resources that shows us how you're thinking about investing.

Daniel Sullivan: We look for high quality companies, generally with low costs. Our preference is for entrepreneurial management teams that are really doing something. We're not trying to buy just a long run dividend stream across resources, which is probably a valid strategy, but that's not the one we've pursued. A great example of that is copper. It's been, for the vast majority of my career, a pretty boring commodity and on the whole vastly disappointing. It's moved up from around $2.50 to $4.60-ish, and that's reasonably good. It's getting increasingly expensive to build a copper mine, and there are several political risks and environmental and indigenous issues.

Of two very good operators that we see are navigating through all that and doing the right thing, one is Ivanhoe Mines, headed up by geologist Robert Friedland. He came up with a deposit in the Democratic Republic of the Congo that’s 6% copper. Most copper mines in the world are 20 to 30 years old and 0.5% copper. He's got this enormous economic moat of competitive advantage. If you look at the videos or you go there, it looks just like Western Australia. It's a brand new mine. He spent money to reinvigorate the hydroelectric power nearby, so it's going to be a very low carbon emitting mine, and it's going to be the second biggest copper of mine in the world.

BHP, Fortescue and Vale are pretty much the entire global iron ore trade. We're not going to get that in copper because the copper mines aren't that big. We're going to need 20 or 30 decent sized new copper mines, and they're not easy to find or build, so it's an exciting space. They’re the type of people we try to look for, who have that sort of entrepreneurial spark.

James Marlay: And what’s number two?

Daniel Sullivan: For this Australian audience, it’s BHP. It sounds boring, because we all talk about it every day and everyone probably owns it, but it's a great case study in this exercise of decarbonisation. So iron ore, it's massive, it's got a great margin, but it's got a huge Scope 3 problem. Scope 3 refers to the carbon emissions that are created when the products are used downstream. So, when you cook your iron ore up in a blast furnace with iron ore and coking coal, it makes a lot of pollution, and that's going to have to be dealt with. Some players around the world have proved you can do that with hydrogen and get rid of the coking coal and the emissions. So that's great.

So that's their biggest business, and they're working hard to fix it. It makes a lot of money. They've just announced they're going to decarbonise their shipping to Asia by bringing in ammonia in the shipping, and that's going to happen across West Australian economy. Again, West Australia's pretty entrepreneurial, and we're going to see hydrogen, ammonia, and lots of other things come into the economy there. Lithium is already kicking along in the industrial processes.

BHP has a lot of copper, with a “sleeper” in Olympic Dam. We've got a mine here with a 100-year life that's never been any good. Sound familiar? And uranium's part of this solution. In different parts of the world, people will get nuclear reactors to work, and it's the world's lowest cost uranium, because basically it's free, because they make money out of the copper. So that should eventually be a good thing.

Nickel West was on the block as garbage, and now it's, oh, this is a fantastic thing, nickel, and we've got to make this grow. So we'll see them try to build their battery raw material business, I think. And they've obviously got the financial clout to do it.

And then exiting petroleum, it’s again a good case study. They toyed with it. think they've done the right thing to come out a bit earlier, and that should help them get a better rating. It seems like a funny old company, but it's doing a lot of good things, and I think it can change yet again into something not entirely different. It'll be different again in 10 years from what it is today.

James Marlay: Dan, Dave, and Jonathan, thank you very much for your time today. I really appreciate you coming in and sharing your thoughts.

To all our viewers out there, I hope you enjoyed that panel discussion. Remember, the Live Wire Megatrend Series on Decarbonisation will be running through late April and early May. Check the Live Wire website. There'll be fresh content coming every day, and make sure you check in to see what the updates are on a daily basis.

More from this Series

Livewire's Decarbonisation Megatrend Series brings you feature articles that go deep on carbon-neutral investing, alongside special episodes of Buy Hold Sell, a megatrend investing podcast and interactive panel sessions with leading fund managers. 

You can find all the articles, videos and the podcast on our dedicated Series page.