How T. Rowe Price generates impactful alpha (and two stocks to prove it)

As an impact-oriented investor, Hari Balkrishna of T. Rowe Price is inherently looking for business models that can develop long-term earnings and leave a lasting impact on the planet. At the fund's big picture level, Balkrishna and the team focus on companies that can generate a quantifiable footprint around at least one of three key themes:

1. Climate and resources
2. Sustainable innovation and productivity
3. Social equity and quality of life 

But he is also very quick to point out that just because he runs an impact fund does not mean he is willing to sacrifice all returns for the feel-good factor. As he puts it, "this isn't charity."

So how do you create a process that balances impact and earnings appreciation? He says it's all about finding durability - companies which can be bought at an attractive valuation, produce quality earnings for five years or more, and can leave a durable change.

In this edition of Expert Insights, Balkrishna gives us an example of a stock that can do exactly that. Plus, he shares details about a recent inclusion into the fund. 

EDITED TRANSCRIPT

LW: What are your core investment beliefs and how do those manifest in your investment process?

Balkrishna: My core investment beliefs really centre around two aspects of market inefficiency and exploits. So the first one is, I believe that over time the market underpays for the durability and persistence of earnings, cash flow, and returns. 

When you have the benefit of horizon, you can really exploit the durability and persistence particularly if it's under-modelled by the market or under-appreciated by the market.

And the second aspect is when there is an improvement in economic returns and an improvement in sustainable economic returns, the market typically underpays for it at the beginning. You want to take advantage of that and ride the economic return improvement over time. 

The way that manifests itself in the portfolio is firstly, I think impact investing itself as an asset class really lends itself to finding durable and persistent business models which the market under-appreciates. 

The Linde (NYSE: LIN) example is a classic case in point where you've got this US$50 billion clean-tech opportunity over the next decade and I believe the current multiple or even the current valuation doesn't appreciate that in terms of what Linde could be worth many years from now. 

I believe we can make a low double-digit total shareholder return from money from here. The way the economic return improvement manifests itself is what I'm trying to find stocks where, because of an impact angle, because of energy efficiency becoming more of a mainstream thing. 

Their organic top-line growth is improving, their cost structures are improving and the overall economic returns are improving. So I draw attention to the efficient HVAC (heating, ventilation, air conditioning) space where we're seeing a meaningful step up in demand. For some of those solutions, they're becoming much more holistic and much more solutions driven which is actually improving returns in that whole industry overall.

LW: How can you achieve meaningful and impactful returns in the public markets?

Balkrishna: Our pillars of climate and resource impact, social equity, quality of life and sustainable innovation are very closely linked with the United Nations Sustainable Development Goals. 

So when you think about the gap in funding to achieve those 17 sustainable development goals, it's roughly US$5 trillion per annum. It's really difficult, in my view, for just private markets and philanthropy to get there in terms of net zero and in terms of you reducing poverty and hunger and things like that. 

So you need the participation of the large, listed equity sector as well to actually get there. That is just a level setting in terms of whether we can deliver impact in public markets - I think we absolutely can. So when you think about stocks like Thermo Fisher Scientific (NYSE: TMO) that are enabling biotech and biopharma companies to innovate better, I think that's what that's an example where you're clearly delivering the impact.

Because of our size at T. Rowe Price, we're able to get a seat at the table with the C-suites and the Board of Directors of these companies where we can impart our views and help companies improve their impact. When we invest in small companies, we can work with them around target setting, goal setting and also improving their impact. 

So I think it's absolutely doable and frankly desirable. 

LW: Pick out two parts of your investment process and explain how they generate alpha.

Balkrishna: Typically for an equity that I'm looking at, I'm taking a minimum five-year forecast horizon in those equities. The reason I take a five-year forecast horizon is it's important to be long-term when investing for impact. 

Taking another example is probably the easiest way to look at it. So one of the banks I'm invested in is HDFC Bank (NSE: HDFCBANK) in India. A majority of their branches are in semi-rural areas and so that's the impact these around financial inclusion. This is a company that generates an 18% return-on-equity and can compound book value at a mid-teens level from here right over the next five years.

And when you compare book value estimates and return estimates versus The Street, we could be meaningfully ahead of The Street. Five years out, we're paying 2.5x price-to-book for it. So it looks expensive on a book multiple. But when you adjust for the returns and you're in it just for the compounding, it's really not that expensive when you look five years out. 

So that would be an example where the investment process, durability, and persistence operationalises itself into looking for insights five years out that are meaningfully different to consensus.

LW: Tell us about a recent inclusion in the fund and its investment thesis.

Balkrishna: One of the recent purchases we made was a company called Monolithic Power Systems (NASDAQ: MPWR) in the US. We started with a half position for now and we're looking for weakness to build it up into a bigger position. 

Monolithic Power is effectively a semiconductor company. Whether that's automotive or factories, they basically provide power management solutions that reduce energy consumption, so it improves energy efficiency meaningfully in every operation.

It's a very early-stage company in the sense of the amount of analogue penetration that has happened in power management is actually still very low. So there's a huge runway for growth for many years. It's a very entrepreneurial, tech-savvy company that really has a lot going for it when we think about the growth potential.

And simplistically, this is a company that's trading at a meaningful discount to its historical trading range because of concerns around some of the analogue semi-cycle that is out there. And it's de-rated to a level where we think it's really attractively priced for the growth that we expect. 

So even in a relatively cyclical industry, we think this is a company through the cycle can deliver between 20 and 30% growth for a long period of time and effectively trade on 25x earnings.

Looking for more than just returns from your investment?

The T. Rowe Price Global Impact Equity Fund targets specific companies that not only make good economic sense, but also focus on making the world a better place for all. Find out more.

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