Some upside surprises, and 8 ethical stocks to watch

With domestic equities markets heavily affected by macroeconomic volatility in 2022, our head of domestic equities analyses the headwinds faced by investors this year, along with some of the opportunities this environment creates for long-term, ethical investors as we approach 2023.

Key takeaways

• Mike Murray's team and role at Australian Ethical
• It’s been a very volatile year, what’s been going on?
• How Australian Ethical remains true to its beliefs, despite inflationary pressures.
• Differences between ESG integration and what we do as an ethical fund?
• The sectors and companies that have outperformed and surprised Mike in 2022
• The ASX themes that Mike Murray is excited about
• Is the recent uptick in performance in the last quarter a positive sign for 2023?
• What sector opportunities do you see for 2023?

Edited Transcript

Maria: Hello, my name's Maria and today we have Australian Ethical's Head of Domestic Equities, Mike Murray, who is going to talk to us a little bit about what's happening in the market at the moment in 2022 and what to look out for in 2023. So welcome, Mike.

Do you want to just tell us a little bit about your role and your team at Australian Ethical, what you do?

Mike: I lead the equities team or the domestic equities team at Australian Ethical. And our main focus is really our Australian Shares Fund, now Emerging Companies Fund, and our High Conviction Fund, which I manage. So those funds are all invested purely in different portfolios of Australian equities, from very small caps to larger cap companies. I joined Australian Ethical around about a bit over six years ago, and I've worked for about 20 years in the sort of ethical or ESG investment space. And so I've seen a lot of change in that time. And just really excited to be leading such a great team at Australian Ethical that's got an attractive long-term track record and is very committed to patiently investing in companies that meet our ethical charter.

Maria: So it's obviously been a very volatile period and a really difficult market. Do you want to just tell us a little bit about what's been going on?

Mike: Yeah, certainly. Look, I'd really characterise it as a market driven by macro volatility rather than bottom-up fundamental company trends. And look, I think that creates challenges and opportunities. Certainly in the first nine months of the year, we saw markets deliver a total return of about minus 10% in Australia. So that was a tough environment for all investors. But look, it was a particularly tough environment for true-to-label, authentic ethical investors because what we saw was the sort of heavy environmental footprint resources sector outperforming, but we saw those companies that are more kind of pure industrial companies and particularly smaller cap healthcare and information technology companies that are having a big positive impact on the world are underperforming quite significantly in that higher interest rate environment. And so that was a tough environment for us. I think since then what we've actually seen, is during October and November, we've seen quite a strong pickup in markets across the board. We've seen markets rise about 13%. And I think that just shows the importance of not reacting to short-term volatility in markets.

And look, the second thing I'd say is it's really important to keep an eye on the long-term returns, not the short-term returns. So, if we looked at our Australian Shares Fund over five years, it's given you 7.7% per annum after fees in the wholesale trust. And then if we actually look at our smaller companies fund or our Emerging Companies Fund, it's given you 11.8% per annum over five years. So that's been a really strong performing fund even taking into account those more recent trends in smaller cap companies.

Maria: So at Australian Ethical, we factor in inflation and what's happening in the macroeconomic environment in terms of our asset allocation and particularly our multi-asset funds, but from a domestic equities perspective, you think about that a little bit differently. Do you want to talk to us a bit about how you are thinking about inflationary pressures?

Mike: Yeah, sure. And we certainly think, like all investors, inflation matters a lot to long-term returns. But the first point I want to make is that just because we're in a higher inflationary environment and that's had consequences for, for example, resources companies, oil companies, we're not actually going to change what we do just because the oil price is higher. We're not going to start investing in fossil fuel companies.

We're a true-to-label ethical investor. We spend a lot of time explaining to people what we stand for and what we do and we don't intend to change what we do. But I think the difference between, I guess running a multi-asset portfolio and running a kind of bottom-up equities fundamental portfolio, is that we're spending less of our time trying to understand what the next inflation number might be and a lot more time with the individual companies understanding their business models, making sure they're resilient to a higher inflation environment.

For example, do they have pricing power? Do they have too much debt which they're going to have to pay a higher rate of interest on? Or in the case of some smaller capitalisation companies, do they need to pivot their business model from growth to free cash flow generation? So, we're much more focused on identifying resilient and sustainable business models than we are on trying to pick macro trends.

Maria: You talked about the fact that we are not invested in fossil fuel companies, but there are a lot of ESG funds that are. Can you talk a little bit about the difference between ESG integration and what we do as an ethical fund?

Mike: Yeah, it's a really good question Maria. And I think it's really important to distinguish between ethical investing, which often involves negative screens and aligning portfolios with an ethical charter in our case, which we hope represents our customer's values and a sort of light touch ESG integration approach. And I'd characterise light touch ESG integration as really being prepared to invest in most companies as long as you've integrated a particular ESG risk or concern into your valuation.

And so you may invest in a fossil fuel company if you're comfortable that on a risk-reward basis the returns exceed the risk of investing in that company. So we're very, very different to that. We wouldn't invest in fossil fuel-oriented companies really under any circumstances.

Maria: Which sectors or ASX companies have outperformed or surprised you this year?

Mike: One of the areas that we do invest in resources is lithium. And we came across Pilbara Minerals (ASX: PLS) several years ago and we put money into it around about 70 cents and promptly fell to 15 cents so we're no strangers to volatility. It's currently trading at over $4. So that's been an example of a company that's really outperformed our expectations in that space.

Look, and I'll give you another example, it's a little bit more normal, or a bit more boring. General insurance companies, you would've expected them perhaps to do poorly given we've had such severe weather events around the country, they've actually held up quite well. And I think it's an example of companies like IAG (ASX: IAG) and Suncorp (ASX: SUN) that have very strong business models with a strong degree of pricing power. And what those companies have found is actually as interest rates have risen, they're getting more return or high yield on their investment. So we've found those companies quite a defensive place to invest in this environment.

Maria: Are there any themes in the ASX at the moment that you're particularly excited about?

Mike: Yes, and I think that's a really good question because even though markets have bounced, we're still finding companies and opportunities that we like. One of the companies we think that hasn't benefited to the extent it should have from higher energy prices is Contact Energy (ASX: CEN), based in New Zealand. We've just had two of our analysts actually visiting Contact Energy. And the reason we like it is that New Zealand is about 85% renewable power and it'll probably go for around 90 or 95% renewable power.

And they're a major player in geothermal hydroelectric power over there. And they've actually got a major new geothermal project coming online and you can buy that company today for about 12 times EBITDA, which we think is very reasonable for that sort of asset. It's quite defensive, it gives you a dividend yield of about 4.5% and we think that dividend will grow at about 5%, giving you a total return of probably somewhere around 10% for an asset we think is sort of below average market risk.

Maria: Do you think that the recent uptick in performance in the last quarter is a positive sign for 2023?

Mike: I don't want to get carried away with short-term market moves, but there's no doubt it was really incredible to see the bounce in the market over October and November of about 13%. It's quite a remarkable turnaround given where we've come from. And I think the positive is certainly that we have seen multiples correct, to some extent.

So, if we look at price-to-earnings ratios, they've come down in Australia from around about 20 times to around about 15 times in aggregate and we think that's a reasonably attractive level. But within that, there are things like the resources sector, which trades on low PEs and is pulling that overall multiple down.

The positive, I think, is if we have seen something of a peak in inflation expectations and we are starting to see some moderation in components of inflation, that could support the market further. But at the same time, we don't see interest rates going back to where they were before. And we also think we're probably entering a period of slightly slower economic growth. And for us, that means we're much more focused just on finding companies that are resilient in that environment. Generally, we're not in this style of strategy investing in those really cyclical areas like resource companies. So we actually think we're positioned quite defensively.

Maria: Looking forward again, to 2023, we talked about renewable energy and healthcare. What are you seeing as the opportunities in those or other sectors for 2023?

Mike: Yeah sure. Look, one of the things that we've seen quite recently is small-cap software technology companies and in fact, small-cap companies in general, sell off quite aggressively in an environment of higher interest rates. And I gave you the numbers before that actually, that's been where we've found some of our best long-term opportunities through time.

So to give you an example, we were very early investors in a company called Pilbara Minerals (ASX: PLS). Around about 70 cents, it fell to 15 cents. It's currently over $4. Another company, Cogstate (ASX: CGS), is a digital cognition company providing services on big pharmaceutical clinical trials. It's another example of a company we identified very early and has grown very significantly in valuation and earnings terms for us. So we do think that the environment for small caps recently has been challenging, but that's likely to throw up opportunities.

Maria: So, sounds like it could be a really interesting 2023.

Mike: Well, it's certainly been a volatile '22, thanks Maria. And I guess we're hopeful of a little bit less volatility, but we also know that volatility creates opportunities for long-term fundamental active investors. And so I think markets have corrected to more normal levels, we should expect more normal levels of return going forward.

There probably will be a bit more volatility as the market works out where inflation is going to end up. And the focus for us is really just on that bottom-up, finding those companies within the market that we think are going to do the right thing by our shareholders through time.

Maria: Well thank you so much, Mike.

Mike: Thank you Maria.

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Australian Ethical started investing ethically in 1986. 36 years later, it is now easier than ever to invest ethically. Their first ETF, 'AEAE' gives you access to a focused basket of stocks from the S&P ASX 300, actively managed by their award-winning team from both an ethics and investment perspective. It is a High Conviction active ETF, giving you the added flexibility to buy or sell whenever you like.

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