Q: How is the fund different from its peers?
The Thornburg Better World International Fund was launched on September 30, 2015, to meet the need of clients who wanted an international product with environmental, social, and governance (ESG) characteristics. We go beyond the general feel-good sense of ESG to identify whether and how these factors might enhance financial performance, allowing the fund to beat the benchmark and provide good returns.
Most ESG funds are guided by a strong social or moral agenda. After an initial wave of investments many tend to underperform and then blow up, ultimately having no positive effect on the world.
Our philosophy is different. Though we take a stance on several social issues that are a net negative to society, we view financial performance as critical. Therefore, we primarily incorporate the ESG factors that enhance our own performance.
Our firm likes the fund because it attracts the type of clients we want, those who are focused on longer-term performance. It is good for the industry as well, providing an alternative to portfolios that are evangelical about the social side of ESG.
Because it lends itself to low volatility and has a low downside capture ratio, the fund tends to outperform in down markets and when they really start to sell off, it shines. This is true in part because of ESG – essentially, we are fishing in a better pond – and also because our stock selection process should diminish risk.
Q: What kind of ESG companies do you find attractive?
Of the ESG factors, we believe governance is most important to investment returns. Critical considerations include whether a company readily discloses information, has an independent board, and a remuneration policy that rewards management for returns not just growth, as this distorts behavior.
Environmentally, we seek companies that are more efficient with waste, water, and emissions than their peers. They generate stronger financial performance today through lower cost structures and higher margins, and should continue to perform in the future. Take automakers, for example. Currently, even though there is no fee for carbon emissions, manufacturers offering cars with lower emissions have cachet; products like a Toyota Prius or Tesla command higher prices while garnering greater customer loyalty.
Socially, we invest in companies with gender diversity. A significant amount of research, including work by Morgan Stanley, links gender-diverse management teams and workforces with stronger financial performance. Looking back 20 years, companies in the top quartile of gender diversity tend to outperform.
There are many reasons this may be true. Diversity is a long-term goal; it takes significant time to shift. We believe the same management teams that are looking farther out at diversity will not necessarily slash R&D budgets to meet a quota. Additionally, a diverse corporate culture is not dominated by a single personality who might miss outside information. By taking in different views, it is less likely to be sideswiped by new trends.
The fund takes a strong stance against owning tobacco, alcohol, weapons, and gaming/gambling companies. Although there is money to be made there, our desire to be net positive to society overrides investing in businesses with such proven deleterious effects.
Neither does the portfolio own coal or oil companies. Instead, we want to invest in renewable energy, where our blended view of financials and ESG directs us. Financially, the coal and oil industries will be incredibly challenged over the next decade, and from an ESG standpoint, a move to renewables is net positive for society.
A Trump presidency might set back renewables for a few years, boosting coal and oil businesses in the short term. But the renewable energy wave is coming nonetheless. The human ingenuity within the space is leading to dramatic cost reductions. Solar is overtaking traditional energy sources, particularly in places like the southwestern U.S. In the very near future, solar will be an indisputable low-cost energy source anywhere there are large open land resources and lots of sun.
Q: What is your investment philosophy?
To select high-quality companies at the right price, we are guided by critical tenets beginning with the ESG principles outlined above. As well, we believe a company is attractive when it has a moat around its business, creating sufficient barriers to entry so it can earn return on its capital.
This point of our philosophy would preclude many companies favored by green funds, like the solar firms which disappointed investors in the early 2000s. Solar is a tough business with low barriers to entry and little in the way of technology that can differentiate companies. The barriers simply are not there to earn the return above the cost of capital. This is a good example of why we are focused on the fundamentals of each company.
The next principle is one we have termed runway, because what we are looking for is reminiscent of where planes take off. When evaluating a company, we ask whether there is a runway in its core business, and barriers that protect its growth. Does it invest capital in things it is good at? Does it grow organically, which is much preferred to acquisitive growth?
Our final tenet prescribes that we use free cash flow as an evaluation tool. Because accrual accounting can be deceptive – sometimes it does not reveal the true earnings – our selection process focuses on a company’s generation of free cash flow instead. We find companies attractive when they return capital to shareholders via dividend or buyback, or at least show a willingness and a discipline to do so.
A final but nonetheless important point of our philosophy is we do not look just for best in class. What matters more is that companies demonstrate improving financials or ESG characteristics. To us, the reward is greater when we find a company that goes from bad to good – or good to great – rather than one that is already good and stays good.
Q: How do you organize your investment strategy and process?
Our strategy is to diversify as much as possible, keep volatility low, and drive the returns of the portfolio through stock selection.
The more disparate assets a portfolio has, the better its volatility characteristics. We diversify across geographies and industries, and essentially look outside of the mainstream markets where many other managers are more comfortable fishing.
Because the fund invests in less-followed places like New Zealand, Norway, South Africa, Korea, Argentina, Indonesia, and the Philippines, our process includes meeting with companies on site so we can kick the tires and learn the real business behind their numbers, collect ESG information, and engage with management, pushing them to get better in a non-confrontational way. As we grow in size, we expect our influence to expand along with it.
Funds at Thornburg are relatively concentrated with the majority of our equity products having 40 to 60 names. This range has proven to be a real sweet spot, and is where the Thornburg Better World International Fund portfolio has been sitting, right around 50 names.
This concentration level lines up with our ability as a team to cover a certain number of names and effectively communicate, but it is not so concentrated that it could become detrimental. It still has enough names to give us diversification benefits and also acknowledge that mistakes invariably happen.
To classify stocks, we use Thornburg’s basket structure that divides them by three fundamental drivers: consistent earners, basic value, and emerging franchise companies. The portfolio is geared toward consistent earners to lower volatility.
Consistent earners are blue-chip companies with steady revenue and steady earnings growth, while basic value stocks are more cyclical. Because they are economically sensitive, appropriate entry and exit points are critical; because they are not compounders, trimming and adding is equally important. The emerging franchise bucket contains long-run growth kickers, typically smaller-size companies at the time we identify them. Over 10 years ago, for example, the firm invested in Baidu Inc because we saw it as a Google equivalent in China.
Q: Could you cite examples that illustrate your research process?
Aguas Andinas S.A., a Chilean water company, was an idea brought to my attention by an analyst doing work on European water companies. One of them, Suez SA, had an indirect controlling stake in Aguas Andinas, which was referred to as the crown jewel in its portfolio.
We found Aguas Andinas particularly attractive for several reasons. The company had strong corporate governance and a good runway approach with the potential to grow its wastewater treatment and clean water services. Compared to most utilities around the world, its return on capital and return on assets were roughly doubled, and it was paying a decent dividend. At this point, I visited the company to have a financial discussion and see some of its assets.
Another example is Koninklijke Wessanen, a food and beverage company domiciled in the Netherlands that focuses on all-natural, organic, and vegetarian products. Wessanen is an exceptionally run business with great diversity; women make up more than half its workforce and are well represented in management. It also has attractive financial metrics, with 5% or 6% free cash flow yield at the time we purchased it.
However, what originally drew our attention to the company were broader disruptions occurring in the food industry. Consumer behavior is changing to reflect new information about what is healthy; the trend is moving away from heavily processed products toward those that are more natural.
We put a lot of effort into identifying disruptors that are giving hell to traditional food companies, many of which are struggling to adapt and losing market share. For example, global dairy giant The Dannon Company Inc. missed the Greek yogurt trend in the U.S. The company has since scrambled valiantly and is recovering, but it remains perplexing how a company that should be the expert did not take this trend seriously at first.
Wessanen and similar up-and-comers dominate their product categories and have sizable market share. Therefore, they can earn good returns and grow nicely. Because they have developed strong brand names and earned the trust of customers, they have pricing power as well – they are simply terrific businesses.
Q: What drives your portfolio construction and what is your benchmark?
The fund’s benchmark is the MSCI All Country World Index (ACWI), excluding the U.S. This unscreened benchmark was chosen so comparisons against it would prove that ESG principles do not handicap our ability to outperform.
We have company limitations of 5% on an initial purchase, but positions generally range from 1% to 3%. To become one of the larger weightings, a company must be quite solid. We consider all the selection factors and additionally look for near-term catalysts.
Our exposure to emerging markets is capped at 30% and position sizes there tend to be smaller. Because there is less information and greater variability in those names, they generally cap out near 2%. The portfolio’s biggest emerging market position is Aguas Andinas, which has appreciated to 2.5%. The basket of emerging franchises, the ones we hope will grow over multiple years, is limited to 25% of the portfolio.
Q: How do you define and manage risk?
For us, the first and most important principle is using our stock selection process to minimize permanent capital loss.
The ESG factors also limit risk in several ways, and in particular, help us avoid catastrophic incidents in companies which can wipe out their value. Because the portfolio has a lower probability of holding such companies, we should have fewer blow-ups; by limiting position sizes, we also restrict the amount of damage that any one company can cause.
Diversification is especially important for ESG products, which may be underweight certain industries and overweight others. We use creative methods to get diversification into different areas of the portfolio.
Too many managers spend too much time focused on the upside trying to differentiate themselves, which is understandably tempting because the markets are up most years. However, a truly effective way to outperform in the long run is to truncate the downside – by focusing on risk as much as the upside potential during stock selection and portfolio construction.
The mathematics behind the downside illustrate why it is so crucial to manage. If a portfolio is down 10%, say it goes from 100 to 90, to return back to whole it needs to be up 11%. These figures blow out exponentially farther down – should it drop 50%, it will need 100% return just to break even.
There is nothing wrong with offering a volatile product – Thornburg has several – as long as that is communicated to clients. With this lower-volatility strategy, I would be disappointed if Thornburg Better World International Fund did not do significantly better than our benchmark in a bear market. Even though our goal is to outperform, a big part of that should come from limiting downside and capital loss.
