Market sentiment on China has become especially fragile of late amid fears over near-term growth. However,

We are in one of the most significant periods of change for real estate. Seismic shifts are taking place as we respond to climate change and decarbonise assets. It is clear the changes will be dramatic and they will be apparent well before some market participants currently assume. The conflict in Ukraine and the resulting higher costs for fossil fuels have sharpened the focus on decarbonisation. At this stage, adopting an agile response and taking steps to prepare for the effects of the transition to net zero are vital. This will allow investors to mitigate the impact on valuations, returns, investment activity, and the future investibility of their assets.

The momentum is building

There is increasing pressure on asset managers to reduce the emissions from the assets they manage. Extreme global environmental changes combined with pressure from governments, investors, regulators, occupiers and employees are forcing change. With the built environment accounting for around 40% of global carbon emissions, the commercial real estate investment sector is in the spotlight. Real estate has a large part to play in limiting global warming to the 1.5 degrees threshold.

While the target of net-zero emissions for buildings is necessary, how to get there is still not clear. Government policies at a global level lag well behind what is required. As a result, the gap has been filled with a proliferation of voluntary standards, such as the Better Building Partnership, the World Resources Institute, and the World Green Building Council. While these are well-intentioned, they are often contradictory. And in the absence of a common definition of what 'net-zero carbon' means, they can cause significant confusion.

A clear trend is emerging where real estate assets with a higher sustainability specification can command a premium, while those that don't are vulnerable to a 'brown' discount.

More sustainable assets are commanding a premium

A clear trend is emerging where real estate assets with a higher sustainability specification can command a premium, while those that don't are vulnerable to a 'brown' discount. Ramping up sustainability performance standards is certainly increasing obsolescence (no longer fit-for-purpose) in buildings. But measuring rental premiums, lower void periods and higher valuations for more sustainable assets is likely to remain challenging, given there is limited data and evidence on which to base assumptions.

Regulatory confusion isn't helping

The current reliance on Energy Performance Certificates (EPCs) across Europe illustrates some of the issues with the existing regulatory regime. EPCs can be helpful in providing information about a property's theoretical energy use, but they tell us nothing about the actual energy used in practice. The key European Union (EU) sustainable finance regulations rely heavily on EPCs. But how these concepts are implemented by each member state renders cross-border comparison nearly impossible. At present, the same building will be efficient or inefficient (under the Sustainable Finance Disclosure Regulations), or it will be sustainable or unsustainable (under the EU taxonomy classification of sustainable activities), based purely on the country in which the building is located.

Estimating the future impact of decarbonisation on assets.

What is the expected cost of decarbonising real estate? No one really knows. The heterogeneity of the asset class and the uncertainty associated with the recommended path to net zero make it difficult to quantify. Numerous factors will have a sizeable impact on the cost. For example, the age of the asset, plant and machinery; the complexity of the layout; the geographic location of the asset; or the costs of construction in the country concerned.

Furthermore, the decarbonisation or otherwise of the electricity grid in a particular country where there is a high level of green energy (nuclear energy, for example) will reduce the overall decarbonisation costs. The degree of global warming in the country concerned will also affect the decarbonisation start and end points. Countries that are more susceptible to global warming will have a greater need to decarbonise quickly.

So how do investors begin to put a cost on decarbonisation? Estimating a decarbonisation cost for the average asset in a particular sector, within a specific country, and taking account of the sustainability of the grid, gives a benchmark starting point. Investors can then collaborate with expert consultants, such as JLL, Verco, and Evora, to analyse assets on a bottom-up basis. This provides the key data that can be used to refine the broad averages.

We take a multi-pronged approach

The key challenge at the moment is finding a consistent pathway to net zero. It needs to take account of different sectors, countries, future climate change, and the sustainability of energy sources in each country. The science-based energy emissions guidance from CRREM (Carbon Risk Real Estate Monitor) is our starting point. This is then combined with the extensive bottom-up data that we have collected from external analysis of our assets. We then take a view on the most appropriate numbers based on our country or sector views. We expect our guidance to evolve as we build up a more precise database of expected and actual costs.   

So what does this mean?

Given the undeniable impact of global warming, along with the ever-tightening and more onerous sustainability regulations, the real estate industry is under pressure to change. Investors are becoming much more aware of the need to tackle excess emissions in their assets.

We are at the early stages of investors pricing in the likely costs associated with 'good' and 'bad' sustainable assets. But given the level of scrutiny in this area of real estate, the pace of change is gathering significant momentum.

Some investors will be left with assets that require too much capital investment to be viable. These assets may not attract tenants or they may not generate a cashflow in the future. Indeed, they may even become obsolete, where the only course of action will be to knock them down. We are taking significant steps now, to avoid such extreme measures in the future.

Author: Simon Kinnie, Head Of Real Estate Forecasting and
Ruairi Revell, Head Of Real Estate Esg (Core, Plus And Value-Add Funds)

The experience of investing in risk assets over the last six months has been a miserable affair for most involved-particularly in some corners of the market where we have seen a collapse in share prices.  We question, however, why this might be a surprise for so many investors. 

The evidence would suggest that many investors have become conditioned by the environment that had prevailed for over a decade, with a smooth and clear road to higher prices for equities and most financial assets. The world's key central banks have had a specific goal of lower yields on financial assets since the great experiment of quantitative easing commenced. We have been in an era that has been less about investing capital and more about deploying capital to the beneficiaries of the great inflation in financial assets.

This era even had its own language: SPAC, FAANG, meme, NFT, crypto, FOMO[1], etc. We live in a world where artificial intelligence is developing rapidly and can join the dots within larger data sets much better than humans can, and we will no doubt underestimate the degree of future advances in this area. However, we have just had a good reminder of the power of human thinking, as joining the dots on the wide array of evidence from different sources has been giving us valuable insights for some time.

As a team, we are always discussing and debating these observations and the insights they provide as they are instrumental in both directing our research towards the best new ideas and a correct appraisal of our current investments. The valuation of companies has been a key area of focus, particularly when the last COVID-related round on monetary creation pushed valuation disparities within the market to exceptional levels. Exactly a year ago we wrote, "These balloons…will not stay high in the sky…and the only debate will be the speed of descent". In January we wrote, "Make no mistake, there are many aspects of this that have the trappings of a bubble". This is the human algo (or "Halgo[2]" for short) in action and a good reminder to ourselves of the value of staying disciplined and bringing experience to the table.

Whether the current outcome is surprising or not, all investors are now faced with a new and ongoing challenge. In our view, policymakers no longer have our back and inflation - rather than the price of risk assets - appears to be their number one priority. The road ahead is not going to be so easy.

Three steps for the new road ahead

It may be easy to become gloomy after the drawdown of the last few months. But we believe that there are plenty of reasons to be optimistic about the prospects for compounding your future capital from today's levels if you consider the following three steps.
 

1.    Recognise that we have shifted to a different road type, and it is rougher and more variable

As investors in individual companies, we are constantly being asked to differentiate between volatility that is just short-term angst and a signal of change. This is our suggested approach: always be open-minded to new information that could undermine a thesis. The thesis, however, is that we are seeing a regime change.

More specifically, inflationary trends are now greater than they were in the past given the scale of monetary creation over the last decade. In the shorter term, there will likely be a period of easing pressures as the pending rate-induced recession commences and supply chain pressures ease somewhat. On balance, however, structural energy undersupply, labour market constraints and military expenditures will all contribute to sticky inflation at rates likely to be above the 2-3% ideal for central banks. Risk-free rates will therefore remain at higher levels.

Secondly, geopolitics will likely remain problematic as the battles for technology dominance between China and the US, and the struggle for military supremacy in Ukraine are likely to be prolonged. The free flow of capital across borders should no longer be assumed, the cost of borrowing in the world's reserve currency will likely stay high and we need to be prepared for an increasing shift from certain actors, such as China, moving away from the US dollar as the currency of external trade in the years ahead.

In short, we believe that growth in the broader economy will be less certain and more cyclical, and as a result, the cost of capital will not return to the low levels we saw in 2020-2021.

2.    Realise that this new road may be best travelled with different vehicles

Those of a certain vintage (myself included) might remember the cartoon series "Wacky Races", courtesy of Hanna-Barbera. With the adoption of a multitude of new and sometimes esoteric ETFs and other thematic vehicles in recent years, it has often felt as though we have been competing in Wacky Races!

The good, albeit challenging, news for investors is that when there is a regime change, as the significant market correction seems to flag, there is a high probability that there will be new leaders in the race ahead. We have done some work on prior periods of significant market corrections and what the probabilities are, with a clear caveat that the number of reference data points is modest in total. As a reminder, the leaders over the last cycle were information technology, consumer discretionary and energy; assuming they will automatically return as market leaders is a brave call based on this work. Our personal intuition is also that new leadership is likely to emerge this time given the scale of surplus of capital that has just been allocated to the winners.

3.    Improve your probabilities by sticking to a few enduring principles
Invest in price makers versus price takers
It is not just the price for assets that has had favourable tail winds over the last decade, but also profitability. Profit shares as a percentage of GDP have been at record levels in most economies, and this has conditioned investor behaviour, with recency bias leading many to assume that this will remain the norm. Work by empirical research previously highlighted that in the decade prior to 2021, about half of the improvement in profit margins for US manufacturers was down due to lower interest costs and taxes. Whilst lengthening of debt duration may dilute the impact of rising rates, there is now a clear headwind for interest costs and taxes similarly are heading upwards in many economies.

Gross margins are similarly being challenged by rising labour inflation (and availability), a shift to more local and higher cost supply chains, rising raw material input prices and (particularly for those sectors previously benefitting from COVID-related revenue boosts) negative operating leverage as sales decline. On average, times are getting tougher for businesses, and franchise strength is being tested more fully. Where products and business models are unique, dominant or gaining share, the scope for passing on costs to customers and sustaining volume growth is greater.

Ensure capital funding is sustainable

It is now patently clear to all that the cost of debt is going up notably, and as is always the case, the availability of debt could become more irregular. The degree of change in debt costs in US dollars is much greater than in other currencies, and given its reserve currency status, it raises the global cost of capital for many businesses. Self-funding growth (high free cash flow) and balance sheets with appropriate and long-duration debt, in our view, will be better placed to keep investing through the pending down cycle. Cash-burning, profitless business models likely won't pass the test.

Focus on justifiable valuations

We have learned, sometimes through bitter experience, that the penalty for investing at inflated prices and a lack of future cashflows can be quite onerous. Compounding capital from levels that can be politely described as "frothy" is difficult. When the music stops, falls of 80-90% are common for the frothy crowd, and more often than not they stay down as profitability remains a dream rather than reality.

Where we find Future Quality winners

If you are a more seasoned investor none of the above should be particularly surprising. The next key question will likely be: where are you investing your capital within global equities? Companies on a unique journey of improvement that can attain and sustain high returns on invested capital over the next five years or more have always been the best starting point, in our view. These Future Quality ideas are what excite us and have been the foundation of our alpha delivery for over a decade.  

For simplicity, though, there are often some common traits for these stock picks and we highlight the following:

Energy transition

Last quarter we highlighted in greater detail the energy transition theme. We very much retain our optimism that an enduring cycle of rising investment is now upon us as societies need to address the challenge of sustaining the still-necessary fossil fuel production, increasing supply from more trusted regimes, improving energy efficiencies, reducing emissions, and further developing alternative energy sources. The latter is key from a climate perspective, but also energy intensive in its own right, creating a circular requirement for the other drivers. In short, the addressable market will grow and surprise investors, and profitability for many suppliers of the "picks and shovels" of the energy transition is on an improving trend. This is an increasing rarity in the current environment.

This quarter we have added Worley, an Australian-based provider of engineering consultancy and design services, and Linde, a leading global industrial gas provider, over the last quarter. Both are expected to be price makers in their respective markets. 

Enduring growth

Given the backdrop of rising rates and pressures on household consumption, we are increasingly cautious about the growth outlook for many consumer-facing companies. We believe that falling propensity to consume (due to greater spending on mortgage and utility costs) and prior COVID-led pulling forward of demand will be difficult and enduring problems to overcome.

Sustainable growth that is less impacted by consumer cyclicality is therefore preferred. Our long-standing overweight in the healthcare sector highlights the fact that we see the demand backdrop for better and more cost-effective solutions across ageing societies as being very much enduring in nature. In other sectors, we have also added new holdings with similar attributes, such as O'Reilly Automotive and beverage maker Diageo. The need to repair autos given the significant ageing of the fleet in the US will remain strong, and premium spirits will remain an affordable luxury with long-life inventory less impacted by the current rise in input costs. 

Other recent additions include leading franchises in areas such as travel, where prior consumption has been constrained significantly by COVID and as a result, we added Amadeus IT, the world's largest provider of travel booking systems, to our portfolios.

The final key comment on the area of enduring growth is that we are increasingly concerned about the prospects for digital advertising. Business start-ups and the funding for newer business models have ballooned over 2020-2021, as conducive capital markets have enabled IPOs, SPACs, and a flurry of activity in private equity funding. Many of these have been technology-related firms with limited customers and cashflow, and they have been focused on finding new customers. This startup funding in 2021 is estimated at USD 650 billion in the US (Source: Crunchbase), roughly double the level of prior years.

We assume that about 40% of this will end up in customer acquisition/digital marketing with the majority going to key players such as Meta and Google. This level of spending may now normalise to more sustainable levels as we see new funding dry up and many existing customers burn through cash reserves. This source of advertising spend will likely see a large drawdown, in turn prompting investors to reappraise their growth assumptions for the leading digital media players. Notable downgrades are not a key attribute for enduring growth and we have no exposure in this area.
 

Author: Will Low, Head of Global Equities

¹ SPAC (special purpose acquisition company), FAANG (Facebook, Amazon, Apple, Netflix and Google),
NFT (non-fungible tokens), FOMO (fear of missing out)

2 Halgo (Human Algorithm)

Disclaimer

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