The Future Quality approach to navigating uncertainty

The great quantitative easing experiment of the last decade set global markets on a course into unknown territory. The repercussions of this are only just starting to play out and are proving near-impossible to predict. Central banks contended a rise in inflation would be temporary until it proved to be persistent and sticky. At the start of this year, markets were collectively expecting the US Federal Reserve to start tapering monetary policy, but we cannot yet be certain that interest rate rises have peaked. Earlier in the year, America's banking sector was unexpectedly impaired by the impact of rapid monetary tightening, but could other sectors also be vulnerable to unforeseen shocks? And we are yet to truly see the impact that central bank actions will have on growth. The major economies have so far avoided falling into recession, but for how long?

Market dynamics reflect this sense of uncertainty. US equity returns have largely been driven by a cohort of seven mega-cap stocks during the first half of the year, a narrow leadership anomaly that is crowding out good performance in other parts of the market. And anyone on the wrong side of this trade has felt the impact of underperformance.

So how should investors be navigating this sea of uncertainty?

Known knowns

At a time when investors are facing many unknowns, it is almost impossible to accurately predict the future. Yet, despite this ambiguity, there are still knowable knowns to be found.

Previous market cycles have taught us that major shifts in the economic landscape generally lead to changes in leadership. So, we must focus on what we know to help identify those sectors and industries capable of taking up the position of market leaders in the forthcoming cycle.

Fortunately, there are several clear and indisputable trends.

The path to clean energy

An energy transition will be key to solving the major social and environmental problems caused by climate change. We know there is a need to reduce humankind's reliance on fossil fuels and create better alternatives through renewable sources of energy. Despite this knowledge, the journey is not straightforward. Paradoxically, given the time it will take to develop the necessary scale of new clean energy sources, we remain reliant on fossil fuel supplies; yet supply constraints have driven up prices, making the transition process even more costly. So, while the general sentiment is that we need to invest in renewable energy sources, continued investment in fossil fuels can be vital to enabling the energy transition.

This creates a fruitful pool of investment opportunities where individual companies offer solutions to both sides of this equation. On the one hand, some services and providers can help sustain fossil fuel production more efficiently, while still considering lower carbon outputs. On the other, technology is emerging to deliver more renewable solutions, and innovations in both hardware and software are helping reduce energy usage, waste, and the scale of emissions. Market leaders in all these areas are likely to surprise in terms of margins and profitability, and therefore present classic future growth opportunities.

Growing healthcare requirements

Healthcare presents a second long-term, structural trend. An ageing global population will only result in greater demand for healthcare while, at the same time, the sector faces increasing challenges in terms of its affordability. In our view, this demographic test will present a great hunting ground for investment ideas as healthcare companies are forced to innovate to ensure more efficient delivery of healthcare services, both in the hospital environment and through consumer-led healthcare solutions.

In the post-pandemic era, the healthcare sector has faced further volatility amid the disrupted labour market for staff, while inventories have needed to be replenished from the high demand necessitated by Covid-19. These challenges are starting to stabilise, and we are optimistic about the sector's ongoing potential due to the 3 • yarracm.com clear need for innovation in the provision of new and more efficient healthcare solutions.

The resumption of travel

Finally, travel is perhaps a less obvious trend, but it's one we believe is worth exploring. The pandemic was a huge challenge for the sector, with many people under-consuming travel services simply because they were not allowed to travel. In terms of supply, the lack of demand meant the availability of flights and the development of hotels completely dried up for a period. While many consumer activities have completely normalised, travel is very much still in the process of recovery. When you look at the core consumers of travel, demand remains robust. This is particularly true for younger generations, who are placing even greater value on 'experiences' during life after lockdown.

Further, a new travel cohort is emerging from developing countries where rising gross domestic product (GDP) per capita means more people will be able to afford to travel in the future. This reflects the same growth trajectory that developed nations have already experienced in recent decades. In our view, there will be many direct beneficiaries of this significant return to global travel, from booking companies to manufacturers of luggage and travel accessories.

Chart 1: Is there a China travel boom pending? 

Addressing the known unknowns

While the investment case for established trends is relatively straightforward, it can often be harder to assess when or if an emerging trend will become a longterm investible opportunity.

AI presents an interesting example of this conundrum. While research in this area can be traced back to the 1950s, it has only recently become a commercial opportunity in the eyes of many investors. The market has quickly latched on to this development, and excitement over its potential has seen the limited number of direct AI players re-rate significantly - hence the dominance of the technology mega-caps so far this year.

Although we have few doubts that the AI theme is both real and profound, there are still many unanswerable questions. The profits and cashflows from AI are yet to materialise, so it's hard to be certain that they will be strong enough to justify current valuations. The adoption of AI is likely to have a meaningful impact across multiple industries - just as the internet did in the early 2000s - but it is difficult to identify who the eventual winners and losers of this disruption will be. There will also be geopolitical implications - the need for specific policy and regulation is already being widely debated.

While we can see the investment potential of having exposure to AI, it needs to be done in a way that's consistent with our Future Quality philosophy of focusing on the knowns rather than blindly following the hype. A raft of companies are benefitting from the rising tide of AI, but only hardware companies are currently seeing any tangible uplift in cash flow and profitability - which is what we are looking for. As more companies look to harness AI's potential, we expect to see strong long-term demand for the complex high-end semiconductors that underpin this technology. For example, Synopsys - a leader in design technology and services for the semiconductor market - could benefit strongly as companies' demand for exceptionally complicated design services grows. Similarly, Hoya is a leading supplier and manufacturer of high-tech components used by semiconductor manufacturers and should be a beneficiary of increased demand.

Future Quality in the Year of AI

While it's impossible to know the ultimate direction of travel, we do know that we are in the midst of a regime change to a world of slower growth that will endure bouts of persistently higher inflation. It is also a time of significant technological transformation that not only encompasses AI but will drive the energy transition and provide new healthcare solutions.

History tells us that during such inflection points, companies delivering high growth and sustained high returns of basic capital - classic Future Quality companies - earn the right to be market leaders and that these companies may come from different areas of the market to the leaders of the previous cycle.

As investors, we believe it's essential to stick to what we know, particularly during times of unpredictable change. Our investment approach is focused on identifying and investing solely in Future Quality companies, those with superior long-term returns on investment that have been shown to deliver better performance over time.

In our view, it is these Future Quality companies, especially in sectors aligned with secure, long-term trends, that will be the market leaders of tomorrow.

The energy transition needed to address climate change will require significant investment in new resources capacity to ensure the efficient rollout of low-carbon technologies. Investors can benefit by acknowledging the key role that the natural resources sector is set to play over the coming decades.

Creating a lower-carbon world will require a significant overhaul of the global energy system. From replacing internal combustion engines with electric alternatives to generating renewable power from solar and wind energy, the steps countries need to take to meet the United Nations Sustainable Development Scenarios to limit global warming to below 2°C as set out in the 2015 Paris Agreement will touch on nearly every aspect of our daily lives.

The energy transition offers significant opportunities for investors to benefit from  decarbonisation over the coming decades. While many have focused on investing in firms with higher Environmental, Social and Governance (ESG) ratings and lower carbon profiles in many cases little thought has been given so far to the vast quantities of critical enabling raw materials required to build the low carbon economy such as copper, lithium, cobalt, nickel and steel and rare earths. The green energy transition relies on sourcing enough of these fundamental building blocks because without these materials, there can be no low-carbon future.

Sustainable resource demand set to surge

The scale of the upcoming resources challenge was made apparent in a recent report by the International Energy Agency (IEA) on the level of resources needed to support critical decarbonisation initiatives. The global energy body estimated that countries will have to source over three and half times the total demand from the same end markets in 2020, every year by 2040 to keep track with decarbonisation targets.

Figure 1: Transition-linked mineral demand and forecast to meet climate pledges

Source: International Energy Agency, as at May 2021. Note: Includes copper, major battery metals (lithium, nickel, cobalt, manganese and graphite), chromium, molybdenum, platinum group metals, zinc, rare earth elements and others, but does not include steel and aluminium. There is no guarantee that past trends will continue, or forecasts will be realised. The views are subject to change without notice.

The IEA expects the demand linked to electric vehicles (EVs) and battery storage to be the most resource-hungry market. Forecasts show the total yearly demand rising from less than half a million tons in 2020 to over 12.6 million in 2040. This is made up of a wide mix of materials, many of which already face supply constraints. In fact, the forecasted 3.3 million tons of additional yearly nickel demand for this market alone exceeds the current 2.8 million tons of nickel produced annually, underscoring the pressing need for investment in new capacity.

Investment in transition-enabling resources is lagging

There is a pressing need to ramp up supply to meet the demand associated with decarbonisation. However, global resources firms have yet to materially lift investments in new capacity after a decade of underinvestment that followed the peak spending in 2011 induced by the China-led demand for resources boom. Figure 2 shows that analysts are forecasting near-term real investments in new capacity across the sector to run at about half the pace seen in the 20 years that preceded the peak of China's hunger for resources.

Figure 2: Real global mining capex (bn USD) per unit of mine production (indexed to 1990)

Source: Jefferies, August 2023. There is no guarantee that past trends will continue, or forecasts will be realised.

Many equity investors ignoring the role or resources in the climate transition

For their part, many equity investors are also unprepared when it comes to investing in resources ahead of the low-carbon transition. The ongoing drive to lower the carbon profile of portfolios - with low carbon-tilted indices or Paris-aligned benchmarks - means many equity portfolios are now underweight the resources sector at a time when the sector's capital needs are set to surge to meet the demands of the low-carbon economy. Indeed, Figure 3 shows that that a Paris-aligned version of the MSCI World Index has significantly less resources exposure than passive index tracking, with investors following the former strategy committing to having no energy investments and about half the materials exposure.

Figure 3: Resources weight by investment strategy (%)

Source: MSCI, September 2023.

Being underweight the resources sector may have made sense previously given these stocks lagged the wider market during the low-growth decade that followed the Global Financial Crisis. However, this position needs to change if investors want to benefit from this key enabler of the low-carbon transition.

A holistic approach to delivering a climate transition investment portfolio

We think investors may want to consider adopting a more holistic approach to decarbonisation. This can be done by looking at the wider picture of how this can be achieved through the products and services offered by the companies they invest in, rather than purely focusing on the categorisation of 'low-carbon'. It is essential to acknowledge the critical role materials play in facilitating a low-carbon economy. Currently, the 'scope' lens applied to gauge the carbon profile of investments puts resources at a disadvantage in the eyes of carbon-conscious investors due to the relatively high carbon intensity of the sector. Measures to acknowledge the role a company's products and practices play in avoiding emissions (Scope 4 emissions) are starting to gain traction. A greater adoption of these metrics will help highlight the key contribution resources firms play in decarbonisation efforts.

Rethinking resources also doesn't have to tie investors to firms with poor ESG profiles. The sector overall has made great strides in improving its sustainability characteristics - both in terms of how new resources are mined and produced, and also with firms playing a leading role in the circular economy. There's no running away from the fact that even sustainable resources companies will have higher carbon intensities than those of low-carbon indices. However, investors can still achieve a significant reduction in the carbon profile of a portfolio relative to the overall market by taking a blended approach that mixes investments in responsible resources with other low-carbon equity investments. For example, a 90% MSCI Paris-aligned portfolio with 10% responsible resources could offer a reduction of more than 70% in carbon emissions compared to the MSCI World Index with the added benefit of potentially more attractive returns and diversification benefits from the allocation to responsible resources.*

Closing thoughts

The unprecedented challenge posed by decarbonisation requires significant investments to enable the roll out of low-carbon solutions required to meet global climate pledges. These investments also need to filter through to supply chain participants to ensure the availability of these technologies at the required scale. The post-COVID economic reopening has shown how even a few bottlenecks can quickly hobble entire industries.

Capital flows need to flow through to the fundamental building blocks that will make the energy transition a reality. Finding a way to properly account for the role companies play in enabling low-carbon technologies should put the resources sector in a better light.

In the meantime, investors should look beyond the near-term carbon profile of their investments and consider whether those investments are 'doing good' by enabling a low-carbon future. Acceptance of a slightly higher carbon profile with the potential for better returns could be a better outcome for investors than simply investing in a low-carbon portfolio that makes them feel good today.

IMPORTANT INFORMATION

Sustainable or Environmental, Social and Governance (ESG) investing considers factors beyond traditional financial analysis. This may limit available investments and cause performance and exposures to differ from, and potentially be more concentrated in certain areas than the broader market.

Natural resources industries can be significantly affected by changes in natural resource supply and demand, energy and commodity prices, political and economic developments, environmental incidents, energy conservation and exploration projects.

Author: Tal Lomnitzer, CFA, Senior Investment Manager

The nuclear industry is undergoing something of a renaissance. For anyone with an interest in the industry, even a passing one, it's been a painfully long wait, but the uranium worm certainly seems to have turned. Over the past 12-18 months, we have added positions in Boss Energy (BOE.ASX) and Paladin Energy (PDN.ASX), two uranium miners. At the time of writing, the uranium spot price had topped US$70/lb, a 13-year, pre-Fukushima high and contracted volumes are on the up. In that time there has been more than one surge in the commodities sector, but uranium has missed out every time. So how did we get here?

Langer Heinrich Stage 3 construction circa 2011 (about a month prior to Fukushima) - uranium was looking up

The Fall

Not much moves quickly in the nuclear industry. The last time we experienced this level of positivity, one of our team was on site at Paladin's Langer Heinrich (LH) uranium mine in Namibia. That was in early 2011 during the Stage 3 expansion (see above). The mood then had turned bullish even though the uranium price had peaked three years earlier at over US$130/lb

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Uranium price, US$/lb (Source: Cameco)

Most commodities overshoot and that was certainly the case with uranium in 2007 as phenomenal Chinese growth erased a decades long malaise in uranium. However, over the next three years, the price did not dip below US$40/lb and exceeded US$70/lb around the time of that LH site visit - about where we find ourselves now. Prices were high, the mine was expanding, and uranium was being hailed as a natural alternative to coal for reliable baseload, driven by a "green energy" tailwind. What could go wrong?

An earthquake. And an unusually big and complex one at that. It struck the east coast of Japan in March 2011, just a handful of months after that LH site visit. At magnitude 9, the so-called Great East Japan Earthquake was the largest in Japan's history and the fourth largest recorded since the advent of modern seismology, 110 years earlier. In other words, this was a very rare event.

The earthquake and resulting tsunami disabled the cooling systems of the coastal Fukushima Daiichi Nuclear Power Plant, resulting in core meltdown in three reactors. While the Daiichi plant, which first began operating in 1971, was able to withstand the ground movement produced by the quake, it was not designed to cope with the 15m tsunami that followed.

Unfortunately, the engineers had used a 1960 Chilean earthquake and its resultant 3m tsunami to design some of the safety systems at Daiichi. The plant's 10m elevation should have allowed plenty of room for a "regular" tsunami but proved to be inadequate on this occasion as no-one anticipated the magnitude of this event. In short, Japan's nuclear industry, which accounted for ~30% of the country's electricity generation, shutdown in a nationwide safety review, whilst a pall was cast over the global industry that would last a decade.

A long, dark winter

Fukushima's impact on the global nuclear industry cannot be underestimated. For example, following the accident, Germany immediately shutdown eight of its 17 reactors and committed to close the remainder of its fleet, the last of which occurred in April 2023. Prior to the disaster, nuclear energy accounted for one-quarter of Germany's electricity production.

Overall, global electricity production from nuclear dropped 11%. Justifiably, fear of further accidents at older reactors and the increased cost of upgrading/replacing to newer, safer designs, impeded growth of the industry. Furthermore, sentiment was greatly impacted by the potential of renewables - would nuclear even be needed as baseload if windmills and solar panels could deliver zero-carbon power? On the supply demand side, Kazakhstan, the world's biggest producer of uranium, was ramping up production at the time of Fukushima, and continued to do so beyond the shutdown of the Japanese industry.

To compound the problem, Canada's Cameco commenced full-scale commercial production at the underground Cigar Lake in May 2015. The eventual commissioning was complex and protracted. Development had started a decade earlier, but a series of water inflows flooded the mine (it's not called Cigar Lake for nothing). At the bottom in October 2016, the spot price of uranium dipped to US$18/lb and it would be another four to five years before market would stir.

The Spring

We can probably trace the start of the current "boom" to mid-2021 when Canada's Sprott Asset Management founded its Sprott Physical Uranium Trust (SPUT), a physically backed financial product. Its purchases helped soak up excess market supply within a gently improving backdrop for nuclear energy. This enthusiasm was shortly followed up at the COP26 meeting in Glasgow, Scotland, later that same year, where nuclear energy again featured as a low-carbon alternative to coal baseload power but arguably with more urgency.

It is increasingly apparent that net-zero by 2050 solely from renewables is extremely challenging and nuclear power represents one low-carbon way to fill the gap. In terms of power generation, nuclear energy offers several advantages over traditional baseload. Nuclear utilities are very long-life assets, land use is 30-100x less than other low CO2 options, CO2 emissions/kWh are lower than all other power sources except for wind, and life extensions of nuclear power plants represents the lowest cost low-CO2 energy.

Other factors have combined to add upward pressure to the uranium price. For example, in the US, the Inflation Reduction Act (Aug 22) provides tax credits and development incentives for existing reactors and uranium resources, while the DoE commenced purchases for its Federal Strategic Uranium Reserve (Sept 22). Elsewhere, nuclear energy has been included in the green energy taxonomies of the EU, UK and South Korea. In geopolitical terms, there is clear uranium (and gas) supply risk around Russia following the invasion of Ukraine and the coup in Niger, the world's sixth largest supplier, has caused consumers like France some concern.

From a capital point of view, we are seeing increased investment in nuclear power from Asia in particular (see above). On the supply side, uranium exploration and development has plummeted and remains at multi-year lows. While the uranium market is a closed and esoteric one that can be difficult to decipher, there is incremental benefit in the short-term from this supply-demand dynamic.

Where to from here?

While the outlook for the uranium market is better than it has been for more than a decade, challenges remain. Nuclear energy is still a divisive issue due to ever-lingering safety concerns, and it could be argued that countries like Australia may never see its use. Other factors that impede acceptance include the upfront cost of construction, strict regulation and the time to build a new plant, where the median time is currently around 80-90 months.

On the flip side, nuclear facilities are amongst the most rigorously engineered structures on Earth and provide very long life, consistent output. While upfront capex is very high, the levelized cost over the life of a nuclear asset is extremely competitive especially if life extensions to existing plants is considered. Moreover, new technologies, such as Small Modular Reactors (SMR) offer potential advantages in cost and safety. Finally, recent geopolitical developments such as the Russia/Ukraine conflict highlight the need for secure, reliable sources of power. In a world focused on low carbon electricity, it is not surprising that many nations are considering a nuclear future.

Author: David Haddad, Principal and Portfolio Manager