Digital assets: unlocking value in the technology of the future

abrdn

August 2023

Funds operated by this manager:

Aberdeen Standard Actively Hedged International Equities Fund, Aberdeen Standard Asian Opportunities Fund, Aberdeen Standard Australian Small Companies Fund, Aberdeen Standard Emerging Opportunities Fund, Aberdeen Standard Ex-20 Australian Equities Fund (Class A), Aberdeen Standard Focused Sustainable Australian Equity Fund, Aberdeen Standard Fully Hedged International Equities Fund, Aberdeen Standard Global Absolute Return Strategies Fund, Aberdeen Standard Global Corporate Bond Fund, Aberdeen Standard International Equity Fund, Aberdeen Standard Multi Asset Real Return Fund, Aberdeen Standard Multi-Asset Income Fund

AI reaches an inflection point

Insync Fund Managers

August 2023

Insync Funds Management believes Artificial Intelligence (AI) has reached an inflection point, brought about by a new phase in the creation of generative AI and large-language transformer models such as ChatGPT. It sees this new leap forward in AI as highly disruptive to most industries, and as such will have a profound impact on where to invest, and importantly where not to.

'We are heavily engaged in deep specialist research to gauge who will be empowered, what to avoid, and where the most significant value and differentiation lies,' says Insync CIO, Monik Kotecha. 'One key area of more immediate benefit is in data.'

RELX is one global company in the Insync portfolio that has a distinct data advantage, making it a major beneficiary of the acceleration of AI.

A global provider of information-based analytics and decision tools, RELX provides products that help researchers advance scientific knowledge across medical, legal, financial services, and government industries and sectors.

'What RELX does so well is gather, analyze, and deliver valuable knowledge and insights to businesses and professionals across industries globally, empowering people and organizations to make better-informed decisions.' Mr. Kotecha said.

The company has been using machine learning natural language processing for well over a decade and has been experimenting with generative AI for over 18 months. It employs 10,000 technologists spending about $1.6 billion a year on technology alone.

'Similar to one of our other holdings, Adobe, it possesses multiple gargantuan databases that result in reliable and trusted sources of data its customers can depend on,' Mr Kotecha said.

'Like all companies in our portfolio, both Adobe and RELX are highly profitable companies based on their Return On Invested Capital (ROIC), have a long runway of growth, modest levels of debt, substantial R&D, and are generating prodigious amounts of cash flow year after year,' Mr Kotecha said.

'While investors are fretting over when interest rates will peak, and the impact on both the economy and company earnings, a select group of companies often deliver excess relative returns versus the benchmark again and again,' he said. 'This is especially so during historical periods of monetary tightening and general gloomy headlines, such as we are experiencing today.'

Results from such companies, even in the current environment, should not be surprising he said. 'We find they often maintain and even strengthen their strong competitive advantages during challenging times, and this enables them to consistently generate economic value even as the cost of capital is rising.'

Funds operated by this manager:

Insync Global Capital Aware Fund, Insync Global Quality Equity Fund

Disclaimer
Equity Trustees Limited ("EQT") (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Insync Global Quality Fund and the Insync Global Capital Aware Fund. EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) ("Insync"), to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

Australian Secure Capital Fund - Market Update July

Australian Secure Capital Fund

August 2023

Funds operated by this manager:

ASCF High Yield Fund, ASCF Premium Capital Fund, ASCF Select Income Fund

How can we ensure affordable housing?

Montgomery Investment Management

August 2023

As I note below, solving housing affordability won't be enough with just a massive supply of affordable dwellings rapidly built by state and federal governments. The market for these properties will have to be tightly regulated, and controlled, with continuous maintenance and updates. It's doable, as is its financing.

The protected species: residential real estate owners

If you've been following the blog for the last decade, you will know I have argued residential real estate owners in the country are a 'protected' species.

Whether it's negative gearing, zero capital gains tax on primary places of residence, stamp duty concessions, the $25,000 homebuilder grant or the First Home Owners Grant, there isn't a government policy that does anything other than help support property prices or at least prevent any kind of crash. 

And if we consider our entire financial system, it's built on the back of loans to fund property purchases. That means not only has the government incentivised people to buy property (and therefore doesn't have any incentive to see prices decline), but the Reserve Bank of Australia (RBA), Australian Prudential Regulation Authority (APRA), the Council of Financial Regulators, and the banks are all aiming to maintain stability in the financial system by avoiding, at all costs, a collapse in house prices.

The illusion of first homeowners grants

So, if you're an economist or a commentator who believes property prices could fall 30 or 40 per cent, you've not considered the real underlying drivers.

The First Home Owners Grants offered by the states is a particularly humorous attempt to make housing more affordable. 

In Victoria, the $10,000 grant is available to those buying or building a home valued at up to $750,000. In New South Wales, $10,000 is also available to those purchasing an existing dwelling up to $750,000, or a new build worth less than $600,001. Up north, in Queensland, $15,000 is extended to those buying or building up to $750,000, while in Western Australia, a $10,000 grant is provided for purchases up to $750,000 or $1 million, depending on location. In the Northern Territory, various incentives are available including a $10,000 grant, the First Home Guarantee, which supports eligible purchasers to buy with a deposit of as little as five per cent and as little as two per cent for eligible single parents. Meanwhile, in South Australia, $15,000 is offered for purchases up to $650,000, and finally in Tasmaia, first home buyers receive $30,000 for the acquisition of a property of any value.

Consider giving everyone in Australia a First Share Portfolio Buyers Grant, or a First Car Buyers Grant; prices would surge. It's inevitable. If you give people more money to buy something, the price rises. We gave everyone money during the pandemic and are now dealing with inflation. You don't need a PhD to work that out.

In the last decade, Australian state and federal governments have outlaid $20.5 billion for various first home buyers schemes. What do you think happens to a property market if an additional $20.5 billion is injected into it?  It only helps to accentuate the influences already pushing property prices higher. Of course, it serves the government, the financial regulators and the banks. But it doesn't serve those who cannot afford to buy in the first place.

Henry George and progress and poverty

During the 19th century, American political economist Henry George made a profound revelation regarding the unprecedented surge in industrial output, which, in turn, led to an escalation in urban land prices. As landowners reaped substantial windfalls, a tumultuous wave of land speculation and real estate bubbles ensued, triggering an era of volatility and uncertainty. The Gilded Age saw the accumulation of vast fortunes by industrialists, bankers, and landowners, but it coincided with a surge in poverty, inequality, and societal unrest.

Singapore's housing system: A solution to affordable housing?

Sound familiar?

In 1879, Henry George boldly presented his critique of the capitalist system in his seminal work, Progress and Poverty (1879). Progress and Poverty, achieved global acclaim with millions of copies sold. It delved into the perplexing paradox of rising inequality and poverty amidst remarkable economic and technological advancements. George advocated for solutions to social issues caused by extreme greed, particularly concerning the laborer's who contribute real economic value through their hard work in production. Among these remedies, George proposed implementing rent capture measures like land value taxation, where higher taxes are imposed on more valuable land.

What would widely be regarded today as going too far, George's thought-provoking stance proposed a radical concept: the communal ownership of land, with society collectively benefiting from any upsurge in land rents. The daring proposition that lay at the heart of his proposal was a single tax on land values, the idea being that by taxing land values, society could recapture the value of its common inheritance, raise wages, improve land use, and eliminate the need for taxes on productive activity.

The mechanics of Singapore's housing scheme

While it challenged convention and is arguably anathema to capitalism, it nevertheless draws attention to the structure of our society and should still promote debate about a fairer, more equitable one.

Singapore has attempted to deal with the issue, with what appears to be a nod to George.  Singapore today enjoys a very high homeownership rate of 91 per cent, and the government's involvement in the housing market is extensive and unique. Despite one of the world's highest concentrations of millionaires and one of Asia's most expensive housing markets, young newlyweds can easily afford to buy a well-located property close to their place of employment. 

Financing Singapore's housing scheme

This is possible because the Housing and Development Board (HDB), a statutory board of the Ministry of National Development, is the largest housing developer. It is important to note, however, that in Singapore, more than 75 per cent of the land belongs to Singapore Land Authority (STA), while the remaining freehold land belongs to statutory boards like HDB, JTC, PSA and other private owners. There are three land 'ownership' types: 99-year lease, 999-year lease and freehold.

Established in 1960, and superseding the Singapore Improvement Trust (SIT), the Housing Development Board was tasked to solve a housing crisis by rapidly increasing the supply of homes for the poor to rent. By the middle of the decade, it had housed 400,000 people.

The dual property market in Singapore

In 1960, just nine per cent of Singaporeans lived in rental public housing. In 1964 the decision was made to offer subsidized flats for sale under the government's "Home Ownership for the People Scheme". By 1985, four-fifths of the resident population were living in HDB flats. Today, more than 90 per cent of HDB's housing has been sold - at below-market prices - on 99-year leases to eligible households. Singaporeans typically purchase their first home from the HDB, and buyers can sell their HDB flats in an active secondary market at market prices only after five years. The pace of supply can be seen in Table 1.

Table 1. Housing Stock, Housing Supply, and Homeownership Rate, 1970-2015

Applying lessons from Singapore to Australia

A quick look at www.propertyguru.com.sg reveals genuinely well-located (everything is close to the city in Singapore) HDB flats for sale for S$550,000, alongside opulent S$30 million penthouses and colonial-era homes that have sold for as much as S$220 million. And remember Singapore's HDB was set up in 1960. Even after 63 years, inner-city apartments are still available for S$550,000. It's also worth noting the buyers of affordable HDB flats don't treat them like slums, they take great pride in property ownership, often renovating with the assistance of professional interior designers.

HDB apartment blocks are meticulously designed. Each cluster of buildings are communities, with essential amenities such as playgrounds, food centers, and local shops. More recent developments include health clinics, community centers and libraries. Importantly, the management of these estates is integrated into comprehensive servicing policies that incorporate the city's transport system and racial integration.

Perhaps in its appreciation of George's 1879 trestise Progress and Poverty, Singapore acknowledges that HDB homes represent the most significant stake its citizens have in the country's prosperity. Consequently, the HDB maintains its buildings and grounds and periodically upgrades them. Residents and businesses pay for maintenance, maintenance is carried out by Town Councils and their funding comes from government grants.

At the end of the 99-year lease, the dwelling is practically worth S$0 and the resident (usually a second-generation occupant who didn't pay for the apartment) is no longer given the right to continue living in the apartment and can apply to buy it or another. Typically, after an HDB apartment turns 39 (with 60 years left), buyers tend not consider the unit, because Central Provident Fund (CPF) usage to pay for the house is restricted, and bank loans are tightened. While Singapore is yet to see any HDB units' leases expire, it is expected interventions, such as a renewing of the lease for a fee, will occur.

In 2020, Singapore had more than a million HDB flats, sold at least 16,600 new apartments and had another, almost 70,000, under construction.

Financing the scheme in Singapore

To finance the scheme, the HDB provides up to 25-year mortgage loans, at an interest rate of 2.6 per cent. Homeownership is financed through CPF savings.

Most public housing in Singapore is lessee-occupied. Under Singapore's housing leasehold ownership program, housing units are sold on a 99-year leasehold to applicants who meet certain income, citizenship and property leasehold ownership requirements. The estate's land and common areas continue to be owned by the government. HDB prices are below market prices, and buyers enjoy additional discounts in the form of housing grants calibrated to incomes. Subsequent sales of HDB flats in the private market originally had to be to buyers who satisfied the requirements for purchasing new flats.  Since 1978 a resale levy was implemented.

The HDB also provides public housing for rental, mainly for lower-income households and households waiting for their purchased flats. Rental public housing has lower income requirements than lessee-occupied public housing. Meanwhile, the government also sells land to the HDB, and fully finances its annual deficit.

Within Singapore's housing sector, there is a high degree of progressive taxation. Higher-income households, foreigners, and investors pay market prices, implicitly higher land taxes, higher stamp duties, and are subject to higher rates of property taxes.  And for those who might immediately recoil at the thought of higher taxes, they haven't prevented some properties commanding the highest prices in the world.

Challenges and future plans

The system isn't perfect - property prices continue to rise and solving the end of the 99-lease issue appears pending. According to Wikipedia "On 4 October 2022, The Minister of National Development, Desmond Lee, elaborated further on the government's policies to intervene to keep public housing relatively affordable and available. In hopes of cooling the housing market, the government plans to implement a fifteen-month waiting period before homeowners can buy an HDB resale flat, continued supply of significant grants for first-time buyers, and tightened maximum loan price limits. Likewise, to keep providing a counter to the resale market, the HDB ramped up its Build-to-Order supply, which is on track to place 23,000 apartments on the market between 2022 and 2023."

Whatever your views, it is clear, however, a dual property market exists in Singapore.

If Australia's government is serious about making housing affordable, it needs to stop handing out grants for buyers to meet market prices, which only fuel further increases. It must consider a dual market approach with one market supplied, controlled and regulated by the government.

As an aside, there is no First Home Buyers Grant offered in the Australian Capital Territory, and coincidentally, it has been the worst-performing real estate market during the latest sell-off in prices and has recovered the least in the more recent recovery.

Does that make Australian Capital Territory property more affordable?

Maybe Victoria thinks so. That state is considering following the Australian Capital Territory and scrapping its First Home Owners Grant scheme. Before doing so, it should think about working with the other states and the Federal Government on a wholesale review of their role in the property market, perhaps with a working group visiting Singapore (who doesn't love a Junket?) to understand what is working there.

Of course, one of the biggest incentives for people to buy property is to make money, or at least to avoid being left behind. Whatever system replaces the various governments' current involvement, it will need to consider this aspect (which Singapore seems to have preserved) while satisfying the other reason people buy; to provide security for themselves and their family, and a roof over their heads.

Author: Roger Montgomery

Funds operated by this manager:

Montgomery (Private) Fund, Montgomery Small Companies Fund, The Montgomery Fund

Global equities: The more AI grows,

the smaller the market could be

Pendal

August 2023

HOW should investors think about AI?

There is little doubt that advances in artificial intelligence technology promise to fundamentally disrupt how business is conducted, says Pendal's Samir Mehta.

But the question investors should ask is not whether the transformation will occur, but when and at what cost -- and who might benefit, he says.

"People have been overly excited by AI. But the reality is that it is not going to be instant. We are talking years before the full benefits start to materialise," says Mehta, who manages Pendal Asian Share Fund.

AI stocks have been on a tear in 2023.

Microsoft's US$10 billion investment in OpenAI, the high-profile creator of ChatGPT, has sent its shares up 40 per cent this year.

Taiwan Semiconductor Manufacturing Company -- which makes silicon chips for companies like AI giant Nvidia Corp -- is up more than 20 per cent this year as investors back its exposure to the AI boom.

But the market's excitement is divorced from reality.

Speculative fervour

Microsoft disappointed investors last month when it cautioned that revenue growth from AI would be gradual, but spending would be aggressive.

At TSMC, AI accounts for just 6 per cent of revenue, with the balance of sales coming from making chips for laptops and phones -- a market that is not growing, says Mehta.

"There are many other examples -- companies like Quanta Computer and Wistron Corp make the servers that mostly go into data centres for the operations of cloud businesses.

"Only a small part of it is being used for AI-related services. But just that association has meant that even though growth is negative in 2023 -- and expectations for 2024 and the perception that demand for AI-related servers is high -- some of these stocks have doubled in the last two or three months.

That's a speculative fervour."

Mehta says one factor counting against investors in AI is that the technology's very success could curtail demand.

Many AI services are priced on a per-user licence, leading analysts to create long term industry revenue forecasts by assuming a take-up rate among employed people.

But if AI succeeds in its promise of making business more productive, companies will reduce staffing.

"The effect of raising productivity is going to mean fewer people will need that software because fewer people are employed," he says.

Lessons from AI mania

So, what lessons can be taken from the AI mania gripping markets this year?

Mehta says the main lesson is that the ultimate beneficiaries of technological changes like AI are not always apparent early on.

"The winners are going to be quite diverse and may not turn out to be the ones that we think of intuitively," he says.

But another more immediately useful lesson for investors is that rising interest rates and tightening monetary policy may not be squeezing off liquidity as quickly as conventional wisdom would suggest.

"It is a truism that when you have a speculative mania or bubble, at the heart of it is always massive liquidity.

"The housing bubbles in the US and China, the credit card bubble in Korea, the cryptocurrency and NFC mania, those shared scooters and bikes -- invariably they are a manifestation of tremendously loose liquidity.

"So, in 2023, any perceptions that we're in a tight market environment have clearly turned out to be wrong."

Author: Samir Mehta, Senior Fund Manager

Funds operated by this manager:

This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at December 8, 2021. PFSL is the responsible entity and issuer of units in the Pendal Multi-Asset Target Return Fund (Fund) ARSN: 623 987 968. A product disclosure statement (PDS) is available for the Fund and can be obtained by calling 1300 346 821 or visiting www.pendalgroup.com. The Target Market Determination (TMD) for the Fund is available at www.pendalgroup.com/ddo. You should obtain and consider the PDS and the TMD before deciding whether to acquire, continue to hold or dispose of units in the Fund. An investment in the Fund or any of the funds referred to in this web page is subject to investment risk, including possible delays in repayment of withdrawal proceeds and loss of income and principal invested. This information is for general purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient's personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation. The information may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information. Performance figures are calculated in accordance with the Financial Services Council (FSC) standards. Performance data (post-fee) assumes reinvestment of distributions and is calculated using exit prices, net of management costs. Performance data (pre-fee) is calculated by adding back management costs to the post-fee performance. Past performance is not a reliable indicator of future performance. Any projections are predictive only and should not be relied upon when making an investment decision or recommendation. Whilst we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections. For more information, please call Customer Relations on 1300 346 821 8am to 6pm (Sydney time) or visit our website www.pendalgroup.com

Market Commentary - July

Glenmore Asset Management

August 2023

Funds operated by this manager:

Glenmore Australian Equities Fund

Investment Perspectives: Thinking about the cycle

Quay Global Investors

August 2023

Being an investor in listed global real estate has been tough of late. With expectations of a global recession caused by unprecedented interest rate increases, sentiment towards listed global real estate has soured. 

Funds operated by this manager:

Quay Global Real Estate Fund (AUD Hedged), Quay Global Real Estate Fund (Unhedged)

For more insights from Quay Global Investors, visit quaygi.com

The content contained in this audio represents the opinions of the speakers. The speakers may hold either long or short positions in securities of various companies discussed in the audio. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the speakers to express their personal views on investing and for the entertainment of the listener.

ESG in 10: Episode 9 -

The Australian Green Bond Program, with Ardea

Fidante Partners

July 2023

Funds operated by this manager:

Are You a Trader, an Investor, or a Hybrid of Both?

Marcus Today

July 2023

Ask the average investor how they invest and you will get one of two answers. 'Fundamental Analysis' or 'Technical Analysis', and never the two shall meet. It all goes back to Benjamin Graham, who wrote 'The Intelligent Investor' in 1949, the Bible of Fundamental Analysis. In there was the line: "We do not hesitate to declare that (Technical Analysis) is as fallacious as it is popular". In that one sentence he erected a wall between Fundamental and Technical Analysis, or to put it another way, between investors and traders, and it has stood for 62 years, with the proponents of both seemingly hell bent on putting each other down, and they both have their points.

The Bad Bits

• Are embarrassingly useless at 'timing the market'. They declare that it can't be done. How ridiculous. They are going to wear the next GFC right on the nose.
• Can't sell. They don't. They don't know how.
• Aren't disciplined. They don't have any discipline. They'll watch stocks get destroyed without doing anything about it, and the bigger the loss, the more likely they are to persist with it.
• Aren't vigilant. They 'set and forget'. Forget! About their money! What planet are they on?
• Don't have a Trading Plan. They don't have one. Incredible. Net result, they let their losses run and cut their profits. The complete opposite of what they should be doing.
• Are emotional. They believe the things that make them feel good, and disregard the things that make them feel bad. They listen to stock tips. They invest on the thinnest of evidence. It's not rational.
• Are 'lemmings'. They get in when it's obvious, and get out when it's obvious. Put another way, they buy at the top and sell at the bottom.
• Are often wrong. Do you know how many flawed assumptions go into Fundamental Analysis, into those highbrow calculations of intrinsic value? Rubbish in, rubbish out, no matter how smart the calculation.

• Rely on past prices as a predictor of future prices, which is ridiculous.
• Know nothing about a company. They might as well trade cabbages.
• Are short-term, which means they'll never see the magic of compounding returns.
• Don't care about dividends and miss out on franking.
• Will never get hold of a great stock and keep it forever because they fidget.
• Can't actually time the market anyway, despite professing to do so.
• Are 'lemmings'. They just look at what everyone else is doing and follows them.
• Have to spend all day doing it, so don't have a life.
• Are out of touch. Many technical devotees use their reliance on charts as an excuse to never read or watch stock announcements, the news, politics.
• "Have you ever met a rich technical analyst?"

But the truth is that they both have a lot to learn from each other, and if we look at the positives instead of the negatives, you'll see why.

The Good Bits

• Are not just technical analysts, they are traders(there's a difference), which means they have trading skills. These skills are universal, and are as useful for investors as they are for traders.
• Are not short-term. Trading techniques can be applied over any time frame. Apply them over minutes and hours, and yes, it is gambling. Apply them over days, and it is trading. Apply them over weeks and months, and it is investing. You can easily adapt trading skills to any investor.
• Have exactly the same ambition as a long-term investor, as Warren Buffett even, the ambition to buy a stock that goes up forever. They are doing exactly the same thing.
• Have a Trading Plan, and because of that, they never miss a night's sleep.
• Are unemotional. They know what they are going to do at all times, because from the moment they buy a stock, they have a system.
• Are decisive. Traders never prevaricate, they never agonise, they know what to do, they decided way before the trade was even opened.
• They are honest. They know that making money in the stock market is about buying stocks with a high probability of going up. It's not about predicting the future. No-one can do that.
• Are not proud. They know that things will change, that they will get themselves into a pickle. The difference is that when they do they act, they don't stand by some grand but flawed declaration about the future through thick and thin.
• Are not 'lemmings'. On the contrary, they see the market as a battlefield, as combat, one on one. They know they are in a war with the herd, and because of that, they retain an independence of mind and action.
• See trading as a business, and they analyse their success and failure like a business. They constantly adapt, educate, and improve.

• Are good at identifying companies that make money, and that's the root of it all in the long-term.
• Are good at identifying rubbish companies.
• Can identify good management.
• Can identify sector trends.
• Are well read.

The Bottom Line

As any experienced trader will tell you, there is no Holy Grail for success, no one approach that works. Amidst so much grey and so little black and white, the game is simply about trying to get an edge on random outcomes and to do that you would be a fool not to use every tool in the shed, and that's the point, every tool. Not one or the other, but every. You dismiss nothing and learn everything, and this is where so many people go wrong. They decide they are in one camp or the other when it would be far more effective to be in both. The bottom line is that you make a big mistake writing off traders as an investor, or investors as a trader. They both have some good bits and some great bits. You would do well to explore both.

Author: Marcus Padley, Founder of Marcus Today

Funds operated by this manager:

Marcus Today Equity Income SMA, Marcus Today Growth SMA

Political lobbying risks in the US

4D Infrastructure

July 2023

In recent years, political controversies involving US utility companies have caused significant concern for investors.

There have been instances where lobbying activities have contravened the law and resulted in companies and individuals being criminally investigated and punished. Other instances, though not necessarily criminal, have also resulted in negative market reactions. In both scenarios, political lobbying controversies have been difficult for investors to foresee and, therefore, difficult to avoid.

Utilities' role in US politics

Utilities are responsible for the delivery of power and gas from source to end-customers, and are considered key players in the energy supply chain. As a result of the importance of both energy prices and reliability to businesses and consumers alike, utilities are central to economic growth, efficiency and quality of life in their operating jurisdictions.

For these reasons, utility operators believe their corporate responsibility dictates that they should have a voice in the development of energy legislation. With energy legislation and regulation established at both federal and state levels in the US, lobbying is considered important in ensuring that legislation is in the best interest of all stakeholders, including shareholders.

Risk to investors of inappropriate lobbying

Lobbying undertaken by utilities in an open and ethical manner supports a more thorough understanding of energy markets for legislators and a better outcome for both customers and shareholders. The obvious concern is that utilities and/or management teams lobby for their own self-interest or solely that of their shareholders, with little consideration to other stakeholders such as customers. Problems eventuate when lobbying contravenes the law and/or ethical expectations.

Companies should have ethical charters outlining the values that guide how they operate, including how they interact in the political sphere. The old saying, "would you feel comfortable with your behaviour being published on the front page of the newspaper" is also a good guide for what constitutes ethical political lobbying.

Potential violations of the law are often difficult to identify until it's too late and enforcement agencies are involved. Regardless of guilt, once a review is underway, the utility in question will feel pressure as the process evolves. This potentially includes:

1. a lengthy process in which share prices remain deflated;
2.  significant financial penalties if found liable;
3. management disruption as changes are made and teams focus on remedial actions;
4. disruption to regulatory/legislative relationships held by the company; and/or
5. reputational harm which is difficult to quantify and doesn't go away for an extended period of time.

Utilities across the world are bound by a social license to operate. Regardless of strict legality, that social license may be tarnished based on the public's perception that the company has received special treatment from legislators/regulators based on aggressive/unethical lobbying activities. This scenario could result in public backlash, and regulators/legislators taking detrimental action against the utility to reinforce their independence. This can take the form of fines, difficult regulatory decisions, out-of-cycle regulatory reviews and irrational oversight. Negative financial ramifications and poor market sentiment are the result, and re-establishing customer faith in regulators and utilities takes a long time.

4D's approach to political lobbying risk

Due to the high legal, financial and reputational risk associated with lobbying activities, 4D undertakes significant due diligence to identify utilities that are at higher risk and steps being taken to mitigate this risk.

Internal controls

Political lobbying should be guided by a political engagement policy or a similar document recognised by the company board. It should be easily publicly available and outline a set of criteria guiding lobbying efforts and political contributions, and provide authority for contributions and oversight.

Best practice for authority of contributions is for the annual political contributions budget to be developed by the corporate affairs team (or equivalent). The individual contributions should be reviewed by a legal professional and signed off by the most senior executive in the team. It's often a good idea to include an executive or leadership committee review it to ensure widespread knowledge and acceptance of contributions. In our view, large contributions should be reviewed and signed off by the CEO (~>$1 million).

The board audit subcommittee should also review contributions on behalf of the board. A recommendation should then be provided to the board as part of that oversight. Any newly planned contributions should also be reviewed by an audit committee.

This ensures that senior leadership approve all contributions, approvals involve multiple parties, and the board has ultimate oversight.

Transparency

Ensure public transparency of all contributions to individual political figures and parties, political action committees (PAC), other tax-exempt structures (such as 501(c)4 structures), trade associations and political consultancy/advisory groups.

Stakeholders should have access to all internal control and governance documents relating to political engagement.

Appropriate size of contributions

The size of political contributions should be moderated so that they don't give the impression that a political favour is expected in exchange for the contribution. Many utilities have outlined that any individual contribution over $1 million requires CEO sign-off, suggesting that this size of contribution is rare.

Overall contributions need to be moderated as no financial return should be expected on these funds - it should be perceived more as a cost, rather than an investment with the expectation of receiving something in return.

Focus on the utilisation of structures for contributions

Some tax-exempt structures provide anonymity to contributors. Companies should seriously question why they need/prefer anonymity when making a contribution. Generally speaking, such structures have attracted scepticism from the media and stakeholders, and should be avoided unless there is a specific reason for their use.

Some utilities in the past have engaged political consultancy groups. These groups have historically provided anonymity in political lobbying. Interactions with these groups should be transparent internally and externally, including taking meeting minutes for all interactions. Companies should be very clear on their motivations for engaging such groups, and they shouldn't be considered as vehicles to undertake clandestine political manoeuvres.

US federal election laws prohibit corporations and labour unions from making political contributions to federal candidates and national political parties. As a result, companies often use their own, or third party, PACs to make contributions to individuals and parties.

'Pay for play' legislation

Some utility management teams suggest that when a company makes significant contributions to support or oppose a particular ballot measure, it can be interpreted as a 'pay for play' situation. Rightfully or wrongfully, this could be perceived as bribery or a quid-pro-quo arrangement. Best practice would be to lobby through trade associations or PACs with correct governance practices in place to avoid any direct link between the company and an individual ballot measure or proposal.

Third party verification of lobbying controls and practices

Third party verification of companies' political disclosures and practices can support investors' due diligence efforts. One of the more well-known verification groups is the Center for Political Accountability (CPA), which releases the CPA-Zicklin Index annually. Using 24 metrics, or "indicators", the CPA-Zicklin Index assesses companies' disclosure practices, spending and accountability policies for utilisation of corporate funds to influence elections. It does not address company spending on lobbying or PACs.

4D's actions post lobbying controversies

Recent lobbying controversies have influenced our decision to divest companies from our funds. We have exited positions based on the likelihood that a controversy violated the law, disrupted relationships with regulators and stakeholders, and/or there was a lack of definitive action from boards in identifying and rectifying flaws in lobbying controls, processes and disclosures. By contrast, we have also retained positions where our due diligence suggested the above negative thresholds were not violated. Every situation is considered on a case-by-case basis involving internal due diligence as well as engagement with the company in question.

As part of our research into political lobbying best practice, we reached out to companies who rate highly on the CPA-Zicklin Index for comment on this paper and their approach to lobbying. Two such companies in Southern Company and CMS Energy provided their feedback below.

"CMS Energy is ranked First Tier in the CPA-Zicklin Index. We are engaged in the political process, supporting pragmatic policies that are focused on safe, reliable, and affordable energy for Michigan. Our code of conduct and other policies strictly prohibit impermissible political activity, and we have strong controls and oversight established to ensure ethical compliance with all relevant laws. We include more information regarding our political engagement on our website." - CMS Energy.

"This paper highlights the tangible benefits of a clear and comprehensive approach to political disclosure and accountability. Southern Company takes pride in our status as a Trendsetter in the CPA-Zicklin Index of Corporate Political Disclosure and Accountability as we seek to achieve optimal outcomes for our customers." - Southern Company.

Funds operated by this manager:

4D Global Infrastructure Fund (Unhedged), 4D Global Infrastructure Fund (AUD Hedged), 4D Emerging Markets Infrastructure Fund

For more information about 4D Infrastructure, visit https://www.4dinfra.com/

^{The content contained in this article represents the opinions of the authors. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the authors to express their personal views on investing and for the entertainment of the reader.}