Ethical investing doesn't mean a lack of choice

The most common objection to the launch of our Ethical Fund involves lower expected returns and a lack of investment options: “Why would you want to invest ethically? It’s hard enough beating the market as it is”.

In part one of this series, I explained why investing through an ethical framework could in fact increase your returns by reducing risk. I’m also right now out on the road busting the myth that investing ethically means lower returns at our national roadshow.

Investing ethically is just another tool to reduce risk. It doesn’t mean owning a portfolio choc-full of poor choices and lesser businesses. In fact, the fund owns many stocks that could grow to multiples of their current size over the next decade. Let’s unpack four of them.

A bumper crop of companies

Reliance Worldwide Corporation operates in the plumbing industry, like the better-known Australian company Reece. Reliance also made a large overseas acquisition recently after raising money from shareholders, including the founding Munz family. In its largest markets, Reliance is the number one seller of push-to-connect (PTC) behind-the-wall plumbing.

Most of Reliance’s revenue comes from plumbing repairs, which are still typically done using slow traditional methods involving welding, crimping and soldering. Through using PTC products, the job can be completed in less than half the time of a traditional repair job. That means the plumber can charge more and complete more jobs.

As ageing plumbers leave the industry, we expect the current ~15% market share of push-to-connect products to increase substantially. Reliance is trading on a forecast 2020 PER of 20, which is attractive for a company with the ability to grow earnings by 10% per year for a long time as the market for its PTC plumbing products continues to grow.

Clydesdale Bank is trading at just 70% of its tangible book value (TBV) after its share price almost halved recently. The UK bank (spun off by National Australia Bank) recently acquired rival Virgin Money, which should provide a range of benefits over time.

However, it will be at least a year before the two banks can be integrated to lower the combined bank’s borrowing costs. Due to the slowing housing market, the banks are currently dropping their prices to attract home buyers.

This puts pressure on bank profit margins across the sector. The UK economy is holding up surprisingly well despite Brexit, but this clearly isn’t helping sentiment or the economy.

Management will announce its latest 3-year plan in June, which we expect will include producing double-digit return on equity and paying much higher dividends given the bank’s strong balance sheet. If management achieves these hurdles over the next 3-4 years, the stock could double our money when dividends are included. 

360 Capital is a ~$200m A-REIT with an outstanding track record. It's managed by Tony Pitt, who is also a 25% shareholder. The company is effectively a cash box trading at net tangible assets. Pitt's strategy is to invest in small commercial developments, then charge fees to investors that want to invest alongside 360 Capital.

In other words, he’s aiming to build a funds management platform that could be worth many times the stock’s current value if he’s successful over the next decade. While it won’t be anywhere near as large as the $70bn managed by Magellan, for example, Magellan’s success shows how highly prized these businesses are when they succeed.

At the current price, you’re paying nothing for the funds management business. It’s a free option. We would expect to do well over time even if the funds business doesn’t take off.

So far, the company has raised $111m, but with property development returns currently around 15%, compared to 11% when the banks are lending more freely, the time is perfect for Pitt to find safe investments. He can demand a range of protective loan covenants for lending money while the banks are walking away from deals.  

Pitt is currently providing secured debt for projects, as it's much safer at this late stage of the cycle than providing equity without any protection. If a project, say, a $13m doctor's office in the suburbs, runs into financial strife, we expect Pitt will take control and manage the project until completion to minimise the financial risk to 360 Capital. You’ll find a fuller explanation of the investment case here.

Frontier Digital Ventures owns stakes in a portfolio of 15 online classifieds businesses across emerging markets. Its CEO, Shaun Di Gregorio, and main backer, Catcha Group, own a combined 66% stake. Unlike offshore acquisitions made by much larger Australian online classifieds’ businesses, Frontier will partner with local operators. It’s a strategy that has worked well to date – as an example, Frontier’s investment in iProperty was sold to REA Group.

Frontier’s largest asset is Zameen, the Pakistan version of REA Group. Zameen’s revenue increased 85% in 2018 despite a range of headwinds. It should break even this year before producing plenty of cash for shareholders. Eventually, we expect it will be sold or spun off and listed independently. But we’re in no hurry to see it sold. The value of the business is growing rapidly, as it’s still early days. Zameen dominates its market, which is a population of 195m people increasingly using mobile phones and the internet to buy homes and apartments that in many cases wouldn’t look out of place in Melbourne or Sydney.   

If Zameen lives up to its potential, then Frontier’s current valuation suggests you’re getting stakes in 14 other businesses for free or less than zero. You’ll find a fuller explanation of the investment case here.

What else gets the 'green' light? 

In addition, three of these four stocks, along with several other portfolio holdings, earn most of their revenue abroad. This adds some high-quality diversification to Australian portfolios that are potentially overloaded with cyclical banks and giant iron ore miners.

Three out of the four companies also have high insider ownership. This is a key thing we look for in all our businesses. While having the right amount of independent board members and separating the chairman and CEO roles are key planks of good governance, we believe risks are reduced when the people running the business have their own wealth and reputation on the line.

The founder of a business is likely to care much more about his customers, shareholders and staff than a career CEO who is incentivised to maximise the company’s share price in a short amount of time.

Think of all the dud overseas acquisitions or expansions that have been done by career CEOs (far too many to name), compared to the successful ones made by companies like Computershare with high insider ownership.

An owner-operator is also likely to care much more about his reputation as it’s intertwined with the business. Failure to please all stakeholders can undo a life’s work, which is why high insider ownership often goes together with an ethical framework and higher returns. Unfortunately, high insider ownership alone doesn’t guarantee high returns, so you still need to analyse each situation.

The grass is greener on the other side

There’s no point owning a stock if it’s overvalued or high risk, purely because it has passed ethical screening. That’s why the Intelligent Investor investment process of thinking long-term, being patient, favouring quality and identifying situations where the market is least efficient, remains at the core of the fund.

These stocks show that investing with an ethical framework provides plenty of excellent companies across different industries to own for the long term. There’s no reason why you should expect lower returns just because you’re adding an ethical framework to your investment process.

If you would like more information on our upcoming Ethical Fund, click here. Be sure to register your interest for further updates.