August 2018 Investment Report

September 21, 2018
Investment Updates

During reporting season the Fund benefitted from holdings in Suncorp, Ooh Media, TPG Telecom, NIB, JB Hi-Fi, Brambles, Nick Scali, and Telstra while CSL (not held), GWA, Medibank and Wesfarmers (not held) detracted from relative performance. Of the 32 companies that are held in the Fund, 21 reported their results at June year end and we were satisfied with the business performance in 19 of them. The Fund established 4 new positions in companies during a period of share price weakness following their results. Pleasingly, 22 companies held by the Fund increased dividends in the last financial year.

Standards and stockpicking

As we thought about opening Ethical Partners we were cognisant of the great deal of trust required to allow someone else to manage your money and we are reminded daily of the additional expectation we created when we put the word “Ethical” on our office door. In society (and in financial institutions in particular, right now) there is a strong movement focused on fairness - of companies towards their customers, of sporting teams towards the rules, of society towards the planet and other people.

When it comes to investments we know you expect a high standard of us and we expect a high standard of the investments we make on your behalf. As Ethical Partners is a stock picker our focus will always be on the individual company positions and, in our view, the quality of those positions is paramount to our clients’ future returns. We look at prospective investments through the lens of the balance sheet, cash flow and quality of management and also consider risk in supply chains, human rights policies, potential environmental liabilities and which countries businesses operate in. Our belief is that understanding companies deeply in all of these areas sets a higher standard and gives us greater insights.

Looking into these issues helps us assess which companies have reasonably considered the risks of the business they are in.Companies we engage with can expect that we will ask questions of their management team around balance sheet, profitability, industry position, supplier segmentation, waste and energy saving programs, independent audit of factories, location of major outsourced manufacturers or owned operations, workforce training and safety, among others. It is no surprise to us that the best companies are already disclosing information on these issues and from a shareholder’s point of view, we are more attracted to these businesses, while, of course, remaining disciplined on valuation.

Longstanding issues

Our preference for companies and management teams that have considered the human and environmental side effects of their business carries more than a feel good factor. While “ESG” issues have been talked about a lot in recent times, we highlight below that they are not new issues and havebeen instrumental in determining risk for shareholders over the long term. One area where Ethical Partners is different is that we have developed a way of formally incorporating these factors into our Investment Process in order to avoid identifiable risks upfront and encourage corporates to lift the standard.We call this the Ethical Partners Operational Risk Assessment (EPORA). Specifically, our Investment Process via the EPORA seeks to identify selected risks such as country, industry, human rights and environmental risks. The following cases are examples of where such risks were prevalent.

  • In 1987 Bougainville Copper had just completed its 16th year in production and had achieved record revenue from copper and gold mined from its open pit mine in Panguna in the North Solomons Province in Papua New Guinea. The company was the largest private employer in PNG with 3700 employees and payments from the mine represented around 17% of Government revenue. Less than two years on however, the company would be embroiled in violent disputes with locals which resulted in the mine being shut down and staff being evacuated from the region. Bougainville Copper is still listed on the ASX (BOC) but the latest production statement notes that there has been no production at the mine for the last 29 years, since 15 May 1989. Needless to say shareholders have not fared well. At the time, had our Investment Process been operating, the company would have been excluded from our investable universe based on country risk and possibly human rights risk as there was no disclosed policies. Even today the company is still attempting to repair its relationship of trust with the local communities, having returned to Bougainville in 2017 to open a local office.
  • The Australian Wheat Board was privatised in 1999, became known as AWB Limited and was, under the Wheat Marketing Act 1989, legislated as the single domestic buyer for all of Australia’s wheat exports. It fulfilled its duties for many years until in 2005 its practices in relation to supplying wheat to Iraq were questioned and the company was subsequently found, by former US Federal Reserve Chairman, Paul Volcker, during an independent UN inquiry, to be the largest source of kickbacks to the Iraqi regime under Saddam Hussein. The stock had touched morethan $6 per share before falling to around $1 as the scandal played out. AWB Limited was subsequently acquired by Agrium. This company would have been excluded from Ethical Partners investable universe based on country risk.
  • In more recent times there have been numerous examples of companies that have lost the market’s confidence on various social or governance issues. In one such case an Australian listed company in 2015 purchased a casino located in Poipet,Cambodia for more than $A450m. The casino is located in the strip of land between Cambodia and Thailand where needless to say, the rule of law is notoriously low. The vendor of the casino was a Thai businessman who was paid 18% of issued capital of the Australian company in scrip, along with more than $A300m in cash funded out of company cash, debt and new shares issued to shareholders. In late 2017 the vendor had reportedly breached the sale agreement, illegally operating a competitive casino next door concealed behind a supermarket. The vendor has subsequently left the company Board and the Australian company in question has taken an impairment of $143m on the assets purchased. The Australian company’s share price has fallen so far since the purchase that the whole company is worth substantially less than the amount of cash paid out to the Thai businessman. This company is excluded from our investable universe based on industry risk, country risk and weakness in the area of human rights policies.

Of course Ethical Partners will not be able to identify future operational risks at all companies accurately, however with all three of the above companies failing to get through our Investment Process and therefore being ineligible from any investment by the Ethical Partners Australian Share Fund, risks like these would have been and are being avoided by our clients.

It’s about risk

When considering prospective investments we think about risk as more than share price volatility. To us it is also a risk if businesses we hold engage in questionable practices in the pursuit of profit, both from a moral and financial perspective. While we like to see businesses doing well, we will avoid investments in companies where we feel a short term profit motive stands above other considerations because the behaviour that it can encourage can put favourable long-term outcomes at risk. The idea that the risk of carrying on a business activity could be larger than the financial gains that could accrue, is an interesting concept for the shareholder to consider.

There are also numerous examples, however, of Australian companies that do manage all aspects of their business soundly and have done well socially, environmentally and financially. Companies that have a thoughtful approach are highlighted when we apply our Investment Process including applying an analysis of their balance sheet, cash flow, management quality, human rights policies, country of operation, industry and environmental factors. On the positive side, a company that has a healthly culture, a successful and trusted brand and a proud and energised workforce is often the projection of a company dealing with these types of issues well.

Standards and returns

Australian listed companies such as Dulux, GWA and Orora amongst others rank particularly well in our Investment Process and operationally at least (with valuation being the other risk) we would consider these examples of everyday companies that just do things well and as a result,operate with lower business risk, in our view. We consider these three businesses through the lens of our Investment Process below.

  • Dulux is Australia's largest paint manufacturer and has low gearing, an experienced and stable management team and excellent cash flow conversion (when compared to profit).Dulux operates in low risk countries and a relatively low risk industry according to our Investment Process. Safety and sustainability has long been part of the company's DNA and are a priority up to Board level. The company takes these issues seriously and communicates with its employees openly, as well as investing significantly in capital projects and training to ensure employee safety. Dulux also views sustainable business as product stewardship through formulation or packaging changes in order to look after customers, as well as their Paint Back program to help to remove waste from the community.The company is in the process of further engaging suppliers with respect to ethical sourcing and ensuring minimum standards, including human rights and modern slavery considerations. Dulux is prepared to discontinue ongoing relationships if required standards cannot be met. The company has policies on water, waste and energy saving that are both measured and reported and supports environmentally friendly proposals such as one third of power at the new Merrifield paint manufacturing facility coming from solar. Since the company was spun out of Orica in 2010 the stock is up three fold, again demonstrating that it is possible to make other considerations at least as important as profit growth and still be successful. The Ethical Partners Australian Share Fund currently holds shares in Dulux.
  • GWA is Australia’s leading supplier of bathroom products (tapware, sanitary ware) through key brands including Caroma, Dorf and Clark. The company has net cash (following the sale of Doors and Access business), high cash conversion (when compared to profit) and we regard management as high quality. The company operates in low risk countries and a relatively low risk industry according to our Investment Process. Sustainability is at the heart of GWA, namely the company sees itself as providing water solutions and has invested materially in innovation in the sector. For example, GWA’s core brand Caroma invented the Dual Flush which currently saves on average 32,000 litres per year for each toilet. In fact, if all of Australia adopted a dual flush it would save the equivalent of Sydney Harbour per annum. GWA also cares deeply about its environmental impact and has specific impact targets it seeks to achieve (last year it achieved a 15%reduction in carbon emissions) and has an increasing focus on supply chain and human rights. The company now has 18 staff on the ground in key sourcing locations to ensure both product quality and the standards of their supply chain are upheld. We see the company as one where shareholders should benefit as it continues to improve its sustainability focus and disclosure and further highlight such measures in showcasing its products. We think this aspect may appeal to customers and could be a source of increased market share and sales.The company has also committed to provide a detailed Sustainability Report during the 2019 financial year to provide further key metrics on safety, human rights and carbon emissions. In our view the stock is attractively valued, amidst current market apprehension towards building related stocks, and the Ethical Partners Australian Share fund currently holds shares in the company
  • Orora is one of Australia’s largest packaging companies. It produces cardboard boxes, bottles, aluminium cans and point of sale displays. The company has low gearing, an experienced and stable management team and excellent cash flow conversion (when compared to profit). Orora operates in low risk countries and in a relatively low risk industry according to our Investment Process. The company has best in class sustainability reporting and a strong human rights policy that addresses risks in supply chain such as forced labour, child labour, discrimination, fair wages and so on. Orora has also outlined and delivered on explicit targets for lower carbon emissions and measures such as waste to landfill have dropped materially. The company’s largest scale paper plant in Sydney collects 450,000 tonnes of recycled cardboard including from Australia's major retailers and supermarkets. Around 27,000 tonnes of the company's supply at this facility is from off cuts from its own manufacturing process, thus saving resources and money. Finally the company recognises a number of global Non-Government-Organisation standards including the UN Global Compact, which is a worthy framework for the responsible management of businesses. The company exhibits a high standard when doing business and has a demonstrated responsible approach, and to us this makes the company an overall lower risk proposition. The company's shares are up almost three fold since it was spun out of Amcor in 2014 showing that it is possible to have high standards and deliver excellent financial results at the same time. Importantly however, being a disciplined value oriented investor the Ethical Partners Australian Share Fund does not hold Orora shares at present as we are waiting for a more favourable valuation.

In summary it is our job to buy shares of companies at the right price, taking into account their financial prospects, and we feel our Investment Process gives us the best chance of choosing companies more likely to deliver better returns with lower social, environmental and financial risk.



Nathan Parkin                                     Matt Nacard
Investment Director                          Chief Executive Officer

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