As ethical investors we’re looking for investments to deliver over the longer term from both an investment, as well as social and environmental perspective.

Yet ethical investors, like all investors, still hear the noise and commotion of short-term market moves via the media.

In this article we give some perspectives on how Australian Ethical is navigating the current market conditions and keeping our eyes on a longer time horizon.

Market conditions in 2022

After many supportive years for investment markets, 2022 has provided some turbulence which is gaining the attention of investors worldwide.

Central banks around the world are now facing elevated inflation, driven by a range of factors including supply chain issues impacted by Covid, labour market constraints and more recently the Ukraine war. For example, annual inflation to April 2022 was 8.3% and 9% in the US and UK respectively, and locally here in Australia it was 5.1% in the year to March 2022.¹ Markets are now seeing interest rates hikes with further expectations of rises to address this level of inflation.

In these conditions investors are seeing stock markets retrace from record highs, and heightened volatility as participants consider the impact on companies and their earnings. We’re also seeing some divergence in performance this year between differing industry sectors. By way of example, the Australian market, with greater allocation to materials (resources), has seen a differing performance profile to global markets in the last 6 months. For example the Australian market’s benchmark (S&P/ASX 300) has a 25% allocation to materials, while the global benchmark (MSCI World) has an allocation of 4%. This difference has been a key driver in Australian shares delivering a positive return over 3 months to 31 May 2022, while international shares has delivered negative returns over that same period (as shown in the tables below).

Australian Ethical’s investment approach

As an equity investor navigating these conditions it’s worth keeping in mind some key elements.

If you’re investing in an equity fund or one of our diversified funds (which includes equities) you are benefiting from the long-term stronger returns of growth assets, which when blended with compounding, can support higher returns over the long term compared to defensive assets (like cash and fixed income). To provide context, below are the benchmark returns of equities over differing time periods to 31 May 2022 compared to Australian Fixed Income and cash. (It should be noted fixed income returns have also recently been negatively impacted by rising interest rates.)

Benchmark returns for asset sectors to 31 May 2022

Australian Shares (S&P/ASX 300 Accum)

International Shares (MSCI World ex Aust)

Australian Fixed Income (Bloomberg AusBond Composite)

Cash (Bloomberg AusBond Bank Bills Index)

Past performance is not a reliable indicator of future performance. Source: FactSet

Australian Ethical, in managing our portfolios, applies dual filters in selecting companies for inclusion. The first filter is of course our Ethical Charter applied by our in-house Ethics research team which identifies a portfolio of companies with a positive contribution to our broader world – people, planet and animals. This is a meaningful filter linked to our conviction on these matters on the basis of both meeting client expectations but to also align with key critical sustainable pathways addressing matters like climate change and biodiversity. Our second filter is disciplined investment processes to provide resilient investment portfolios with input from our Portfolio Management teams.

It is this dual filter which has allowed our portfolios to deliver for our investors successfully over extended periods of time. By way of example, our flagship Australian Shares Fund has outperformed its benchmark by over 2% over 20 years to 31 May 2022 and our Balanced Fund is a top quartile performer in the Mercer survey over 3 and 5 years to 31 March 2022² (keep in mind that past performance is not a reliable indicator of future performance).

In this context it’s interesting to consider equities within the current market conditions and how our dual filter is helping our investors’ portfolios through the current cycle while positioning for long term returns.

Short term headwinds, with long term tailwinds for our ethical equity portfolios

As a conviction ethical investor seeking impact, we are looking to direct capital to more sustainable companies. This also means avoiding companies which are not aligned with the sustainability agenda, which include fossil fuel companies and a significant number of resources companies. We also favour companies providing solutions to some of the key environmental and social and challenges we face today which typically means overweighting technology and healthcare companies, and often smaller companies.

We do not waiver from our approach in this regard, but we do have a financial overlay that helps navigate the pathway and provide more resilient performance. We also apply deep expertise in companies and sectors better aligned with key sustainability challenges like climate change, which can underpin strong performance.

In the present market conditions, key headwinds are inflation and supply constraints, which is seeing rising prices for commodities and fossil fuels. Heightened inflation is also seeing rising interest rates which can impact growth-oriented companies (like technology) and smaller entities. With our Equity funds the combination of being underweight in resources, having no exposure to fossil fuel companies, plus holding a material exposure to growth-oriented technology and smaller companies, has caused some shorter-term underperformance over the last 6-12 months.

At the same time key long-term tailwinds continue in our favour. One significant example is the recent Federal election which has underpinned the community focus on climate, with more ambitious net zero targets in place under the new government, plus also greater expectation going forward of taking climate action supported by the newly elected Teal and Green candidates.

Navigating the current environment

Finding better value in technology and small companies

While as a whole technology and small companies have been out of favour in 2022, we have found our active financial approach has helped lessen the performance impact. We remain committed to these themes, but we are careful to invest in companies that have attractive metrics on valuation relative to peers.

In the case of technology companies, we target companies with high gross profit margins, low incremental cost of customer acquisition, balance sheets funded to cashflow breakeven, global exposure, large addressable markets, and strong management teams.

In the context of small companies, it is a tough environment with early-stage companies not in favour and liquidity a key driver as well. Our active company selection seeks to identify better performing companies trading at low revenue multiples, while also retaining our focus on growth-oriented companies in this segment.

On the upside opportunities are emerging in the small companies space, which have not been evident for some time. Some smaller companies are trading at multiples lower than during the GFC. Additionally at these levels we are starting to see corporate transactions, as larger companies look to acquire small companies to scale their business and buy in innovation.

Industrials vs Resources

Linked to the guidelines within our Ethical Charter we have strict criteria for a resources company to be added to the portfolio. As a result, our portfolios have material underweight vs benchmark, which in the current period of high inflation and commodity prices has been a performance headwind.

To address this, we can have positions in other companies that can benefit from inflation (eg. agricultural business GrainCorp) and continue to benefit from significant holdings in resilient industrial companies (eg Healthcare). We also apply a significant depth of expertise in the healthcare sector given the alignment with our Ethical Charter, and our active selection has seen the inclusion of some very high performing companies.

One of our best stocks selected in healthcare is CogState. This global cognitive science company specialises in digital and optimised brain assessments which streamline and enhance the clinical trial process. This company has had a 10-fold increase in price over the last 3 years.

We also note in resources we are starting to see some days when commodity prices are materially lower. This is in part linked to flow on concerns on aggregate demand from the current rising interest rates around the world.

Rising energy prices and long-term transition to renewables

Energy prices have rallied recently, particularly linked to the Ukraine war and limiting of gas supplies from Russia. These rising fossil fuel prices has seen fossil fuel companies focused in this area benefit. While this has cost ethical investors short term, we note these rising prices are also making alternative and renewable energy more attractive.

In addition to the pricing of fossil fuels we are seeing supply of fossil fuels an increasing issue. Again renewables, which derive from unlimited energy sources like solar and wind are not subject to the same restriction. Already we are seeing states with higher allocations to renewables proving more resilient in the present energy squeeze, which is likely to help garner further support.

Outlook

Equities as a growth asset can deliver stronger returns than income assets (cash and fixed income) but do come with higher volatility.

It is important in these conditions that investors look to maintain their focus on their investment objectives. Know that Australian Ethical is looking towards providing resilient long term returns via a dual filter approach which selects companies aligned with our Ethical Charter that have a positive impact in our world, plus are also better performers on key financial metrics (eg. valuation vs similar companies). And over the longer term, as evidenced by our track record for our Australian Shares and Balanced Funds, this approach has shown not only to align with investors interests and concerns on key issues like climate change and biodiversity, but it also delivers portfolios with competitive performance.

1. US Bureau of Labour Statistics, UK Office for National Statistics – Consumer price inflation, Australian Bureau of Statistics.

2. Mercer Investment Performance Retail Balanced Growth Survey.

Past performance is not a reliable indicator of future performance. Australian Ethical offers a diverse range of investment options depending on your investment objective, timeframe and risk profile. This information is of a general nature and is not intended to provide you with financial advice or take into account your personal objectives, financial situation or needs.

Before acting on the information, consider its appropriateness to your circumstances and read the Financial Services Guide and relevant product disclosure statement (PDS) and target market determination (TMD) available on our website. You may wish to seek financial advice from a licensed financial adviser before making an investment decision.

This article may contain material provided by third parties derived from sources believed to be accurate at its issue date. While such material is published with necessary permission, Australian Ethical accepts no responsibility for the accuracy or completeness of, nor does it endorse any such third party material. To the maximum extent permitted by law, we intend by this notice to exclude liability for this third party material.

Where MSCI data is used, data is the property of MSCI. No use or distribution without written consent. Data provided "as is" without any warranties. MSCI assumes no liability for or in connection with the data.

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