Into the Woods, 4th Issue.

ESG Stock Pick, Alternative Investments' Conference and Water Issues are the main topics of my fourth issue of: Into the Woods. This investment series provides insights I gained through networking, meetings, and conference within the (sustainable) finance industry. It aims to help investors to take responsibility for their investments and use them as resources to the resolutions of society’s challenges.

This fourth edition mainly contains insights from the AIMA and SFAMA Swiss Investing Forum, which is a dedicated conference on alternative investments in Switzerland. It further discusses global water issues and contains another ESG stock from the water investment theme this time.

SFAMA / AIMA conference

• The conference mainly discussed the attractiveness of alternative investments at the moment and where do investors go with their portfolios. A survey from Prequin shows that family offices are going for more alternatives rather than less. This represents a third in Hedge Fund (HF), a quarter in Private Equity (PE), a quarter in Real Estate and the rest in Infrastructure.
• There were USD 300 bn of outflows from HF over the last years as 40% of investors are not happy with their performance. Yet total HF AuM remains stable because of their good performance. It seems that whoever went to HF for relative performance went out of the space to pick up on the bull market.
• This is supported by the fact that outflows from HF came mainly from the big names and famous strategies. The few inflows went into niche and small managers' opportunities. Macro and relative value were the favored strategies at the expense of equities. They further said that most investors in hedge funds now are here for diversification and protection. Furthermore, volatility in the public markets now gives a good opportunity for hedges funds to prove themselves.
• On the other hand, private equity and other private markets are very popular at the moment. PE is the single largest alternative asset class owned by investors. Yet the inflows were very concentrated as 55% went to the top 50 PE boutiques. I hear many other institutions going there mainly for diversification and protective reasons. I like to call it "valuation hedge". Many seem to operate under the dogma "what you don't know can't kill you".
• There is still seems to be quite an amount of distrust in the bull market of the last 10 years and people are seeking alternatives of various natures, shifting from one to another. It is unclear yet whether the correction from the coronavirus will have a lasting impact on valuation and what will be the global monetary response. I think it will definitely put pressure on central banks and push them out of their comfort zone. I personally think this is a healthy correction considering the amount of liquidity that has been added to the system over the years. It is unclear what will be the economic consequences of the disruptions in (tight) supply chains but I definitely think there has been quite an overreaction on the severity of the virus (if you speak French, I found this post to be quite insightful). In any regard, alternative allocations will be tested in February/March and it will be interesting to see who comes at the top and who proved to be a good protection in one's portfolio.
• At the conference, ESG was claimed to be a big topic. Yet more than 50% of alternatives managers don’t have any plans to implement any ESG policy. It is furthermore unclear what kind of policies the ones who do have. From the discussion I subsequently had, the existing ESG policies are pursued from compliance reasons (tailoring the investment universe to ESG factors). More sophisticated managers saw ESG as a macro tool one needs to consider to steer their portfolio in a changing world whilst others say they were using thematic investing as opportunistic allocations. They said this also allows them to keep their social license to operate as growing public concern is asking for a change. This further strengthens that these considerations are relevant to one's asset allocation and a strategy must be put in place to avoid unpleasant pitfalls. I've finally asked whether they would create specific ESG allocations on a top-down level (like creating a 15% energy bucket) but they said it would depend on the clients' demand.
• It was further stated that asset raising remains fiercely competitive. Differentiating the value proposition will be key. This is why I believe ESG / Thematic Investing as an important role to play and can provide new avenues of values.
• A big pension fund in Switzerland presented its SAA (strategic asset allocation) and said they were reducing fixed income because its yield was no longer supporting their liabilities. They are now increasing alternatives to be as diversified as possible. This is a trend for many other Swiss Pensions, its manager stated. I think they are afraid of the current conditions and expect some sort of large downturn, which may be happening now. High equity valuation and the low-yield environment has been a (big) challenge for institutionals that seek stable yields to cover their long-term liabilities. Yet, alternatives were few and difficult to venture into, and the opportunity cost of not participating in the bull equity market has been big.

• The manager further said that alternative investments bring many challenges for swiss pensions because of their limited availability, the poor quality and scope of the data, the heterogeneity and the complexity of the asset classes, illiquidity risk, and finally non-normality of returns. Alternatives investments are also difficult to model in an ALM (Asset Liability Management). This requires a lot of work and manpower to analyze and make the necessary due diligence for these investments, which they can't afford. They therefore often rely on external consultants. He also said that swiss pensions funds worry about the increase in correlations between alternatives and other asset classes during market downturns, and he said this is not considered enough by asset managers.
• All these reasons further strengthen my confidence that ESG thematic investing can be integrated into a portfolio as a new sort of alternative. For example, Water funds are more liquid as they mainly invest in public equities and thus can fit within a traditional equity allocation. The data is publicly available, transparent and can easily be integrated into portfolio models. Water stocks and funds thereof are mainly growth stocks, paying health dividends and can be seen as fixed-income substitutes with an attractive and diversifying risk-return profile. Moreover, you avoid the opportunity cost issue as you are still participating in the bull market albeit on a safer side (60% correlation) and these investments tend to have better downside protection as well (especially utilities). Finally, these investments in water are needed for modern society to continue functioning (see Water Issues later in this post). They will have to be made eventually. If not carefully made over the next 10 years, they will have to be implemented in a rushed manner. They are likely to be spurred by fiscal expansions after the next downturn and provide a good boost to the investment theme. This creates an implied optionality that can be a great protection and rebounder in the next crisis. I think this is a sort of "long-only" protection that is particularly suited for long-term investors such as pensions, plus the long-term realization of the strategy over the next years (if not decades) also fits well the timeframe of such investors. It remains nonetheless interesting for any type of investor.
• In other strategical moves, another bank is increasing its capabilities at analyzing private equities, using machine learning models. I am a bit skeptical about this trend to apply quantitative techniques everywhere and try to make alternatives more like traditional asset classes. PE, in my opinion, is not well suited for that. I think it is much craftier (and easier) to carve out alternatives out of traditional investments rather than the opposite. I've argued how ESG thematics can be asset allocation in their own right in my previous issue.
• CME Group also made a presentation about alternative data such as using satellite imagery or web traffic to value financial contracts. They monitor clicks on the internet about various subjects of people's concern and derive a market sentiment indicator through Machine-Learning techniques. They also give each topic a level of concern and then map these risks to various derivatives contracts. They also use indices' options and futures with an economic model to derive a future probability distribution for the index performance through stochastic calculus. This models the market psyche with various states: complacent, anxious, conflicted or confident. All of this can be used as a new market monitoring tool and assess the risk in an investor's portfolio. I think this is a very interesting topic albeit it requires a lot of data and engineering. The choice of the statistical model is critical. I think a thorough assessment of the methodology is necessary for investors to trust these data for their investment decisions.
• They also work with IndigoAG, which I talked about in previous editions. They use satellite data to measure the colors of the leaves in plantations. This information is used to assess the health of the crops. They then see a lag between an increase in the crop's health and the increase in its price. At the moment the trend in the crop's health is increasing but the price is remaining low. I think this is a very interesting fact for regenerative agriculture and early adopters of this sort of investment. Regenerative agriculture aims to restore the natural ecosystem of the soil so that it is more healthy and productive, but it requires a bit of time to show results (3 years). These lags suggest a ramp-up phase where investors can get into these sorts of investments. Kellog and Danone are implementing now their first projects so we are at the beginning of this new opportunity.

Water Issues

• I recently came upon an interesting french article relating various world issues in water, and which I am translating some facts here coupled with other interesting statistics I found around.
• Earth has 1.4 billion km^3 volume of water, 225’000 km^3 is drinkable (0.016%), 40’000 km^3 is renewable, 15’000 km^3 is easily accessible, we are currently using 3’800 km^3 of it and 1'320 km^3 is lost every year (in the sense that they are stored elsewhere in the industrial supply chain than going back into the planet's water cycle). Meanwhile, this 25% consumption sounds promising, it is only an average. Water use is widely different across regions and types of usages. It has strong seasonal variability and a couple of “hot zones” where the risk of shortage is really high (25% of people only have access to 2% of the drinking water). But the real problem is a growing demand from a growing population, not only for drinking purposes but also in terms of food production since as much of water is used for agricultural purposes.
• Despite its vital characteristics, water is suffering from a chronic lack of political interest, severe mismanagement and is in dire need of investments. Water has however the characteristics of a long-term investment market, with steady growth and growing needs to satisfy. There are no substitutes for most of its usage and should be perceived much more valuably than is oil. Indeed its is a pivotal resource in many other industries beyond drinking purposes: Agriculture for irrigation and food production, Energy and IT for cooling, Construction for cement, Mining for extraction and Textile for production and dye.
• The 5 hotspots where water has become a critical issue is the Aral Sea, Gange River (India and Bangladesh), the Tiger and Euphrate (Turkey, Syria, and Iraq) and the Nil (Egypt and sub-Saharan countries upstream). Some of these tensions have led to military interventions but no declaration of war. Peaceful collaborations were, however, 2.5x more likely to be achieved. The consumption of water and its legal usage is also a tension in other countries, whatever their level of development. These can be at several levels of institutions: locally, state-wise, national and international.
• 70% of the world’s consumption is for agriculture (only 9% of water use is currently for drinking purposes). According to the FAO, 4.4 billion hectares of land is cultivable and 1.6 thereof were already in 2000. However, Asia, Middle East, and North Africa are already at capacity. Most of the agriculture flourishes under rainfall but irrigation is increasingly important (it only concerns 17% of the surfaces but feeds 40% of human consumption). A study from CIRAD and INRA in '09 put the additional need for water to feed a 9bn population by 2050 at 4’500 km^3 per year! This is just for agricultural use and these numbers suggest this is mathematically not feasible with the reserves at hand. Part of the solution will require double the land used for agriculture, which will eventually impact the climate and the biodiversity as well if not done in adequation with natural systems. The available land is primarily in Africa and South America. Food is also competing with Energy (biomass, which is itself very gourmand in water) for land use.
• Beyond agriculture, the general state of the infrastructure of the water network is aging and decaying. This is a major theme in developed markets. The maintenance is difficult and often reactive, and a lot of water is lost through the system. This is called Non-Revenue Water and is similar in thought to food waste and amounts 7% for Germany, 19% for UK, 26% for France, 29% for Italy, 51% for Mexico and 96% for Nigeria.
• This is only for water accessibility but water quality is as much of a problem if not bigger. It is claimed that 80% of the wastewater is put back into the environment untreated and more people die from drinking unsafe water than all wars and forms of violence combined. The main source of pollution is the inappropriate disposal of waste, fertilizers and agriculture chemicals used in fields that are integrating the water system and the general use of water for industrial pollution. All these agents are infiltrating the water systems through swamps, rivers, lakes, underground water and seas and oceans, as everything is connected. I've recently watch Dark Waters with Mark Ruffalo that relates the vindication of a corporate lawyer that went against the chemical company Dupont that was knowingly disposing of a toxic agent to human health into rivers. I will not "spoil" the rest of the story as it is worth watching.

Xylem

• Xylem is one of the leading water technology companies in the world. Its extensive portfolio of companies spans a wide range of equipment and solutions for the water industry, including the distribution, treatment, testing, and efficient use of water for public utilities as well as industrial, commercial, and residential customers. Xylem operates three business segments: Water Infrastructure (40% of revenue), Applied Water (30%), and Measurement & Control Solutions (30%). The first segment as its names suggests deals with the infrastructure that supports water, the second delivers the tools used for this infrastructure and the third is the software to monitor the lot. Xylem is basically operating along the entire water supply chain and aims to provide the best technology for the responsible use of the resource, both on the hardware and software side. It has thus a holistic view of the challenges and can provide comprehensive and custom solutions. This is an interesting way to access the water investment theme that is not directly connected with the management of the resource. It thus holds less political risk.
• Xylem seems furthermore to take water issues at its heart and this is reflected through his material and strategy. Its Measurement & Control Solutions segment spawned from several acquisitions of technology firms over the last years with adequate debt issuances (BBB+ senior notes with laddered maturities over the next few years). Xylem hence focuses on acquisitions and growth to complement its offering, while still serving an attractive dividend (1.34% LTM that is 43% of earnings and 28% of FCF). The company has often been touted as an ethical leader and is enjoying a MSCI AAA rating (within the top 5%). Xylem also seems to hold a solid reputation as a reliable provider with utilities, enjoys a steady client base and resilient sales from aftermarket services (reparation, replacements and monitoring fees).
• Xylem is in good financial shape. Despite the slight increase in the debt ratio from 60.4% to 69.8% over the past 5 years, the debt is 1.2x covered by short term assets, 40.5% covered by operating cash flows and its interest payments are 10.4x covered by EBIT. Gross Margin has been steady over 10 years around 38%, Operating Margin 10-12% and Net Profit Margin 7-10% with a 124% FCF Conversion Rate fo 2019. This makes an RoE between 10-20%, RoA 5-9% and ROI 6-11% over the same time frame. They are not only steadily solvent, profitable but also liquid as the Current Ratio fluctuated between 1.5x and 2.5x. Some analysts see weakness in sales induced by trade tariffs and global economic slowdown but that does not change the challenges the company aims to face. I actually think it makes it an interesting buying opportunity has its share price has declined 12% since the coronavirus outbreak and its PE ratio is now "only" 35. I see some short/mid-term estimation of $70 and $74 of fair value (trading today around $79), but they stem from forecasted cash flow models and don't seem to incorporate long term macro trends.
• The company is definitely an asset to own towards the goal of responsible and sustainable use of water. I think they have a key role to play on the technology side and are already well-positioned in that regard. They have built their leading position with robust patent acquisitions that have been complementing an already comfortable and valuable portfolio. As time goes forward and the limits of the current system become more apparent (as I discussed previously in this article), the need for solutions will grow in importance. Indeed, the state of global water infrastructure is poor and maintenance has become nothing but reactive by patching up failures across the supply chain. This poor method of management coupled with a historically slow pace of adaption for new technology, makes Xylem uniquely positioned to serve better management tools and services for Water. A resource that will need ever more responsibility, and whose consumption will be ever more closely watched and judged by the community. Utilities operators are also slowly getting towards retirement, and young employees are more technologically friendly and demanding. Xylem is a growth stock (albeit not cheap) with healthy operations and returns on investments, and that has been building a leader position to overcome a serious macro challenge. This makes it an interesting investment for any long-term investor.

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