Under the Spotlight – Fund Manager Q&A

All eye’s over the past few months have been on the cost of fuel at the pump in the UK. This, as we are told, is largely down to reduced supplies of oil following the ongoing conflict in Ukraine. Ultimately, the rising price in oil has impacted the performance of financial markets over the same period. Is it time to start considering an investment into Electric Vehicles and become more conscious of sustainability?

We remain committed to helping our clients prosper during difficult periods, so this month for our Under the Spotlight blog, we caught up with an ESG specialist.

We were joined by Chi Chan of Federated Hermes Limited this month for a Fund Manager Q&A – a series we’re running, enabling us to provide our readers with insights into the strategies some of the managers within our portfolios deploy. We also like to go a little bit further and allow our readers to get to know the fund managers personality a little too.

Chi very kindly answered a host of questions for us, including his thoughts on the rise of inflation in the UK and consequently, the rise in interest rates. Chi also provides his personal insight on the challenges the Electric Vehicle (EV) market faces and his outlook for ESG investing over the next 5 years.

We hope you enjoy the read!

So let’s take a look at Chi’s answers to our questions…

How did you become a fund manager?

My professional path to becoming a fund manager was disappointingly traditional – from “Big 6” chartered accountant to investment bank equity analyst, to buy-side equity analyst then to fund manager. As the son of immigrants and growing up in a Chinese takeaway, I like to think that my unconventional background helps me to look at the world in a slightly different way to my peers. If fund management doesn’t work out for me, I’ve always got my wok skills to fall back on.

Tell us a bit about yourself, what hobbies do you have?

My reflexes have slowed with age so my wife has put a stop to my motorcycling and boxing antics. I’m still allowed to play video games which also rely on quick responses but has the advantage of being less painful when I get it wrong. I get my physical exercise from trying to keep up with our Labrador, Lucy.

It’s a bit of a cliché but I love my job. As a child, I loved reading books about corporate competition (Coke vs Pepsi, Japanese vs US autos) and I get a real buzz from identifying companies that I think are going to become the leaders in their field.

What is the aim of your fund?

When you invest in a fund, you’re putting your trust in the managers. James Rutherford, head of the team and co-manager on both funds, and I have worked together for 15 years. I’ve been analysing stocks professionally for over twenty years and James had an additional decade head start on me. We’ve got a lot of experience between us so we’d like to think that we know what we’re doing at this point!

As an investment product, the main aim is to provide an attractive risk-adjusted return to investors. We aim to do this by investing in a relatively concentrated (30-50) number of companies that we believe have competitive advantages in structural growth markets, while offering good value.

Valuation discipline is very important when looking at growth stocks because they almost never look cheap on near-term multiples. However, if our expectations for market growth and company performance are correct then they’ll look cheap in the future.

The funds also have Sustainable labels, meaning that the portfolio companies must have a benefit to the environment or to society. As part of this criteria, we exclude some industries that we feel automatically disqualify themselves from this, such as fossil fuels, weapons and tobacco.

What are your thoughts on the rise in inflation and consequently, the rise in interest rates?

Rising inflation is an unavoidable consequence of the economic cycle – at some point it’s bound to happen. Investing in equities is a way to hedge against this because rising costs for one person (or company) is rising revenue for another. Not all companies experience inflation in the same way though – those that have strong enough franchises to raise prices without disproportionately reducing demand will fare better.

The standard policy response to combat high inflation is to raise interest rates to encourage saving and therefore reduce spending to cool the economy, and therefore relieve pressure on pricing. Policy interventions since the financial crisis has led to far too much debt in the world but abnormally low interest rates have been able to keep this in check. Consequently, raising rates too quickly (even if they remain below the long run average) could lead to a particularly painful downturn.

How does either impact your fund?

Our companies typically have some competitive advantage that should allow them to be relative beneficiaries in an inflationary environment. However, the response of raising interest rates will initially be painful for long-duration assets, including growth equities.

Because we tend to look for structural growth, our companies should see relative earnings strength in a downturn. On top of this, we would expect to see weaker players failing or being consolidated, leading to the winners emerging even stronger.

Being patient should be rewarded in the medium-long term as the shares will eventually be driven by their fundamentals again.

Other than delayed computer chip deliveries, what is the biggest challenge the Electric Vehicles market faces in the UK?

Not just for the UK but globally the biggest challenge will be the retooling of manufacturing capacity from combustion-engine vehicles to electric-powered ones. We’ve gone from less than 1% of car production being EVs in 2016 to 8% in 2021, and getting to 100% at some point in the next 15-20 years is going to need a lot of investment.

I do think that most people will be surprised at how quickly adoption will take place. EVs are cheaper to run, cheaper to maintain, and in a few years will be cheaper to buy too. This will lead to a tipping point where demand for EVs will ramp up dramatically as it won’t make financial sense to buy a combustion-engine car anymore. When that happens, will there be enough global production capacity to satisfy that demand?

The other potential bottleneck could be the raw materials for the batteries; lithium, nickel, manganese and cobalt, as well as copper for the wiring. We know there’s already enough global steel capacity to produce 100m cars in a year because it was already achieved in 2017 and 2018 but there isn’t enough current supply of these other materials to reach that level without dramatically increasing production in the next two decades.

Do you envisage many challenges to UK infrastructure to meet the growing demand for EV’s? example – public charging points

A lot of infrastructure still needs to be built out to support 100% EV penetration but the challenge isn’t as insurmountable as some might think – any plug socket is a potential charging point. Since UK cars typically only drive 20 miles a day, this can easily be topped up overnight.

People without off-street parking will be dependent upon third-party charging infrastructure and this will have to be scaled up rapidly to meet the growing demand. The good news is that there’s no shortage of potential places where chargers can be implemented, such as car parks or supermarkets. Fast charging means you can fill an almost-empty battery in less time than it takes to do a weekly grocery shop.

It’s not necessary to have a single global standard but it helps EV adoption to have a dominant charging standard within a country or region because consumers don’t have to worry about whether they are part of the “right” network.

Just like the VHS/Betamax war in the 1980’s, there have been competing charging standards battling out for dominance. CCS (Combined Charging System) has won out in Europe and has been mandated as the standard for a number of years now. Tesla’s proprietary system is the market leader in the US and has been a competitive advantage for them until now and new buyers frequently cite Tesla’s extensive supercharger network as the swing factor for their purchase. However, with everyone else in the US supporting CCS now, that is likely to become the dominant standard over time. China and Japan also have their own widely accepted standards.

A much bigger issue than whether we have enough charging points is whether we have enough electricity to power all these electric cars. According to the Department for Transport, UK cars and taxis travelled 278bn miles in 2019 (to avoid covid skew). The average EV uses 0.346kWh per mile so this will require a total of 96.2TWh. To put this into context, the UK generated 323.7TWh of electricity in 2019 so this implies a 30% increase in production – and that doesn’t include the electrification of trucks, trains and boats that will have to happen eventually too.

Although replacing a petrol car with an electric one removes the CO2 emission at the tailpipe, there is still an environmental impact if the electricity powering the car is generated with fossil fuel (43% of UK electricity came from natural gas and coal in 2019). So if we want to fully decarbonise transportation, we need to install enough renewable energy capacity to offset this as well as accommodating the increased demand from EVs – more than tripling the installed capacity from the 2019 level.

What is your outlook for the ESG investing over the next 5 years?

There’s been growing public debate about the effectiveness of ESG investing, combined with accusations of exaggerated environmental benefits (aka “greenwashing”) at a time when the number of ESG-labelled investment products has exploded. This debate has been further muddied by confusion within the industry of what ESG-integration actually means. For example, S&P dropped Tesla from it’s main ESG Index in May while keeping Exxon. From a layperson’s perspective, it seems a bizarre move to keep big oil in there at the expense of an electric car company.

We would recommend investors always ask what is meant by ESG in the products they are offered. In our experience, when investors ask for ESG funds they are usually looking for sustainable ones – those that are offering some kind of benefit to the environment or to society.

For us, ESG-integration can be simply defined as “risk management across environmental, social and governance factors”. An example of this in practice might be if a company has a factory in an area prone to drought. The probability of drought affecting production, combined with the financial impact if it does, needs to be considered in the price you’re willing to pay (or if you even want to invest at all with that knowledge).

Many years ago, fund managers might have boasted of being able to value companies accurately by calculating DCFs on their new computers but today it’s taken for granted that they can all of do it. In a similar fashion, as regulation pushes companies to disclose more ESG information over time, we would hope that it becomes a standard part of company analysis for everyone.

Anything else you wish to share?

Having been spun out of BT, Federated Hermes Limited background is in managing the pension funds of it’s former employees, for many of whom this will be their sole source of retirement income. Coming from a modest background, I know the difference that a few extra pounds can make to some households. It’s very humbling to be entrusted with this level of responsibility and we take it extremely seriously.

All Federated Hermes employees have signed a pledge to act ethically and with integrity and to put our clients’ interests first. We can’t guarantee returns but we can promise to manage your money responsibly and to the best of our abilities.

We’d like to thank Chi for his time and excellent insights provided, especially his insights on the challenges faced in the infrastructure of electric vehicles.

At Fiducia we are continuously looking to deliver outstanding value and expertise to our clients, if you have any questions regarding your investment portfolio please do not hesitate to speak to a member of our team. We are a multi award-winning Chartered Financial Adviser based in Colchester, Essex. Our advisers will ensure you have the right investments to help you meet your financial goals, in a tax efficient way that works for you.

Disclaimer: The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. The views and opinions contained herein are those of Chi Chan, and may not necessarily represent views expressed or reflected in other communications, strategies or products. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations.