Have your cake and eat it too: Generating top return from impact investing

With the many problems we see around us, either in our own economy or across the globe, it's tempting to put them in the too-hard basket and look to invest elsewhere. 

But problems create investment opportunities. Take the transition to net zero, where there are several ways to play the theme. You can invest in:

• the natural resources (either legacy or the commodities that will fuel the new energy technologies), 
• the utilities, and
• the companies providing the solutions for companies in both of these sectors to help them achieve their future visions. 

Extend this idea to the problems of health, or to circular economy and the scope appears broad. So it requires guardrails and a framework to identify the opportunities arising from the megatrends.

For Hari Balkrishna, Global Impact Equity Portfolio Manager and Vice President at T. Rowe Price, it's not about defining the problem or even about defining the solution. It's about searching for companies that have the solution to some of the world’s largest social and environment problems, understanding the fundamentals of the business and mapping out the impact of that company's activities on helping others to address the problem.

It is about going beyond the labels and looking at the outcomes for Balkrishna, "particularly when we are dealing with values", that is, those investors who seek investments aligned with their values. 

And it's not as simple as "taking out a bit of oil and gas and scaling up a bit of Microsoft or  Amazon", according to Balkrishna. The fund he manages, the T. Rowe Price Global Impact Equity - I Class  has a dual mandate, "which seeks both long-term capital appreciation as well as seeking to have a positive effect on the environment and society by investing in companies whose current or future business activities are expected to generate a positive impact under one of the following three impact pillars (“Impact Pillars”):

1. climate and resources
2. social equity and quality of life
3. sustainable innovation and productivity 

Its universe is the MSCI All Country World Index and it searches for mid to large cap companies around the globe. 

Managed Fund

T. Rowe Price Global Impact Equity - I Class

Global Shares

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Measuring impact: it's about materiality

Explicitly measuring outcomes and impact achieved by a company starts from a theory of change. Balkrishna and his team of analysts have taken the 5 Dimensions of Impact developed for impact investing in private markets and translated it into the listed space. Measuring impact is a disciplined process that translates into quantitative KPIs that can be tracked alongside the financial fundamentals.

As Balkrishna explains:

Materiality is making sure that the companies that we invest in have the majority of revenues or profits aligned with delivering positive impact outcomes. Companies that provide solutions for reducing greenhouse gases, promoting healthy ecosystems, creating a circular economy, enabling social equity, improving health care, or creating sustainable technology.

Impact investing isn't ESG investing, although he acknowledges that ESG is an important risk management tool. As Balkrishna sees it:

"If you don't look at your ESG footprint or profile, there can be real financial consequences that follow from that"

As he says in the fund's FY22 report, "This is where we believe impact investing can be part of the solution, by creating clearer research and measurement frameworks that reduce the scope for greenwashing, while better aligning stakeholders with their intended goals." 

Just because a company has a positive impact on megatrends doesn't make it a good stock, or one he would consider for the portfolio. Balkrishna explains why this is:

"It's about companies that have a tailwind attached to their business model. There are areas of the market where there is positive impact but what they provide can be easily commoditised or there's too much competition. 

So the traditional investment tenets of looking at Porter's 5 Forces, industry analysis and industry structure, business model, and how management allocates capital still apply. What we would look for is a company that has a business model that operates in a business structure that allows for expanding economic returns, however we want to ensure that the financial objectives won’t be put ahead of their impact."

The materiality threshold for revenue or profits is set at 50% for stocks to be included within the fund, however since inception it has remained above 90%. And then Balkrishna and his team consider if that impact is a market-leading impact before drilling down to the investment fundamentals, including those noted above but also capital allocation and management capability: the management team has a track record of allocating capital well. 

Stocks in the portfolio

Currently, there are 65 stocks in the portfolio, a mix of mid-large caps from around the globe including emerging markets. And the chart below shows the allocation across the three pillars and breaks this down into sub-pillars.

The approach of impact investing can be seen in the top 10 holdings as of 30 September 2023. It's perhaps not the mix you'd expect to see regarding the sectors the fund invests in, such as chemicals.

One such chemicals example is Linde plc (NYSE: LIN), an industrial gas supplier to a variety of end markets such as chemicals and energy, food and beverage, electronics, healthcare, manufacturing, metals and mining. It can achieve impact at scale via the solution it provides to allow its clients to decarbonise their businesses. 

Headwinds in the economy 

Balkrishna identified two headwinds he's seeing in the market. Yes, historical data indicates that higher interest rates impact stock prices. And the MANGMA stocks (including Microsoft, Apple, Nvidia, Alphabet, Meta, and Amazon) have dominated market returns, accounting for 46% of the total contribution to the MSCI All Country World Index return in the year-to-date. 

As he sees it, this means there are some companies that are being both overvalued and undervalued.

Tailwinds in this investment style

So what's the potential? Balkrishna sees a lot of tailwinds in this style of impact investing in pursuing the solutions to the megatrends noted above. 

"When we think about the genuine megatrends, they aren't here for the next 6 to 12 months but for the next couple of decades."

Take companies like Danaher (NYSE: DHR) and Thermo Fisher Scientific (NYSE: TMO), which provide the bioprocessing equipment that enables biopharma companies to manufacture biologic drugs curing rare diseases. Balkrishna is excited about these two businesses.

"When you look at the tailwind in healthcare, there is a very meaningful long-term growth opportunity, a double-digit end market growth in biologic medicine."

But he notes that currently, the market is so worried about destocking at these bioprocessing companies as they benefited heavily via COVID demand for testing, vaccines and therapeutics. Balkrishna notes how the consensus forecasts are at odds with the view that his team have of these stocks when they look out five years. And then when he looks at the industry dynamics of low competition, he sees possibility with large potential gains to be shared between few players. Take Danaher for example:

"Danaher has specified 90% of all approved monoclonal antibodies. So, 90% of these cancer drugs have a Danaher-specified product in the application. 73% of all biologic drugs use Danaher equipment to make them."

During his presentation today, Balkrishna also called out some examples of companies in the portfolio beyond those noted above.

• Nibe Industries (STO: NIBE-B) is providing indoor climate comfort products, with its heat pump products allowing its customers to reduce their Co2 emissions (reducing greenhouse gas emissions)
• Trex Company (NYSE: TREX) makes composite decking by recycling plastic into composite decking (nurturing circular economies)
• Evotec SE (FWB: EVT) is a small-cap company listed in Germany. It is Europe's largest contract research provider offering a one-stop outsourcing model for the pharmaceutical industry (improving health sub-pillar). Balkrishna notes, "50% of their business is to help early-stage biotech companies do more and smarter research, such as clinical trials. The other 50% is in the rare diseases that are licensed by Evotec to a number of universities, such as the Oxford School of Medicine."
• Tomra Systems (OSE: TOM) is a market leader in reverse vending machines that enable increased plastics recycling (nurturing circular economies). 

It's all about risk management and risk mitigation. Looking for double-digit growth and impact over a five-year time horizon. It's not about looking for the latest instant gratification stock. As Balkrishna notes, "The nice thing about impact is that it takes time. "