That gifted stockpickers exist in the world of sustainable investing may come as a surprise to skeptics, who insist that investors must sacrifice returns for values.
But Karina Funk and her colleague, David Powell, have run the $1.1 billion Brown Advisory Sustainable Growth fund (BIAWX) since its 2012 inception; over the past five years, it has returned an average of 16.7% a year, versus 11.8% for the S&P 500 index (.SPX), and 12.4% for the big-cap growth funds tracked by Morningstar.
Funk is a former engineer, with degrees from Purdue University and Massachusetts Institute of Technology, who worked as a venture capitalist before she started picking stocks. She believes that companies that embed sustainability in their business can provide compelling customer value. Recently, she chatted with Barron’s about how she plies her trade. Read the edited conversation to see how her investment philosophy translates into performance, and which companies she likes most right now.
Q: You manage an outperforming fund that has the hot-button word “sustainable” in its name. What does that word mean to you?
A: Sustainable growth means durability and constancy in growth rates. It does harken to the term sustainability. This isn’t opinion or political territory. The secular drivers aren’t hot button issues. I’m looking out at Boston Harbor right now, thinking about what cities like Boston or Miami are doing about sea-level rise. These are real issues. We try to keep it simple, looking for strategies that companies are employing to be sustainable and resilient in the long term, in their own interest.
Q: What do you look for?
A: Our three key criteria are fundamental strength, attractive valuation, and a sustainable business advantage. A company has to be interesting on a fundamental basis; it has to have high barriers to entry. It must have an extremely compelling customer value proposition.
Table stakes for our high-quality companies is to stay out of trouble. One of the first things we look at is whether they’re playing defense, generally managing their ESG risks well. We look at different aspects of company risk. MSCI or Sustainalytics puts a lot of information in one place that companies aren’t even required to disclose. It’s easy to see if the company has a history of emissions or proxy fights or business controversies. That body of work is aligned with more traditional ESG [environmental, social, and governance] analysis.
But we expect our high-quality companies to do more, to improve over time, just like you expect that my investment process should improve over time. Right? I should learn, get better at research. It’s not enough to squeeze out efficiencies and stay out of trouble. Companies need long-term sustainable growth that will put them ahead of competitors in a meaningful way. We call that sustainable business advantage. We look for evidence of shareholder value in at least one of three ways: faster revenue growth, cost improvements, or enhanced franchise value. It keeps us focused.
Q: Not many companies meet those criteria; your fund has only 35 holdings.
A: We’re attuned to those massive secular growth drivers—people entering the middle class, how we have clean water, and how we power and cool data centers, which are now contributing as much emissions to the world as airplanes. That’s a massive opportunity because data and networking are going to increase. You can find those opportunities anywhere in the economy. We’re attuned to these critical challenges that need solutions. When there are dislocations in the market, we find opportunity in that confusion.
Q: These are long-term issues, and many of the companies involved can run up or fall quickly, based on headlines. What sort of timeline do you use for the portfolio?
A: When we see companies bumping up against our one- and three-year valuation ranges, we have to reassess if the model is getting stronger, or getting ahead of itself. There are always stock-specific misunderstandings.
In the first quarter, one of our best-performing stocks was Danaher (DHR), which is buying GE’s life-science business for 17 times enterprise value to earnings before interest, taxes, depreciation, and amortization, which is an attractive ratio for the biopharma business. Danaher’s multiple expanded after the announcement. Over the past 30 years, Danaher has successfully transitioned from an industrial tools company to a leading science and technology company, with high margins, high recurring revenue, and excellent cash flow. There is still room for up to 25% upside over the next three years. Another gainer was Thermo Fisher (TMO), which announced its intention to buy Brammer Bio, which has expertise in CDM, or contract development and manufacturing, for life science.
Q: Two years ago, you were a fan of Facebook, which has since faced all kinds of controversy. Is there value there today?
A: We first bought Facebook (FB) in 2014, when there were questions about whether they could monetize mobile. At the time, Snapchat was raising a ton of money. We talked to Facebook’s executives to understand their infrastructure and platform, and their meticulous attention to optimizing hardware, optimizing software, and improving data-center energy efficiencies. That gave us the conviction to know that whatever they did, they could plug it into an infrastructure ready for scale. So, no, Snapchat wasn’t going to take a ton of share.
Q: But you, along with a lot of other sustainable investors, have different concerns about Facebook today.
A: Facebook has faced existential risks: governance, key person risk, privacy and data security, consumer trust, and regulation. Right? In early 2018, these risks got elevated. We went back to our original research, because if we missed something, we needed to learn from it. Then we sought to understand how the risks flowed through the financial statements. Could the model handle slowing user growth, or the expense required to get this right?
Ultimately, when the risks got elevated, we cut our position in half because we didn’t want to subject our clients to whatever Mark Zuckerberg was going to say as he was testifying around the world on live TV. The last straw was understanding that they could have violated an FCC consent decree, and that there are now potentially criminal investigations. We lost faith in management.
Q: What else do you like, besides Danaher?
A: In the fourth quarter, we picked up Aspen Technologies (AZPN), which provides modeling and simulation software for process industries. Frankly, I used to use their software in my engineering days. So I have a good sense of their competitive moat. You are absolutely leaving money on the table if you are not using Aspen software. It helps you reduce your inputs, increase your yield, and just increase overall efficiencies. They have statistics about increasing efficiency—literally saving customers $50 billion because of their process optimization. They can also provide predictive diagnostics: If you can understand, a few weeks ahead of time, that a particular sensor or a filter or unit will fail, you can replace it beforehand without having to shut down your entire process.
Aspen has high gross and operating margins, high and growing free cash flow, high revenue visibility in a subscription business with high renewal rates, and top-line growth rising to a high-single digit rate, thanks to continued product innovation. The valuation has snapped back up to the mid- 30s, but there could be as much as 30% upside to the stock if we look out to 2022.
Q: What’s the thesis for Ball Corp.?
A: There are so many companies you wouldn’t think are moving the needle on sustainability, but they are. They are going to be crushing it for years to come. Ball (BLL) is the largest manufacturer and distributor of aluminum cans. If you can save a fraction of a penny on every can you produce, and get to it by using less materials, but having the same structural integrity, that’s a competitive advantage.
Ball has several tailwinds. One is innovation. If you ever see interesting form factors in a can, it’s likely to be Ball. You can charge more money for the same liquid in an interesting form, right? You’ve never fallen for that? They’re the only ones who make a resealable aluminum beverage container. And aluminum is a molecule. It’s an element. It’s infinitely recyclable. Any aluminum can has over 60% recycled content, which you cannot say about plastic. And recycling glass is less sustainable. It’s heavier, and it uses a lot of water to recycle. So Ball has a competitive advantage because of their scale and distribution and their customer value proposition. They are taking share from glass because of sustainability issues. There’s a good chance they’ll be taking share from plastic. We’re very excited about a company like that.
Ball has consistent mid-single digits revenue growth, high-single digits Ebitda growth, and low-teens earnings-per-share growth. The stock almost never looks cheap, but valuation is generally reasonable at 6% free-cash-flow yield, and a price/earnings ratio of 18 times. We see 25% upside within three years. Just as important, given the consistency on the top and bottom lines, Ball can be a great defensive stock in a growth portfolio.
Q: What are you reading these days?
A: I tend to read nonfiction, like Sapiens by Yuval Noah Harari. It’s humbling to reflect on human behavior and, frankly, our impact on the environment. Also, Why We Sleep by Matthew Walker. We don’t have a superb scientific explanation for why we sleep, so I’m intrigued to know more.
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