Intelligent Investor: Mickey Mordech

Concerns about climate change and the environment are driving the strong growth of ethical investing

Most fund managers must outperform to survive. When there are thousands of competitors – not to mention low-cost, passive investment options – there’s simply no other way to be noticed.

It’s easier said than done, though. Over 10 years, 70%-90% of funds fail to beat their benchmark and those that pull it off are never totally safe. Star managers move on, all managers experience bouts of underperformance and, eventually, you become a victim of your own success.

So, why would investors even bother with the sector when the odds are so stacked against us?

Because of Magellan. Magellan is the example of what can happen when everything goes right. Terrific investment performance coupled with fantastic marketing have led to a deluge of inflows and exploding profitability (earnings per share have grown 75 times over the past decade, the share price 150 times).

Can fast-growing fund manager Australian Ethical become the next Magellan? With just 4% of the funds under management (FUM), it’s a bold comparison; but it might even be better than that.

Australians are becoming more socially and ethically minded. Four-fifths of people say they’d be willing to switch funds so their money is invested according to their values while 64% say climate change is “a critical threat” and that “we should act now even if it has significant costs”.

This trend is only getting stronger, which explains why “ethical” and “sustainable” options are now popping up everywhere. Having first adopted its ethical charter in 1986, it’s the tide shift Australian Ethical has waited more than 30 years for. The company doesn’t have a monopoly on ethical investing, but it has trademarked the “ethical” moniker, which is the next best thing.

A quick online search followed by a fast online onboarding process makes Australian Ethical as close to a no-brainer as it gets, which explains why 93% of its super fund members join this way.

We expect Australian Ethical to face more competition over time, but funds like Fidelity or Future Super face an uphill battle being heard. Indirectly, their marketing spend helps grow awareness of the space overall, boosting the value of Australian Ethical’s “ethical” moniker.

Australian Ethical is actually really ethical, too. It employs ethics analysts whose job it is to explore companies’ social impact and the ethical grey areas that require thoughtful consideration. Its ethical charter goes further than simply filtering out of “sin” stocks;

funds proactively seek out companies that do good and advocate for positive change in portfolio businesses.

The company hammers the point home by donating 10% of its pre-bonus profits to charitable organisations, keeping a strong focus on sustainability within its own offices and devoting large sections of its annual report to social activities.

This is a business with a relentless focus on ethics across all facets of its business. That sort of culture is hard to replicate – especially for smaller or older-world competitors – and it’s a key point of difference in a crowded market that should attract ethically minded consumers.

Which brings us to one thing Australian Ethical has over Magellan. Customers who join Magellan expecting performance will leave when it does not eventuate. By contrast, ethical investors should be stickier: do you really need to eke out that last dollar of return when you’re saving the planet?

There’s also the advantage of being in superannuation. As APRA forces sub-scale competitors to shut down or merge, barriers to entry are rising and the number of funds is shrinking.

And with a younger-than-average customer base, a steady stream of contributions, population growth and a regularly rising equity market, growth is baked into Australian Ethical for decades to come. Growth rates of 10%-15% growth rates are quite possible, and that’s before any inflows from customer switching.

In fact, growth rates have been faster than that; Australian Ethical is doubling FUM roughly every three years and is the country’s fastest-growing super fund. Rather than simply harvest the profits, management is continually slashing fees, ramping up marketing and investing in its team.

Analysts don’t like seeing profits delayed into the future, but when the opportunity is this big, the point isn’t to maximise profits today. It’s to crush your competition, increasing your ultimate slice of the pie.

In short, Australian Ethical is shaping up to be a wonderful business, boasting good barriers to entry, a market-leading position, significant scale advantages and a strong brand. That it’s outperforming across all of its funds only strengthens the case.

Management expects 2020 profit of $9 million-$9.5 million, with a good chunk of that coming from an unusually good year of performance fees. Our base case for 2021 is $8 million-$9 million, so the market is currently paying 80 times earnings for a business that won’t grow profits this year.

The risks don’t stop there. The company is battling industry funds, which are big and don’t need to make a profit. A rogue employee or an errant investment in an unscrupulous company could also tarnish its brand and big declines in markets will bring about large swings in earnings from time to time. A depression-style collapse in markets – not impossible – would see earnings evaporate, although this would likely also bring a fantastic buying opportunity.

And while we downplay performance, outperforming removes a valid excuse not to invest. Plus, several super comparison sites rank on performance, which drives a quarter of Australian Ethical’s website traffic. All else equal, without outperformance Australian Ethical would be a weaker business.

With those sorts of risks, and in a market where the buy now, pay later stocks are flying, it’s easy to write off the market as crazy.

But this valuation makes more sense if we work backwards. Ignoring dividends for a moment, and assuming the market needs an 8% return, Australian Ethical’s market capitalisation must grow to $1.5 billion in 10 years to justify its current price.

We’ll also assume that it trades on 30 times earnings in 2030 – roughly in line with Magellan’s current multiple of 27 – and that profit margins can grow from 20% in 2020 to 30% as aggressive fee reductions moderate and revenues grow faster than costs.

Under these assumptions, the market is pricing in 16% annual growth in FUM. That’s surprisingly conservative; FUM grew by 19% in 2020 alone – a year plagued by market volatility, early withdrawals from superannuation and the introduction of protect-your-super legislation that removes low balance accounts. In good years, historical growth rates of 25%-30% might persist.

So, if we assume the business keeps gathering funds at 25% a year, FUM should reach $35 billion by 2030, which might mean $100 million in net profit. Australian Ethical could easily be worth $3 billion in that scenario (which would imply a 15% annual return, excluding dividends).

If that sounds too crazy, consider that superannuation assets are projected to reach $5 trillion-$6 trillion by 2030, so FUM of $35 billion implies a tiny market share for Australian Ethical.

A multiple of 80 times earnings puts the company well beyond our usual hunting grounds, but we think it can live up to that price tag and then some. We’re upgrading the stock to buy for up to 3% of your portfolio.

Note that the stock is likely to be volatile, given its magnified exposure to equity prices. We recommend that you stagger your purchases in case further declines bring about better opportunities.