Goldman identifies likely big hitters of the future

Financial Times, 18 January 2009 - The offer by an investment manager of a “responsible investment policy” or a “sustainable fund” surely raises the question of whether their other products are irresponsible or unsustainable.

The question tends to make fund managers splutter, but in recent months, advocates of sustainable investment have been able to point to clearly unsustainable investment strategies, and indeed an unsustainable global financial system, as proof they are not just posturing.

Now Goldman Sachs Asset Management is marketing a fund across Europe that claims to be sustainable. Unlike many so-called sustainable investment products, the Goldman Sachs Sustain Fund does not start from a dogma about the inevitability of climate change or the advisability of behaving as a responsible investor.

Instead, it uses the research generated by a team within the investment bank, not normally known for its touchy-feely approach to the world.

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Since 2004, Goldman's global investment research division has been building a research resource under the title “Sustain”.

This pictures what the world will look like in three to five years' time and then figures out which companies will do best in that environment.

“We're looking for new business models and asking what do companies of the future need to look like,” says Sarah Forrest, head of the Sustain team. Her 10-strong team looks at a global universe of 3,200 companies, divided into 10 industry sectors, and chooses the businesses most likely to do well in the future as Goldman envisages it.

The next step is an index, run by S&P, based on the Goldman Sachs Sustain Focus List. The fund, a Luxembourg-domiciled Sicav, will invest in a portfolio of 80 to 120 holdings with the aim of replicating the return of the index.

Selling this concept to investors and their advisers is easy, says Nick Phillips, head of third-party distribution in Europe for GSAM. “This is something different and innovative,” he says. “Advisers like a product an end-investor can relate to.”

For all the vaunted rigour of the research process, Sustain does indeed have a simple core concept, which explains both why it claims it will offer outperformance, and why it need not be the basis for all investment, a question other investment products using the term “sustainable” sometimes struggle with. Ms Forrest says equity markets are unable to distinguish between likely winners and losers in the long term.

In an increasingly challenging world, where companies will have to contend with climate change and globalisation, in addition to a tough economic environment and tighter regulation, the distinction between winners and losers is likely to become ever more important, she claims.

The Sustain process uses a tripartite analysis to pick out the likely winners. It includes return on capital, industry positioning and management quality.

“Return on capital is a key driver of long-term performance advantage,” says Ms Forrest. The Sustain team analyses companies' return on capital in a strictly data focused manner, ranking each stock relative to its sector.

“Then we add in industry positioning, based on three or four drivers of returns.” Here the team draws on Goldman's economic research and the material produced by its industry equity analysts. To explain the concept of industry positioning as conceived by Sustain, she cites banks.

“We saw the need to move to working in a deposit-led world,” she says. “Our financials team picked up on a move from a focus on securitisation to deposits and we were looking for banks that knew what was on their balance sheet and had taken steps to mark it to market.”

The third point of the triangle is management quality, for which they use performance on environmental, social and governance issues. This is in part a straightforward proxy for management quality, which is difficult to reduce to an objective metric, but also reflects the team's expectations of the challenges companies will face.

“Because the world is more difficult to operate in, we think there are certain factors companies will need to manage if they are to succeed,” says Ms Forrest. Although climate change is one of the larger factors, it is not the only one.

“Economic power is shifting to different parts of the world. We are seeing increasing rates of urbanisation, which leads to social and environmental change,” she says, pointing out that people who live in cities typically consume more than those living in rural settings, as well as producing significantly more waste.

While the industrialisation of less developed countries may be a welcome indicator that people are moving out of poverty, it poses its own challenges, not least because of the accelerating speed with which it is happening.

All of these considerations applied to the retail banking sector led the researchers to eschew the US banks altogether in a sector report of October 2008.

Instead, the Sustain team expects the leading banks of the future to include HSBC, Spanish bank BBVA and the Indian Housing Development and Finance Corporation.

Over the four years since it was established, the team has issued 10 sector reports, each of which took three to six months to complete. Currently each report ranks companies based on 20-25 indicators, but this is likely to expand to as many as 100 as the process is refined and developed.

The analysis is applied to companies across all regions and includes both large cap stocks and small and mid-cap companies.

Not all sectors have obvious leaders likely to succeed. The telecommunications industry, which will need a round of consolidation before return on capital approaches a level Goldman considers sustainable, and consumer cyclicals, suffering from the global downturn, are two sectors where the team have “struggled to see which companies will be leaders of the future”.

Many investment managers put sustainability at the centre either of a single product or overall investment philosophy, and many others use return on capital as a core metric within their investment process.

Several even use the idea of identifying the key drivers for change in the world over the next few years.

But Ms Forrest believes her research team is the only one to integrate these ideas.