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Global Equity
Investing in an
Uncertain Age
The Nikko AM Future Quality
Approach to Global Equities
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Navigating the road ahead for global equities‘Future Quality’ companies

ESG in the investment process

Appendix: How to choose between growth and ROIC

Foreword
Welcome to our latest three-part investment guide where we detail our Future Quality
investment approach to navigating turbulent times.
The three sections are outlined below, simply click to jump to the respective chapter.

1. NAVIGATING THE ROAD AHEAD FOR GLOBAL EQUITIES
2. FUTURE QUALITY COMPANIES
3. ESG IN THE INVESTMENT PROCESSTo learn more about Future Quality investing, click here to watch our recently released
webinar.
We hope the guide is helpful as you navigate the road ahead,
The Global Equity team at Nikko Asset Management

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2Navigating the road ahead for global equities‘Future Quality’ companies

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Appendix: How to choose between growth and ROICPart 1

Navigating theroad ahead for
global equities

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Appendix: How to choose between growth and ROIC

Navigating the road ahead for global equities
In the first section of this investment guide, the
Nikko AM Global Equity team explores how global
equity investors can respond to the more challenging market conditions.
In recent times, the experience of investing in risk assets
has been a rather miserable affair for everyone involved– particularly in some corners of the market where wehave seen an utter collapse in share prices. We wonder,
however, why this was so surprising for so many
investors.
The evidence would suggest investors have become
conditioned by the benign environment that had beenprevalent for more than a decade, creating a smooth andclear road to higher prices for equities and indeed mostfinancial assets. The world’s key central banks had thespecific goal of lower yields on financial assets since thegreat experiment of quantitative easing commenced.
This post-financial crisis era has been less about investing
capital and more about the ‘great inflation’ of financial
assets.
This era even had its own language: SPAC, FAANG, meme,
NFT, crypto, FOMO, and so on.1 We live in a world where

1 S PAC (special purpose acquisition company), FAANG (Facebook,
Amazon, Apple, Netflix and Google), NFT (non-fungible tokens),
FOMO (fear of missing out)

artificial intelligence is developing rapidly and is able tojoin the dots within larger data sets much better thanhumans can. We will, no doubt, underestimate the degreeof future advances in this area. However, we should notunderestimate the power of human thinking, as joining
the dots on the wide array of evidence from different
sources has been giving us valuable insights for sometime.
As a global equity team, we are always discussing theseobservations and the insights they provide. In fact, they
are instrumental both in directing our research towards thebest new ideas and appraising our current investments.
The valuation of companies has been a key area of focus,
particularly since COVID-related monetary interventions
pushed valuation disparities within equity markets to
exceptional levels. In 2021, we wrote “These balloons…
will not stay high in the sky…and the only debate willbe the speed of descent”. Then in early 2022, we wrote“Make no mistake, there are many aspects of this thathave the trappings of a bubble”. This is the humanalgorithm (or “Halgo2” for short) in action, and a goodreminder to ourselves of the value of staying disciplined
and bringing experience to the table. Being constructively
critical is essential in today’s turbulent world.

2 Halgo (human algorithm)

Source: Getty Images

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Navigating the road ahead for global equities‘Future Quality’ companies

All investors are now faced with a new and ongoingchallenge. Policymakers no longer ‘have our back’, andinflation (rather than the price of risk assets) is now their
number one priority. The road ahead is not going to beso easy for investors, but there are several useful steps
they can choose to take.

THREE STEPS FOR THE NEW ROAD AHEAD

It may be easy to become gloomy in the turbulence of
today, but there are plenty of reasons for investors to be
optimistic about the prospects for compounding future
capital from today’s levels, provided the following threesteps are taken into account.
1.	Recognise that the road is rougher and more
uncertain
As investors in individual companies or markets more
broadly, we must constantly differentiate between
volatility that is just short-term angst and a signal ofchange. Our approach is to always be open-minded to
new information that could undermine a particular thesis.
Our current thesis, however, is that we are experiencing
a regime change. More specifically, given the scale ofmonetary creation over the last decade, inflationary trends
are greater now than they were in the past.

ESG in the investment process

Appendix: How to choose between growth and ROICIn the shorter term, we expect a period of easing pressures
as higher interest rates cool inflation (and result in lower
growth) and supply chain pressures ease somewhat.
However, on balance, structural energy undersupply,
labour market constraints and military expenditures
could all contribute to ‘sticky’ inflation at rates above the
2-3% ideal for central banks. Risk-free rates will therefore
remain at higher levels for the foreseeable future.
Second, geopolitical uncertainty shows no signs ofabating as the battles for technology hegemony
between China and the US and Russia’s struggle formilitary supremacy in Ukraine continues. The free flowof capital across borders can no longer be assumed, thecost of borrowing in the US dollar – the world’s reserve
currency – will likely stay high. Additionally, we need to
be prepared for an increasing shift from China and otheractors who intend to move away from the US dollar as
the currency of external trade.
In short, we believe that growth in the broader economy will be less certain and more cyclical. As a result,
we do not expect the cost of capital to return to the
low levels seen in 2020–2021 any time soon.

Source: Getty Images

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Navigating the road ahead for global equities‘Future Quality’ companies

2.	Realise that this new road may be best travelledwith different vehicles
The good, albeit challenging, news for investors is thatwhen there is a regime change, as the significant market
correction seems to flag, there is a high probability that
there will be new leaders in the race ahead.
We have done some work on prior periods of significant
market corrections and what the probabilities are, with aclear caveat that the number of reference data points ismodest in total.
As a reminder, the leaders over the last cycle were theInformation Technology, Consumer Discretionary andEnergy sectors. Assuming they will automatically return
as market leaders is a brave call based on this work. Our
team’s view is that new leadership is likely to emerge
this time, given the scale of surplus of capital that has
just been allocated to those winners.
3.	Improve probabilities by sticking to a few
enduring principles
Invest in price makers versus price takers
It is not just the price for assets that has had favourable
tailwinds over the last decade, but also profitability.
Profit shares as a percentage of GDP have been at record
levels in most economies, and this has conditioned
investor behaviour, with recency bias leading many toassume this will remain the norm. Work by empiricalresearch previously highlighted that in the decade prior
to 2021, about half of the improvement in profit margins
for US manufacturers was down due to lower interest
costs and taxes. While lengthening of debt duration
may dilute the impact of rising rates, there is now a clear
headwind for interest costs while taxes similarly areheading upwards in many economies.
Gross margins are also being challenged by rising labour
inflation (and availability), a shift to more local and higher
cost supply chains, rising raw material input prices, and(particularly for those sectors previously benefittingfrom COVID-related revenue boosts) negative operating
leverage as sales decline. On average, times are getting
tougher for businesses, and franchise strength is being
tested more fully. Where products and business models
are unique, dominant or gaining share, the scope forpassing on costs to customers and sustaining volume
growth is greater.

ESG in the investment process

Appendix: How to choose between growth and ROIC

Ensure capital funding is sustainable
The cost of debt is going up notably, and as is always
the case, the availability of debt could become more
irregular. The degree of change in debt costs in US
dollars is much greater than in other currencies, andgiven its reserve currency status this raises the global costof capital for many businesses. In our view, self-funding
growth (high free cash flow) and balance sheets withappropriate and long duration debt will be better placed
to keep investing through down cycles. Cash-burning,
profitless business models likely won’t pass the test.
Focus on justifiable valuations
We have learned, sometimes through bitter experience,that the penalty for investing at inflated prices and a lackof future cashflows is quite burdensome. Compoundingof capital from levels that can be politely described as‘frothy’ is really difficult. When the music stops, falls of
80-90% are common for the frothy crowd, and more
often than not they stay down as profitability remains a
dream rather than reality.

WHERE WE FIND THE ‘FUTURE QUALITY’
WINNERSFor more seasoned investors, none of the above shouldbe particularly surprising. The next key question will
likely be where to invest capital within global equities?
In our view, companies on a unique journey of improvement that can attain and sustain high returns on
invested capital over the next five years or more offer
the best starting point. We call these ‘Future Quality’
companies, and they have been the foundation of ouralpha generation for more than a decade. Here are thecommon traits shared by Future Quality companies:
Energy transition
Energy transitions take a long time. The first modern day
energy revolution in the early 19th century, from woodto coal, fuelled great innovation that helped power the
first railroads and ocean-going ships. The introduction ofwidespread electricity in the 1880s, led to inventions suchas electric elevators, refrigerators and the mechanisationof agriculture. By the late 1920s, refined oil dominatedthe transport sector and reached a high point as apercentage share of all energy by 1973. Each transition
required massive infrastructure spend before thebenefits from adjacent technologies could be realised.
These were ‘system’ changes, fighting incumbents andvested interests, and on average took 50 years before
reaching maturation.

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Appendix: How to choose between growth and ROIC

Figure 1

Probability of maintaining leadership after market drawdowns greater than 20% (1957-2022)

1st Leader -

18%
2

0%
0

27%
3

4%
2

9%
1

9%
1

18%
2

2nd Leader -

18%
2

0%
0

0%
0

15%
7

9%
1

0%
0

9%
1

- 50%

- 40%

18%
2

18%
2

0%
0

10%
5

18%
2

0%
0

0%
0

- 30%
-

18%
2

36%
4

27%
3

48%
23

36%
4

55%
6

55%
6

3rd Laggard -

9%
1

18%
2

9%
1

8%
4

9%
1

18%
2

0%
0

2nd Laggard -

9%
1

0%
0

18%
2

12%
6

0%
0

9%
1

9%
1

9%
1

27%
3

18%
2

2%
1

18%
2

9%
1

9%
1

3rd Leader

2nd Leader

1st Leader

1st Laggard -1st Laggard

2nd Laggard 3rd Laggard

Next Cycle Probability

Next Cycle Position

3rd Leader -

- 20%

- 10%

- 0%

Previous Cycle Position

The above table looks at the probability of a sector in the equity market
leading in the next market cycle having led in the previous one. We may
all be familiar with the outsized gains made by the Technology sector inrecent years, but after the 20% drawdown in markets in early 2022, what
are the chances that a former market leader can repeat their outperformance in the next market advance?
This study ranks sectors for the US market back to 1957. It counts the bullcycle as the point of the price low after a 20% bear market to thesub­sequent price high before the next 20% drawdown. There were 11 suchcycles in the last 65 years. The question “what is the probability of techleading the market over the next five years or so” is answered in the top
right of the table. The answer is just a 27% chance of tech being in the top
two sectors for forward returns from here – in other words, it’s possible but
less likely than one might expect. In fact, the top left portion of the tableshows a higher probability that the next cycle could be led by those sectorsthat have lagged the most. This study underlines the need for investors tokeep an open mind as to where market leadership will emerge.

Source: RENMAC

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Navigating the road ahead for global equities‘Future Quality’ companies

We are optimistic about the fourth energy transition as
an investment theme, and believe that an enduring cycleof rising investment is now upon. Societies must address
the challenge of sustaining the still-needed fossil fuelproduction, increasing supply from more trusted regimes,
improving energy efficiencies, reducing emissions anddeveloping alternative energy sources further. The latter is
key from a climate perspective, but also energy-intensive
in its own right, creating a circular requirement for theother drivers. In short, the addressable market will growand surprise investors, and profitability for many suppliersof the “picks and shovels” of the energy transition is on
an improving trend. This is an increasing rarity in thecurrent environment.

ESG in the investment process

Appendix: How to choose between growth and ROICof spending may now normalise to more sustainablelevels as we see new funding rounds dry up and many
companies burn through cash reserves. This source ofadvertising spending will likely see a large drawdown,in turn prompting investors to reappraise their growth
assumptions for the leading digital media players.
We therefore do not consider these companies as
illustrative of the Future Quality theme; notable down­
grades are not a key attribute for enduring growth, andtherefore we have no exposure in this area.

Enduring growth
Given the environment of higher interest rates, andcontinued pressures on household consumption, we are
increasingly cautious on the growth outlook for many
consumer-facing companies. We believe that the falling
propensity to consume (due to greater spending on
mortgage and utility costs) and prior COVID-led pulling
forward of demand will be difficult and enduring
problems to overcome.
Sustainable growth that is less impacted by consumer
cyclicality is therefore preferable. Our long-standing
overweight in the Healthcare sector highlights that we
see the demand for better and more cost-effective
solutions across ageing societies as being a long-term
positive. Healthcare companies typically have lesscyclicality in demand and, in many cases, have been
indiscriminately derated in the reappraisal of higher
growth companies. We keep finding more Future Quality
picks here, where confidence in growth is higher
compared to other sectors.
One final comment on enduring growth is that we are
increasingly concerned about the prospects for digitaladvertising. Business start-ups and the costs of funding
for newer business models have ballooned in recent
years, as conducive capital markets have enabled initialpublic offerings (IPOs), SPACs and a flurry of activity inprivate equity funding. In 2021, start-up funding wasestimated at $650 billion in the US (Source: Crunchbase),roughly double the level of prior years. Many of thesewere technology-related firms with limited customers
and cashflow. We assume that 40% of this will end up in
customer acquisition/digital marketing, with the majority
going to key players such as Meta and Google. This level

Part 1 Summary
Within the Global Equity team, we believe ‘Future
Quality’ companies should have long competitive
advantage periods through which they can sustainhigh and/or improving cash returns. The challenge
for investors is that only a fraction of companies
within the global universe will display suchcharacteristics.
In Part 2, we take a deeper look at the Future
Quality concept, outlining the three fundamental
principles that underpin our definition of Future
Quality investments (value creation, long-term
outperformance, and competitive advantages).

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Appendix: How to choose between growth and ROICPart 2‘Future Quality’
companies

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Appendix: How to choose between growth and ROIC

‘Future Quality’ companies
The Nikko AM Global Equity team believes investingin ‘Future Quality’ companies will lead to outperformance over the long term. Part 2 draws on academic
evidence to outline the three fundamental concepts
underpinning our definition of ‘Future Quality’
investments.
First, we look at business value creation models. We assess
the level of excess cash return on invested capital earned
by firms – and the future sustainability of those returns– by assessing the firm’s competitive advantage period.
Second, we analyse past stock market returns tohighlight that it is not merely the level of excess cash
return on invested capital earned by a company thatdrives shareholder returns. Rather, the market rewards
companies that can allocate capital to improve cash
returns on investment and maintain their competitive
advantage.
And third, we assess the role of growth and its impact
on shareholder returns for businesses with high, medium
and low cash return on invested capital structures.

Drawing on this academic research, we explain in detailwhat we mean by ‘Future Quality’ and why we believe it
leads to long-term outperformance. If an investor cananticipate a meaningful positive change in excess return(cash return on invested capital minus cost of capital),
identify firms that have a longer competitive advantage
period than the market anticipates, and can reinvest thoseexcess returns into the business (growth), they should
generate shareholder returns above the market. These
are the characteristics of a Future Quality company.
Defining Future Quality
We define ‘Future Quality’ as a business that cangene­rate sustained growth in cash flow and high andimproving returns on invested capital at attractive
valuations. Our portfolios only comprise companies thatexhibit these characteristics and our research is devoted
to unearthing companies that meet our criteria.
This concept underpins the Global Equity team’s
investment approach, and our analysis of a stock’s‘Future Quality’ characteristics determines whether a
new investment opportunity merits inclusion in theportfolio or if an existing holding should be sold.

Future Quality companies are those that will attain and sustain high returns on investment.
Figure 2

Four pillars of Future Quality

Balance sheet

Valuation

FranchiseManagement

Growth is appropriately
financed, not reliant on
issuing significant debt
or new shares

Disciplined approach, paying
too much for a high quality
company can turn it into a low
quality investment

Lasting sustainable
competitive advantage,
protecting the high return on
investment over the long termSound strategic and capital
allocation decisions,
supporting high return growth
opportunities

ESG is firmly embedded in our process
High, long-term returns cannot be sustained with unsustainable business practises.

Source: Nikko AM

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Navigating the road ahead for global equities‘Future Quality’ companies

The Value Creation Model

Spread*Costof equity

Expected
growthof company

Appendix: How to choose between growth and ROIC

decision-­making should focus on allocating capital tobusiness units that can generate excess returns over thelong term.

Figure 3

Expected
returnon equity

ESG in the investment process

Value ofcommonequitySource: Professor Enrique Arzac, Harvard Business Review*Spread = Excess return on equity above cost of equity

When identifying ‘Future Quality’ companies, we analyse
several variables including management quality, franchisequality and balance sheet quality. We then combine thisanalysis with a disciplined valuation approach.
Excess return and the competitive advantage period
A company creates value by generating a spread between
its cash return on invested capital (CROIC) and the costof capital. The length of time this spread or excess returncan be earned by a company is known as its ‘competitive
advantage period’. Forecasting the sustainability of thisspread (competitive advantage period), the magnitude(excess return) and the ability to reinvest the excess
return into the business (growth) are key to determining
Future Quality attributes.
Focusing on the sustainability of excess returns andimprovements in CROIC is vital. The market rewards
companies that can improve returns and maintain theircompetitive advantage. In his paper titled ‘Do Your
Business Units Create Shareholder Value?’, Professor Enrique
Arzac of the Columbia Business School described thisconcept as the Simple Value Creation Model.3

Similar studies have explored the concept of value
creation over the years. Professor William Fruhan (Harvard
Business School) in his book ‘Financial Strategy: Studies in
the Creation, Transfer, and Destruction of Shareholder Value’4
concludes that the only way to increase the value of anasset is to influence either the cash flow derived fromthat asset or the discount rate (weighted-average cost ofcapital). He further explains that the profitability of a firmis based on the capital intensity, profit margins andleverage and that the value of the firm is determined by
the excess return, growth and the competitive advantage
period. Hogan et al. (1999)5 pointed out that shareholder
value is created when a company invests in projects
earning a return in excess of the cost of capital.
Value creation and share prices – are high returns
on invested capital all that matter?
Buying the best or worst quality company based on
historical returns is a poor investment strategy. Empiricalevidence suggests high or low return businesses exhibit
very little correlation to future shareholder returns.
Michael Mauboussin and Dan Callahan6 from Credit Suisse
HOLT conducted a ten-year study of historical returns
and forward share price returns. The universe (1,355 US
companies excluding financials and utilities) was divided
into quintiles based on HOLT’s cash flow return on
investments (CFROI) in 2002, with quintile 1 (Q1) being
the best return businesses and quintile 5 (Q5) being theworst. Figure 4 shows the performance of each quintile
over the subsequent ten-year period. This suggests thatlow quality companies (as defined by historical returns)
perform well and even better than their high-quality
counterparts; however, when risk is adjusted, there is no
discernible pattern. The Sharpe ratios for Q1, Q2, Q3, Q4

4 W
 illiam E. Fruhan, Jr., Financial Strategy: Studies in the Creation,
Transfer, and Destruction of Shareholder Value - Homewood 1979
pp. 7-15

Arzac identified the importance of the sustainabilityof that excess return in valuation. Management’s

5 James Hogan, Robert Neyland and Mark Greslee, “Creating Shareholder Value” – Electric Perspectives, September/October 1999 pp.
44-54

3 E nrique R. Arzac, “Do Your Business Units Create Shareholder
Value?” Harvard Business Review January/February 1986 pp. 123

6 M
 ichael J. Mauboussin and Dan Callahan, Economic returns,
Reversion to the Mean and Total Shareholder Returns – Anticipating
Change is Hard but Profitable, Credit Suisse Global Financial
Strategies 2013 pp. 2-7

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Appendix: How to choose between growth and ROIC

Figure 4

20%

20%

18%

18%

16%

16%

Q1

14%

14%

Q2

12%

12%

10%

TSR

TSR

Total shareholder returns (2003-2012) by quintile based on 2002 CFROI ranking

Q1

Q2

Q3

Q4

10%
20%

Q5

Q5

Q4
Q3

30%

40%

50%

Standard Deviation

Source: Credit Suisse HOLT and FactSet

and Q5 were 0.45, 0.34, 0.42, 0.41 and 0.29, respectively.
However, improving future returns is a very powerfuldriver of share prices. Using the same sample, Michael
Mauboussin and Dan Callahan7 found the stocks with thelargest improvement in returns over the ten-year period(i.e., moved from Q5 to Q1) delivered the highest returns,
whereas stocks that migrated from the top quintile tothe bottom quintile delivered the weakest returns.
This suggests the change in investment matters most.

Importantly, the persistence in high returns together
with improvements in return, which is integral to a firm’s
competitive advantage period, is a bigger driver of future
shareholder return. Looking at the same data, those stocks
that showed persistence in high returns over the period
had higher returns and a significantly higher Sharpe ratio.
Stocks that started in Q1 and remained in Q1 for theten-year period delivered a total shareholder return of
19.2% with a standard deviation of just 22.8%. These
companies essentially ‘beat the fade’ or had a longer
competitive advantage period than the market forecast.

7 Michael J. Mauboussin and Dan Callahan, Economic returns,
Reversion to the Mean and Total Shareholder Returns – Anticipating
Change is Hard but Profitable, Credit Suisse Global Financial Strategies
2013 pp. 2-7

Figure 5

Total shareholder returns (2003-2012) for all 2002 to 2012 quintile combinations

2002 Quintile

Q1

Q2

Q3

Q4

Q5

TSR

St Dev

TSR

St Dev

TSR

St Dev

TSR

St Dev

TSR

St Dev

Q1

19.2%

22.8%

12.9%

27.4%

11.7%

41.8%

7.4%

23.9%

6.3%

27.2%

Q2

17.9%

29.9%

17.2%

26.9%

11.1%

21.1%

6.6%

26.0%

3.9%

28.1%

Q3

24.4%

27.7%

15.3%

26.0%

20.4%

31.4%

13.9%

28.3%

9.3%

32.2%

Q4

29.0%

33.4%

23.0%

34.4%

15.1%

31.6%

18.9%

39.3%

10.9%

27.7%

Q5

27.2%

54.3%

25.4%

43.7%

20.6%

59.6%

16.7%

38.3%

10.2%

44.5%

Source: Credit Suisse HOLT and FactSet

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Navigating the road ahead for global equities‘Future Quality’ companies

If an investor can anticipate a meaningful positivechange in excess return (cash return on invested
capital – cost of capital), identify firms that have alonger competitive advantage period than the market
anticipates and can reinvest those excess returns into
the business (growth), they will generate share­
holders returns above the market. These are thecharacteristics of a Future Quality company.
The importance of growthThis concept was explored further in two McKinsey research
papers that investigated the relationship between total
returns to shareholders and the change in return on
invested capital (ROIC). Published in 2006 and 2007
respectively, ‘Balancing ROIC and growth to build value’ 8and ‘How to choose between growth and ROIC’ 9 both also
incorporated the impact of growth (as defined by change
in revenues). They identified high correlations between
value creation, growth and returns and showed that if
companies grew faster and increased returns more thanthe market, they subsequently outperformed the market.
These two studies highlight the importance of focusing
on changing profitability as a driver of share pricereturns. However, neither study incorporated a cost ofcapital or discount rate due to the inherent challenges
of assigning an appropriate cost of capital to individualcompanies in an empirical exercise. True wealth creation
does not come from the absolute level of ROIC, butfrom the spread between returns and the cost of capital.
Wenner and LeBer10 in 1989 spoke of the importance ofmanagement’s focus on shareholder value analysis (SVA)– the process of analysing how business decisions affecta company’s economic value (net present value of the
expected cash flows discounted at the cost of capital).
They emphasised that long-term cash generation isrewarded by the market, not growth for growth’s sakeor earnings per share.
It is also important to understand the relationshipbetween growth and excess returns. When a company

8 B ing Cao, Bin Jiang, and Timothy Koller, “Balancing ROIC andgrowth to build value” - McKinsey on Finance Spring 20069 B
 in Jiang and Timothy Koller, “How to choose between growth and
ROIC” - McKinsey on Finance Number 25 Autumn 2007 pp. 19-22
10 David Wenner and Richard Leber, Managing for Shareholder
Value – From Top to Bottom (Harvard Business Review,
November – December 1989)

ESG in the investment process

Appendix: How to choose between growth and ROIC

Figure 6

Change in terminal value based on changes in growthand excess returns
Excess return = -2%

Excess return = 0%

$1,400.00

Excess return = 2%

Terminal value increases as growth increases$1,200.00

ROC=12% vs WACC=10%

ROC=10% vs WACC=10%$1,000.00
ROC=8% vs WACC=10%$800.00

Terminal value decreases as growth increases$600.00$400.00$200.00
$0.00

0%

1%

2%

3%

4%

5%

Source: Aswath Damodaran, Stern School of Businessis generating excess returns, growth will be rewarded.
When a company is generating returns below thecost of capital (in other words, destroying value),
growth will be penalised. In the example shown in
Figure 6, Aswath Damodaran11, Professor of Finance at
New York University Stern School of Business, highlights
the change in terminal value based on changes ingrowth and excess returns. If a company is generating
returns in line with its cost of capital, growth will not
be rewarded or penalised, meaning the terminal value
will remain unchanged.
Cash-based measures of value creation
We believe cash flow is a better measure of profitability
than reported or operating earnings and has a higher
predictive power than the other two measures interms of shareholder return. We therefore focus on
CROIC, rather than the return on equity metric used in
Arzac’s12 Value Creation Model and Fruhan’s13 study.

11 Aswath Damodaran, “Return on Capital (ROC), Return on
Invested Capital (ROIC), and Return on Equity (ROE): Measurement& Implications” – Stern School of Business July 2007 pp. 62-64
12 Enrique R. Arzac, “Do Your Business Units Create Shareholder Value?” Harvard Business Review January – February 1986 pp. 123
13 William E. Fruhan, Jr., Financial Strategy: Studies in the Creation,
Transfer, and Destruction of Shareholder Value - Homewood 1979

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Navigating the road ahead for global equities‘Future Quality’ companies

Kenneth Hackel, Joshua Livnat and Atul Rai14 havewritten extensively on the subject and demonstrated
that investment strategies based on free cash flows
have merit.
Models linking cash returns and cost of capital (also known
as value-based measures), started evolving meaning­fully
about 30 years ago, and this forms the basis of ouranalysis. The best-known value-based measures are
economic value added (EVA), cash flow returns on
investment (CFROI), shareholder value added (SVA),
economic margin (EM) and cash value added (CVA).
For more detail on each of these, Daniela Venanzi15 in‘Financial Performance Measures and Value Creation:
the State of the Art’ is a good reference.
The other benefit of these value-based measures is thatthey allow investors to compare corporate performanceand profitability globally. Accounting differences between
regions are reconciled and given the cost of capital isembedded in some of these calculations, a clear comparison can be made between firms around the world.
We have identified that improving and sustainably highcash returns are correlated with positive relative shareprice returns, and that this is enhanced when combinedwith growth.
It also requires a robust valuation framework to identify
the most attractive opportunities. In ‘Measuring andManaging the Value of Companies’ 16 Tim Koller,
Marc Goedhart and David Wessels discuss the value-­
based concepts in detail and define the fundamental
principles of value creation.

ESG in the investment process

Appendix: How to choose between growth and ROIC

Figure 7

ROIC and growth drive multiples(

Value = Invested Capital x ROIC x 1 –

g
ROIC

)

WACC – gSource: Tim Koller, Marc Goedhart and David Wessels

The above calculation sets a framework, but assumes
growth and ROIC remain constant in perpetuity. It doesn’t
integrate an appropriate competitive advantage period,
after which returns would fade towards the cost ofcapital. This can be addressed in part by incorporating a
two-stage discounted cash flow model with appropriate
terminal assumptions. Many value-based valuation
models, including CFROI and economic margin (EM),incorporate a specific competitive advantage period
over which a company can generate excess return, after
which returns will fade towards the cost of capital orweighted-average cost of capital. This is appropriate as
most high return businesses and industries will attractcompetition and will see their returns erode over time.
Similarly, low return businesses and industries will see
competitors exit the industry and can see their returns
rise over time. Aswath Damodaran17 outlined theseconcepts in his paper ‘Return on Capital (ROC), Returnon Invested Capital (ROIC), and Return on Equity (ROE):
Measurement & Implications’.
This is the theory behind HOLT’s Competitive Life-­
Cycle Framework as outlined below and analysed byBart Madden18 in ‘Maximising Shareholder Value and
The Greater Good’. A typical firm will move through fourphases of profitability and growth through its life.

14 Kenneth Hackel, Joshua Livnat and Atul Rai, “A Free Cash Flow
Anomoly” Journal of Accounting, Auditing & Finance Volume 15
Winter 2000
15 Daniela Venanzi, “Financial Performance Measures and Value
Creation: the State of the Art” Springer Milan Heidelberg Dordrecht
London New York 2012 pp. 13-30
16 Tim Koller, Marc Goedhart and David Wessels, “Valuation – Measuringand Managing the Value of Companies” - McKinsey & Co Fourth
Edition pp. 66

17 Aswath Damodaran, “Return on Capital (ROC), Return on
Invested Capital (ROIC), and Return on Equity (ROE): Measurement &Implications” – Stern School of Business July 2007 pp. 53-60
18 Bart Madden, “Maximising Shareholder Value and the Greater
Good” – LearningWhatWorks 2000 pp. 7-10

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ESG in the investment process

Appendix: How to choose between growth and ROIC

Figure 8

HOLT’s Competitive Life-Cycle Framework
High Innovation

Fading CFROIs

MatureFailing Business Model

FADE

CFROIsCost of Capital

Reinvestment Rates

Source: Credit Suisse HOLT

To value the company appropriately, an investor must
therefore forecast economic cash returns, growth,required operating assets and the competitive advantage
period.
Madden’s work highlighted that in most cases, positive
shareholder returns are associated with ‘surprising’
positive patterns of actual fade in relation to earlier
expected patterns for that period and vice versa.
In other words, the company was able to grow andgenerate excess returns for longer than expected, so
the competitive advantage period was longer than themarket forecast.

In summary, value-based profitability measures are betterat identifying corporate performance. The change inthese profitability measures, growth and the competitive
advantage period are key drivers of future share priceperformance, and the capital allocation decisions ofmanagement will impact both.
Future Quality companies will have long competitive
advantage periods through which they can sustainhigh and/or improving cash returns. The challenge forinvestors is that only a fraction of companies within
the global universe will display such characteristics.

Earll Murman et al.19 in the book ‘Lean Enterprise Value’stated: “Understanding value creation is not difficult, but
determining the specific actions to create value can be
more complex and a challenge, especially in a changing
world”.

How Nikko AM’s Global Equity team identifies
Future Quality
Recognising Future Quality requires long-term
fundamental research. To evaluate whether anindividual investment may meet our Future Quality
criteria, we focus on several factors that help us toaccurately forecast the competitive advantage period.

19 Earll Murman, et al., “Lean Enterprise Value” – Palgrave Macmillan /The Lean Enterprise Foundation 2002 pp. 177

Understanding the quality of the franchise helps us makeinformed assumptions on growth rate, profitability and

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Navigating the road ahead for global equities‘Future Quality’ companies

ESG in the investment process

the competitive advantage period of the company.
As Michael Porter20 explains in his “value chain approach”,
the profitability of a company is influenced by its industry
structure (quality of the franchise) and the strategic
decisions (quality of management) it makes. The company’s
profitability is influenced by industry attractiveness(Porter’s21 five competitive forces) and its position withinthat industry will dictate whether it can generate
above-industry or below-industry returns (competitive
advantage period).

Appendix: How to choose between growth and ROIC

governance, identifiable and aligned incentive
programmes, an excellent track record, and disciplined
capital allocation. Ideally all stakeholders should benefit
from management actions as this will ensure a moresustainable business. The quality of management is
integral to understanding the sustainability of a firm’s
competitive advantage period. Management’s capital
allocation decisions will have a meaningful impact on
the competitive advantage period and the ability togenerate excess returns. This is clearly a crucial factor
in the financial outcome for shareholders.

In assessing the quality of management, we look fora strong and consistent strategy, good corporate

The quality of balance sheet underpins the company’s
growth aspirations. A strong balance sheet will be able
to finance profitable growth and make the management
team’s capital allocations decisions far easier. Investors
must focus on funding sources and the cost of thatfunding, the leverage within the business and working
capital requirements and changes.

20 Michael Porter, “Competitive Advantage” – The Free Press.
New York 1985 pp. 11-15
21 Michael Porter, “How Competitive Forces Shape Strategy” – Harvard
Business Review, March/April 1979 pp. 137-145

Figure 9

Future Quality – the change in return on invested capital impacts performanceHigh Quality
Strong Fundamentals
Highest Quality
1st quintile

am

en

ta

ls

Highest Quality
1st quintile

Beating the Fade
High Quality companies that can keep
compounding longer than anticipatedHighest Quality
2nd quintile

Climbing to the Top
Companies with improving returns thatcan maintain high returns in the long run

Average Quality
3rd quintile

Average Quality
3rd quintile

It is the future quality that counts!

Low Quality
4th quintile

Low Quality
4th quintile

Fallen Champions
Return on capital revert to the mean or
below, the returns were not sustainable

Highest Quality
2nd quintile

Im

i
ov
pr

ng

n
Fu

d

Lowest Quality
5th quintile

Lowest Quality
5th quintile

Year 1

Year 5

Digging Continues
Companies in a hole that keep digging,returns are not sufficient nor improving

Likely tooutperform

Unlikely tooutperform

Source: Nikko AM

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ESG in the investment process

Appendix: How to choose between growth and ROIC

Valuation through analysis of the balance sheet,management and franchise, allows us to forecast growth,margins and asset turns of the business, the capital
expenditure and funding requirements, the competitive
advantage period and cost of capital. These are the key
components to calculate future CROIC and the value ofthe company, and helps us to make an informed decision
as to whether a potential investment is Future Quality
and valued attractively.
Future Quality companies should outperform themarket over the long term
Future Quality investing aims to identify companies thatcan generate superior or improving cash returns above
the cost of capital and have competitive advantage periods longer than the market anticipates. Simply buying
the top quintile highest quality companies alone does
not lead to outperformance, rather it is the future qualityof the companies that impacts performance. Figure 9
illustrates that Future Quality businesses with ‘Strong
Fundamentals’ generate high returns on invested capital
today which we forecast to be sustainable due to theirextended competitive advantage position. These arecompanies that can “beat the fade” in returns. Companies with ‘Improving Fundamentals’ are generating
lower returns on invested capital today, but we expect
them to generate substantially higher returns in the
future. These are companies that we forecast to surprisepositively as they generate incrementally better returns
over time.

Part 2 Summary
Regardless of the starting point, Future Quality
investing is about identifying companies that can
attain and sustain high returns on investment in
the future. We believe a portfolio of Future Quality
companies should outperform the market overthe long term.
In Part 3, we look in greater depth at how
Sustainability and Environmental, Social andGovernance (ESG) issues are an integral
component within our definition of Future
Quality investments, and within the Global
Equity Team’s investment process.

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ESG in the investment process

Appendix: How to choose between growth and ROICPart 3

ESG in theinvestment
process

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Navigating the road ahead for global equities‘Future Quality’ companies

ESG in the investment process

Appendix: How to choose between growth and ROICESG in the investment process
Building on our first two sections, Part 3 frames
how the Global Equity team integrates ESG factors
into our investment process. We considered thegrowing body of academic research as well as ourown investment experience to determine that ESG
has become an integral part of being a fundamental investor.
There are four pillars to Future Quality investing, eachcontributing to the investment case. Some, such as thestrength of a company’s balance sheet, give a picture offinancial health at a specified date. However, the Global
Equity team believes a company’s value is a reflection of
its future earnings – hence our focus on Future Quality –and that these future earnings are determined by strengthof both the company franchise and its management.
We spend a great deal of our time on the analysis ofthese critical variables.
Like with balance sheet data, ESG ratings add value by
providing a snapshot of a company’s status. However,
ESG factors are contingent liabilities or assets that aren’t
standardised and are often difficult to measure. If suchfactors are significant, they will impact future returns andconsequently corporate value. Therefore, understanding

Figure 10

how ESG factors might influence future returns makes
integrating ESG an essential part of being a fundamental
investor. Our detailed conclusions are:• Correlation: There is increasing evidence of a strong
correlation between companies with high ESG scoresand financial performance. However, there are limitations
to ESG data and the data itself doesn’t explain why
ESG matters.
• 	Corporate value: ESG factors influence value in many
ways. The sustainability of a company’s future returns
can be influenced by Environmental and Social factors,
while Governance acts as the mechanism for establishing
how a management team is likely to allocate capital in
the future.
• 	Decision-making: Engagement, in the form ofinvestigative discussion with management through tovoting, provides long-term investors with a uniqueposition to determine which ESG factors may be material
and are therefore better placed to add value.
The rise of ESG
It is becoming increasingly recognised that companies
cannot achieve high, long-term returns with unsustain­
able business practises. ESG factors can help identify

Four Pillars of Future Quality

The four pillars of Future Quality: Subjective Nature of Franchise and Management Quality

Balance sheet

Valuation

FranchiseManagement

Growth is appropriately
financed, not reliant on
issuing significant debt
or new shares

Disciplined approach, paying
too much for a high quality
company can turn it into a low
quality investment

Lasting sustainable
competitive advantage,
protecting the high return on
investment over the long termSound strategic and capital
allocation decisions,
supporting high return growth
opportunities

Objective

Subjective

ESG is firmly embedded in our process
High, long-term returns cannot be sustained with unsustainable business practises.

Source: Nikko AM

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Navigating the road ahead for global equities‘Future Quality’ companies

ESG in the investment process

Appendix: How to choose between growth and ROIC

Figure 112017 ESG survey of ‘mainstream’ investor responses to: ‘do you consider ESG information when making investment
decisions?’
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%

Yes

ESG Informationis Material
to Performance

Growing
ClientDemandCan Bring
About
Change at Firms

No

No
Stakeholder
DemandYes, Because:

Lack Reliable
Ineffective at
Non-Financial Bringing About
Data
Change at Firms
No, Because:

Source: Amel-Zadeh, A., and George Serafeim, “Why and How Investors Use ESG Information: Evidence from a Global Survey.” Working Paper, SSRN23 (2017)change and the potential for accelerating returns(see Figure 11). Certainly, the growing interest is reflectedin strong asset flows across the globe22 but none of this
explains the changing attitude of asset owners.
The age of the millennials
Demographic trends suggest a huge transfer of wealthis underway. Millennials are inheriting billions of dollars
from their parents and this new group of investors havedifferent expectations as to how their money is managed.
These investors are increasingly asking how their returnis generated.

impact in these areas is a key consideration when
they make investment decisions.
Wealthy individuals across generations are interested
in investing for environmental or social impact, but
millennials are by far the most active in evaluating andindeed, demanding these strategies. We believe thisshift is secular and this paper explains how we add value
for our clients by integrating ESG into all aspects of our

Figure 12

Where will millennials invest?

Consider the following survey data:•	66% of all US consumers think it is important forbrands to take a stand on issues like harassment,
discrimination, and diversity.
•	44% of full-time millennial employees would feel moreloyal towards their organisation if their CEO took astand on a hotly-debated issue.
•	76% of millennials believe their investment decisions
are a way to express their social, political and environmental values, while 87% said that a company’s

87%
64%

65%
48%

46%

Men

Women

Millennials

Gen X

39%

Boomers Silent

The majority of Millennials, Gen X and women believe that acompany’s track record in environmental, social and governanceis an important consideration for investing. In fact, 37% of all
high-net-worth investors are reviewing their portfolio’s for impact
investments.

22 Global Sustainable Investment Alliance, 2020 Industry Report
23 Amel-Zadeh, A., and George Serafeim, 2017. “Why and How Investors
Use ESG Information: Evidence from a Global Survey.” Working Paper,
SSRN

Source: Bank of America’s US Trust 2018 Wealth & Worth Report

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Navigating the road ahead for global equities‘Future Quality’ companies

investment process. First, we start with a brief summaryof the research.
Value of ESG data
The reporting of ESG data is a relatively new field. MSCI
only started rating companies in 2006. Given the increasing
interest in the area, there is a growing body of research
testing the link between ESG factors and investment
performance. With more than 1,000 studies on the subject,featuring a broad range of negative, neutral and positive
conclusions, consensus has been difficult to find.24
However, in our search for Future Quality companies, wehave found some areas of ESG that we believe add value.
For example, Kim et al. (2012) examined the relationshipbetween sustainability scores and earnings quality.25
Their conclusions suggest a link between the quality ofreported earnings and companies deemed to follow
socially responsible practices. They found that firms
exhibiting strong ESG characteristics are less likely (1) tomanage earnings through discretionary accruals, (2) tomanipulate real operating activities, and (3) to be thesubject of SEC investigations. These characteristics are
all disqualifying from a Future Quality perspective.
Other academic studies (Gompers et al., 2003), using avariety of indicators of effective corporate governance,
have provided evidence that companies with stronger
shareholder rights and management accountability havedelivered stronger fundamental performance over time.26
More recently, MSCI published research (Cass Business
School; Giese et al., 2017), found data supporting theassertion that high rated ESG companies were higher
quality companies compared to bottom quintile
companies,27 as measured by profitability.
In other words, well managed, quality companies shouldbe effective at managing their ESG risks. The economic
rationale for this transmission is explained in Godfrey et al.

ESG in the investment process

Appendix: How to choose between growth and ROIC

(2009),28 Jo and Na (2012)29 and Oikonomou et al.
(2012)30. This body of work shows that companies withabove-average ESG scores typically have above-averagecompliance standards and risk control, and suffer lessfrom severe incidents that result in significant shareprice loss. Moreover, Giese et al., Gregory et al., (2014)31
and Nagy et al. (2015)32 also found significantly predictive power from changes in ESG factors.
The limitations of ESG data
Although a selective review of the research suggests ESG
ratings add value, we are wary of the inherent limitationsof relying too heavily on ESG data in our process.
The first limitation is the lack of standardisation andlegal authority given to the quantification and disclosureof data by management teams. Unlike the accounting
profession – which benefits from decades of standardisation backed by case law – ESG remains in its infancy.
One of the main pillars of the accounting profession is
the understanding of materiality. Every day, evidence ofmaterial ESG factors is wide ranging: extreme weather;
man-made disasters such as the Deepwater Horizon oil
spill; child labour, to name but three. However, all ofthese are easily identified after the event. Identifying amaterial ESG factor ahead of time, understanding howthat might alter value and whether it should be disclosed
is significantly more problematic. One of the common
features between the ESG pillars is their contingent
nature. And contingent events are inherently difficult toestimate and enforce disclosure. This issue is evidenced
by the existence of the Sustainable Accounting Standard
Board (SASB), which has a focused framework for targeting
disclosure of ESG factors based on the SEC’s interpretationof materiality.

28 Godfrey, Merrill & Hansen, 2009, The relationship between
corporate Social responsibility & shareholder Value, Strategic
Management Journal, Vol 30, pp. 425-445
29 Jo & Na, 2012, Does CSR Reduce firm risk, Journal of Business
Ethics, Vol 110, pp. 441-456

24 For examples see Carpenter et al. (2009) and Fulton et al. (2012)
25 Kim et al. (2012)26 P. Gompers, J. Ishil, A. Metrick, Quarterly Journal of Economics,
Vol. 118, No. 1, February 2003
27 Giese, Lee, Melas, Nagy & Nishikawa, Foundations of ESG Investing,
November 201730 Oikonomou, Brooks & Pavelin, 2012, The Impact of Corporate
Social Performance on Financial Risk & utility, Financial
Management, Vol 41, pp. 483-515
31 Gregory, Tharyan & Whittaker, 2014, Corporate Social responsibility
and Firm Value; Strategic Management Journal, Vol 30, pp. 633-657
32 Nagy, Kassam & Lee, 2016, Can ESG add Alpha? An analysis of ESG
Tilt and Momentum Strategies, Journal of Investing, Vol 25, No.2 ,pp. 113-124

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Navigating the road ahead for global equities‘Future Quality’ companies

The second and more often raised issue with ESG research
to date is the inability to split correlation from causality.
Academic research has identified the statistical issue ofcorrelation mining (Harvey et al., 2016)33 and a lack ofdifferentiation between correlation and causality (Kruger
et al., 2015).34 Even where some research has attempted totest the transmission mechanism behind why high ESG
scores might lead to improved financial performance,
researchers have suffered from a lack of data.35 That the
ESG data industry is still in its infancy presents an issue
for those needing statistical proof that ESG adds value.
The third and final issue with ESG data is that most of itis backward looking. In a similar way that companies
with high returns today may not generate high returns
in five years’ time, companies with high ESG scores today
may not be tomorrow’s quality companies. Finding acompany in an industry with high returns or a high ESG

33 Harvey, Liu and Zhu, 2016, Review of Financial Studies, Vol 29, No.1,
pp. 5-68
34 Krueger,P 2015, Corporate Goodness and shareholder Wealth,
Journal of Financial economics, Vol 115, No. 2, pp. 304-329
35 Giese et al. (2017), as above, pp. 26

Figure 13

ESG in the investment process

Appendix: How to choose between growth and ROIC

score is not enough. Finding a good business capable ofsustaining high performance requires a thorough under­
standing of the conditions the company operates in as
well as an assessment of both its management and its
governance structure.
We believe ESG has greater value in understanding thetransmission mechanisms behind why the link between
high ESG scores and quality may be high. Giese, Lee etal., try to address this issue by reviewing three different
transmission mechanisms: cash-flow generation, tail risk
management and systematic risk such as increased
regulation. However, with just over a decade of MSCI
ratings data, they have concluded that data sets are too
small and that it is difficult to differentiate between
causality and correlation.
The transmission mechanism and context is important
as without that we are unable to determine whether ahigh ESG score has led to better returns or lower risk, or
if the high returns have simply afforded a management
team the resources to address these risks. Without under­standing the transmission channel, we are unable tounderstand how ESG might improve returns or how
management might allocate capital to sustain highreturns into the future.

Four Pillars of Future Quality

The four pillars of Future Quality: Franchise Quality

Balance sheet

Valuation

FranchiseManagement

Growth is appropriately
financed, not reliant on
issuing significant debt
or new shares

Disciplined approach, paying
too much for a high quality
company can turn it into a low
quality investment

Lasting sustainable
competitive advantage,
protecting the high return on
investment over the long termSound strategic and capital
allocation decisions,
supporting high return growth
opportunities

Objective

Subjective

ESG is firmly embedded in our process
High, long-term returns cannot be sustained with unsustainable business practises.

Source: Nikko AM

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Navigating the road ahead for global equities‘Future Quality’ companies

Figure 14

Michael Porter’s five forces that shape industry structure
Threat of new
entrants

Bargaining powerof suppliers

Rivalry
among
existing
firms

Bargaining
power of buyers

Threat ofsubstitutes

Source: M ichael E. Porter, Competitive Strategy, New York:The Free Press (1980)

A company’s fair value (and ultimately its share price)
should equate to the present-day value of those future
returns. Therefore, ESG is an integral part of the subjective analysis required in understanding likely future returns.
This is important because it is the assessment of acompany’s competitive advantage period (‘Franchise
Quality’) and how they invest their capital (‘Management
Quality’) that will determine the likely cash flow returns
the company will achieve in the future. We discuss how
ESG impacts a company’s Franchise Quality first.
Franchise Quality: ESG and the sustainability of returns
We believe the link between ESG and a company’s future
returns is intuitive and that ESG must form a core part ofunderstanding a company’s future return profile – what
we call ‘Franchise Quality’. The Franchise Quality of abusiness is one of the four pillars of our Future Quality
investment philosophy.

ESG in the investment process

Appendix: How to choose between growth and ROIC

and understanding how external forces within anindustry might alter a company’s future return profile.
Importantly this framework demonstrates that a firm
does not operate in a closed loop. External forces willundoubtedly have an impact such as how suppliers or
consumers behave.
Traditional theory (based on Graham & Dodd’s ‘Security
Analysis’), provides a logical approach for making
investment decisions and requires a qualitative assessment of financial performance and value. Analysis byexperienced investors of a wide variety of public infor­mation, supplemented with management interviews
combine to create a ‘mosaic approach’ to long-term
investing.
The historical foundation of this approach assumes thatvalue is aligned with book cost. However, this link has
dissipated in recent decades as capital intensity has
decreased and the hold of technology on society hastaken root. Intangible assets such as brand value,
reputation, trust, research and development (R&D) pipe­lines, employee turnover and equality have all exerted agreater influence on management action and returns.
According to Mauboussin et al. (2013),37 there are threebroad sources of added value: production advantages,
consumer advantages, and external factors. Production
advantages are easier to contextualise and may include
resource or production economies of scale. Consumer
advantages are more prevalent in today’s technologicallyadvanced society, with natural network effects forcompanies such as Google. The final ‘external’ factor
impacting value includes subsidies, tariffs, quotas, andboth competitive and environmental regulation.
Changes in government policy can have a meaningful
impact on corporate value. Consider the impact ofderegulation on the airline and trucking industries,
Basel III on financial services, or subsidies on the solar
energy industry.

Porter’s Five Forces: the competitive advantage
periodMichael Porter’s Five Forces framework36 is the ‘gold
standard’ for analysing competitive advantage periods

Porter’s Five Forces and ESG
An obvious area of focus in the ESG field has been on
the external forces created by environmental legislationand its impact on a firm and industry returns, mostrelating to carbon pollution. Although many investors

36 Porter’s Five Forces, Michael E. Porter, Competitive Strategy, New
York: The Free Press, (1980)

37Mauboussin, Callahan & Majd, Capital Allocation: Evidence,
Analytical Methods, and Assessment Guidance, October 2016

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Navigating the road ahead for global equities‘Future Quality’ companies

Figure 15

The competitive advantage period and a company
ecosystem

Environmental
ImpactSupplier
Acces &
Viability

EnergyUse

Competitive
Advantage
PeriodWater
Use

Employee
Health

Employee
SkillsAppendix: How to choose between growth and ROIC

simply address this issue with exclusion policies, thisapproach may be too simplistic.
On the subject of exclusions, Porter’s work on thecompetitive advantage period and the impact of environ­mental legislation is controversial. Porter’s researchsuggests that strict environmental regulation does nothinder competitive advantage periods, but can often
lead to further advances.
This has been tested many times as summarised by
Ambec et al.,38 and concludes that there is a positive link,
although varied in strength, between regulation andinnovation. This work confirms our view that integrating
ESG isn’t confined to merely minimising risk but alsooffers up significant investment opportunities too.
Of course using the word ‘external’ is a misnomer.
Regulation, the environment, waste, diversity, employee
safety, etc. are all part of the company’s ecosystem.

WorkerSafetySource: N ikko AM, Harvard Business Review, Creating Shared
Value – Michael Porter and Mark Kramer

Figure 16

ESG in the investment process

38 Ambec, Cohen, Elgie & Lanoie, ‘The Porter Hypothesis at 20:
Can environmental regulation enhance innovation and competitiveness?’(2010)

Four Pillars of Future Quality

The four pillars of Future Quality: Management Quality

Balance sheet

Valuation

FranchiseManagement

Growth is appropriately
financed, not reliant on
issuing significant debt
or new shares

Disciplined approach, paying
too much for a high quality
company can turn it into a low
quality investment

Lasting sustainable
competitive advantage,
protecting the high return on
investment over the long termSound strategic and capital
allocation decisions,
supporting high return growth
opportunities

Objective

Subjective

ESG is firmly embedded in our process
High, long-term returns cannot be sustained with unsustainable business practises.

Source: Nikko AM

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Navigating the road ahead for global equities‘Future Quality’ companies

ESG in the investment process

Companies do not operate in a bubble and with theincrease in penetration of social media, management
teams are increasingly aware of how ESG factors caninfluence future returns. How and why management
chooses to invest capital will also have a significant
bearing on returns.
Management Quality: Governance and theallocation of capital
Governance is the mechanism for how a company
achieves its objectives. Our understanding of governance,and role of management, is key to determining whether
the company’s capital will be deployed effectively.
Since the world of business is dynamic, companies must
constantly assess trade-offs and make difficult decisions.
A clear strategy and objective will provide all stakeholders
with the starting point for assessing a company’s
prospects and evaluating performance.
Corporate behaviour is also impacted by local law, customs
and culture. As a general rule, companies that operate
under common law have the strongest protection forshareholders, whereas those operating under civil law
have weaker protection for shareholders and stronger
protection for other stakeholders, such as creditors.
These different starting points perhaps explain why
countries with a bias towards shareholder value also
generate higher returns than those with a morebalanced stakeholder approach. However, as is sooften the case, the statistics don’t tell the whole story.
To conclude that one specific country or approach ispreferable would be wrong.

Appendix: How to choose between growth and ROIC

Despite these differences, the framework for analysing
governance and management has not changed
significantly over the years. Graham & Dodd,39 in theoriginal edition of their ‘Security Analysis’, raised thequestion of governance by emphasising potential
conflicts of interests between stockholders and corporate management. The lack of information or control facedby ‘outside’ investors – known as the agency problem– is well known and the nature of the issues during thestart of the 20th century remains the same today.
Agency theory explains why management action may not
be aligned with shareholder interests. There are threeareas in capital allocation where these conflicts may arise:•	‘Size isn’t everything’: Company size is a crude proxyoften used for remuneration and may lead management teams to ‘empire build’.
• ‘Long shots’: Management teams may have a different
risk tolerance and may undertake high risk strategies
to achieve remuneration goals.
• ‘Short-termism’: Different time horizons can also leadto unwanted behaviours. The most common being
the focus on short-term returns or targets.
Determining the right incentive scheme for a company
is difficult. We can certainly point to the dominance of
earnings-based measures within incentive schemes –and in particular, ‘adjusted earnings’ – as a concern for
long-term investors. This is illustrated below:

39 Graham & Dodd, Security Analysis (1934)

Figure 17

Use of incentive metrics among 1,721 US companies
Count of US firms between 1998 and 2013
14,0007,000

0IncomeIndividual
goals

Returnon capital

Total shareholder
returnSales

Cashflow

Operations

Source: CSFB Holt Governance Database, ISS

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Navigating the road ahead for global equities‘Future Quality’ companies

The focus (and failure) of short-term incentives is ofparticular concern given the debate over timeline isultimately meaningless. There should only be one aim:
to generate value. This applies to activities that management expect to deliver value, both in the short term andlonger term.40
Ultimately, good ESG disclosure, appropriate longterm incentive schemes and a governance structurethat protects shareholders’ interests are all positive
signals, but are not in themselves substitutes for thevalue created from engaging with management.
Engagement: why engagement creates value
To have a greater understanding of how ESG may impact
future returns, engagement with management should
be a key goal for any fundamental investor. Discussions
with management regularly help us contextualise thelikely success of future capital allocation decisions andhow ESG factors may impact future returns.
Research to date – though limited – has shown a link
between engagement and long-term value. (Blackrock

ESG in the investment process

Appendix: How to choose between growth and ROIC

& Ceres41 and Dimson, Karakas & Li42). The full value
gained from appropriate engagement is best illustrated
by the following table developed for the Principles for
Responsible Investment (PRI) by O’Sullivan & Gond from
Cass Business School43.
Although the Global Equity team are active investors,
we are not activists. Our engagement with management teams is intended to help us understand how they
can achieve high returns and to assess whether they aregood stewards of our clients’ capital. We prefer to work
constructively with management teams rather thanagitating for change, although we will seek change
where we feel the sustainability of returns is at risk.
Voting is another key area of engagement. We vote on
all matters put to shareholders, following our voting
guidelines, investment philosophy and our clients’wishes. In normal circumstance we support company

41 Blackrock & Ceres, ‘21st Century Engagement, Investor Strategies for
Incorporating ESG Considerations into Corporate Interactions’ (2015)42 Dimson, Karakas & Li, Active Ownership. Review of Financial Studies(2015)

40 Alfred Rappaport , 2011 ‘Saving capitalism from short termism: how tobuild long term value and take back our financial future’ (NY: McGraw
Hill, 2011, pp. 140-142)

43 Cass Business School and PRI, ‘How ESG engagement creates value
for investors and companies’ (2018)
44 O’Sullivan & Gond (2018)

Figure 18

How engagement creates value
Value Creation
Dynamics
Communicative
Exchanging
Information
Learning
Producingand diffusing
knowledge
Political
Deriving politicalbenefits

Corporations

Investors

Clarifying expectations and enhancing accountability

Signalling and defining ESG expectations

Managing impressions and rebalancing misrepresentations
Specifying the business context

Seeking detailed and accurate corporate information

Anticipating and detecting new trends related to ESG

Building new ESG knowledge

Gathering feedback, benchmarking and gap spotting

Contextualising investment decisions

Developing knowledge of ESG issues

Identifying and diffusing industry best practice

Enrolling internal experts

Advancing internal collaboration and ESG integration

Elevating sustainability and securing resources

Meeting client expectations

Enhancing the loyalty of long-term investors

Building long-term relationships

Enhancing investors ESG communication and accountability

Source: PRI, O’Sullivan & Gond,44 Cass Business School (2018)

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management, however, we will withhold support or
oppose management where we believe it is in the bestinterests of our clients.
Stakeholder analysis is an integral part of what we do.
As Future Quality investors, we want to know whether
the company has a sustainable competitive advantage,
whether it has an organisational and governance structurethat will help management maintain and enhance thatcompetitive advantage, and if its structure provides
management with both accountability and strong
incentives to add value. We are also looking for evidence
that management is thinking about the company’s future;
about what the organisation will look like in 10-15 years
from now.

Appendix: How to choose between growth and ROICPart 3 Summary
ESG research helps us find Future Quality
companies and ESG factors are integrated inevery step of the research process. While ESG
ratings are imperfect, engagement helps us
understand where issues exist, and we use theinformation to help companies address areasof weaknesses. We believe long-term, active
investors have the opportunity to add value
by integrating ESG factors into their analysis.
We consider ESG to be an essential lens throughwhich to implement our Future Quality
philosophy.

Figure 19

Our Future Quality ESG Approach

ESG is firmly embedded in our process
High, long-term returns cannot be sustained with unsustainable business practises.

Stakeholder analysis is an integral part of our research process
Consumers

Company

Employees

Shareholders

Many companies are providing solutions to society’s largest challenges, including
expensive healthcare, climate change and pollution.

CustomerGood management teams have already identified the need to provide value forall stakeholders if they are to achieve and sustain high returns.

PlanetCompanies providing solutions to the world’s problems anddelivering stakeholder value are likely to be the long-term winners.

Society

Promoting ESG in the portfolio

Engagement & Integration

Substantially lower carbon
intensity vs the benchmark

ESG helps us find Future Quality companies and ESG factors areintegrated in every step of the research process
We undertake ESG research directly and do
not delegate ESG decisions to other teams

Zero UN Global
Compact violations

Zero ‘very severe’controversies

Zero
tobaccoZero controversial
weapons

ESG ratings are imperfect, engagement helps us understand why
and we help the company address weaknesses

Source: Nikko AM

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Navigating the road ahead for global equities‘Future Quality’ companies

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Appendix: How to choose between growth and ROIC

Investment guide conclusion
Our belief is that we have moved into a new regime
where inflation will be structurally higher, despite thelonger-term structural anchors of higher debt burdens,
ageing societies and ongoing technological disruption.
Energy markets remain constrained, labour in short
supply and fiscal policies remain vulnerable to thedemands from voters to alleviate the pressure on real
wages, particularly for lower income groups.
As focused stockpickers, the future profitability ofcompanies is always a priority for us. The advantage ofbeing active stock pickers is that we are not beholden to
the market weighting of past winners, burdened withpotentially bloated levels of profitability. Instead, we canfocus on companies more likely to experience positive
surprises in revenue and profitability in the coming
years.
In summary, the search for Future Quality stocks withenduring drivers of growth will continue to define ourportfolios. We believe that over the next 18-24 months,
the focus on companies capable of creating meaningfulvalue will only intensify. Future Quality companies will
therefore find themselves in a strong position. Ourconsistent focus on enduring high-return franchiseswith strong management teams, robust balance sheets
and credible starting valuations, will help us navigate apath through these challenges.

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Appendix: How to choose between growth and ROIC

Appendix:
How to choose
between growthand ROICGLOBAL EQUITY INVESTING IN AN UNCERTAIN AGE THE NIKKO AM FUTURE QUALITY APPROACH TO GLOBAL EQUITIES

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Appendix: How to choose between growth and ROIC

Appendix:
How to choose between growth and ROIC
Figure 20

High ROICFor companies that already have high ROIC, growth generates
higher TRS than further improvements to ROIC.
Total returns to shareholders (TRS)1 for companies with highreturns on invested capital (ROIC),2 1996-2005, %Median TRS
exceeds market

S&P 500 average = 6.9

Increased

7

Decreased

6

ROIC3

Below
Difference,
percentage points

Difference,
percentage
points15

811

Bin Jiang and Timothy Koller45 explored the relationshipbetween total returns to shareholders and the change in
ROIC. However, they took this a stage further and also
incorporated the impact of growth (as defined by change
in revenues). They identified high correlations between
value creation, growth and returns. They looked at HighROIC, Median ROIC and Low ROIC companies andanalysed the dynamics of these companies over a ten-year
period (1995-2005) when growth and returns improved
more or less than the market.

5

Above

Growth, CAGR of revenues

1

41	Median of compound average annual TRS from 1996 to 2005 foreach group of companies, adjusted for compound 1996-2005
average TRS of S&P 500 index companies (6.9%).
2	78 companies with 10-year average ROIC ≥20% and market
capitalization >$2 billion in 1995.
3	Excluding goodwill.
45 Bin Jiang and Timothy Koller, “How to choose between growth and
ROIC” - McKinsey on Finance Number 25 Autumn 2007 pp. 19-22

Source: B in Jiang and Timothy Koller

Figure 21

Figure 22

Medium ROIC

Low ROIC

Total returns to shareholders (TRS)1 for companies with highreturns on invested capital (ROIC),2 1996-2005, %Total returns to shareholders (TRS)1 for companies with highreturns on invested capital (ROIC),2 1996-2005, %Companies with medium ROIC must maintain their growth andimprove their ROIC.

Median TRS
exceeds market
Increased

S&P 500 average = 6.9

610

Difference,
percentage
pointsFor companies with a low ROIC, improvement in ROIC is clearly
more important than growth.

Median TRS
exceeds market

4

ROIC3

Increased

S&P 500 average = 6.9

11

Difference,
percentage
points

12

1

ROIC3
Decreased2
Below

Difference,
percentage points

7

5

Above

Growth, CAGR of revenues

4

Decreased

3

3
Below

Difference,
percentage points

7

4

Above

Growth, CAGR of revenues

851	Median of compound average annual TRS from 1996 to 2005 foreach group of companies, adjusted for compound 1996-2005
average TRS of S&P 500 index companies (6.9%).

1	Median of compound average annual TRS from 1996 to 2005 foreach group of companies, adjusted for compound 1996-2005
average TRS of S&P 500 index companies (6.9%).

2	129 companies with 10-year average ROIC ≥9% but <20% andmarket capitalization >$2 billion in 1995.

2	64 companies with 10-year average ROIC ≥6% but <9% and market
capitalization >$2 billion in 1995.

3	Excluding goodwill.

3	Excluding goodwill.

Source: B in Jiang and Timothy Koller

Source: B in Jiang and Timothy Koller

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Navigating the road ahead for global equities‘Future Quality’ companies

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Appendix: How to choose between growth and ROIC

Important
Information

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Appendix: How to choose between growth and ROIC

Important Information
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ESG in the investment process

Appendix: How to choose between growth and ROIC

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Navigating the road ahead for global equities‘Future Quality’ companies

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Appendix: How to choose between growth and ROIC

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About Nikko Asset Management
With over US$200 billion* under management,
Nikko Asset Management is one of Asia’s largest asset
managers, providing high-conviction, active fundmanagement across a range of equity, fixed income,multi-asset and alternative strategies. In addition, its
complementary range of passive strategies covers morethan 20 indices and includes some of Asia’s leadingexchange-traded funds (ETFs).
Headquartered in Tokyo since 1959, Nikko AssetManagement and its subsidiaries employ personnel
representing 25 nationalities, including 233 investment
professionals. The firm has a presence through subsi­
diaries or affiliates in a total of 11 countries and regions.
More than 400 banks, brokers, financial advisors and life
insurance companies around the world distribute thefirm’s products.

The investment teams benefit from a unique global
perspective complemented by the firm’s historic
Asian DNA, striving to deliver consistent excellence inperformance. The firm also prides itself on its progressive,
solution-driven approach, which has led to many
innovative funds launched for its clients.
For more information about Nikko Asset Management
and to access its investment insights, please visit thefirm’s homepage.

* Consolidated assets under management and sub-advisory of
Nikko Asset Management and its subsidiaries as of 30 June 2022.