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Hosking Post
• Taking on the blob – a case study in active
engagement (Dec 2021)
• Tandem – At Length, or How long is the
Cycle (Nov 2021)
• The Green Energy Revolution – trying to
see the wood for the trees (Oct 2021)
1
Hosking Post
Taking on the blob
A case study in active engagement
1
TAKING ON THE BLOB 1
Publicly-listed corporates are at a disadvantage. Unlike private firms, public companies face
intense and increasing scrutiny from an array of observers, intermediaries and other helpers.
Proxy advisors, institutional investors, environmental groups, politicians and NGOs are all now
vocal in lobbying the public company. A consequence of this trend is that boards of public
companies spend more time responding to the ever longer compliance agenda than in stewarding
the core business. Whilst this might (or might not) be appropriate for an oil major, many small-
and mid-cap public companies are increasingly disadvantaged. This is galling for practitioners of
public equity investing such as ourselves because asset allocators appear, inconsistently, to
accept differing standards of behaviour in the public and private spheres: in high-fee private
equity investments all manner of ruthless, goal-orientated behaviours are not just permissioned
but actively incentivised. Yet in the public equity bucket we see a relentless ratchet of compliance.
The result is a pattern of ‘lost’ public companies where the original corporate purpose is obscured
by a muddy Blob that has evolved in reaction to various external pressures.
Private equity has ruthlessly exploited this compliance arbitrage to take over these lost corporate
souls. Once private, these companies are then re-invigorated by refocussing management on the
core business, with incentives reset outside the harsh public glare. The public-to-private-merry-
go-round often comes full circle when, often just a few years later, these same companies
reappear, at higher valuations, to be re-sold to the good old public equity investors. Whilst this is
not particularly ‘new news’ – and we abstain here from commenting on the societal level inequality
driven by this low-to-high fee enrichment process – the opportunity for public market investors is
to resist this patsy-at-the-table position through the practice of genuine active management. By
joining forces with other shareholders it is possible to cut through the Blob and have a real impact.
1
Blob is a phrase made popular by UK politician Michael Gove
2
Foxtons: a £1bn brand
Foxtons is an ongoing case study of this approach. As an exceptional, category-defining private
company it ticked many of the lollapalooza boxes with a founder-led culture and win-win
stakeholder incentive framework that led to industry dominance. With positive capital cycle
tailwinds from a consolidating UK estate agency market (see quarterly report) and a leading
deployment technology platform (the MyFoxtons portal has over 700,000 active users), Foxtons
is well-positioned to transition into a digital-first agent model. However, its 8-year history as a
public company has seen the original sense of corporate purpose slowly calcify.
Founded in Notting Hill by Jon Hunt in 1981, Foxtons is one of the most recognised real estate
brokers in London and the South-East of England. Built on a brash, high-energy, sales-led
culture, the model historically generated c.2x the profitability of peers whilst simultaneously
achieving c.8% higher average selling price for clients than what was achieved by traditional
brokers: a client-centric, win-win business model. It achieved this result by putting the client – the
house seller – first. Traditional agency models contain an inherent conflict between the competing
interests of the vendor and purchaser. Although it is the vendor that pays the selling agent’s fees,
traditional agents often appear to act on behalf of the purchaser. In explaining the Foxtons’ model,
an early Foxtons pioneer relayed the following story:
“I used to go to dinner parties in Notting Hill where people would say to me ‘I hate Foxtons. They
are too pushy. I would never buy from them. But I would let them sell my house’. This was gold
dust for me. All I wanted were listings as that is what you ultimately get paid for. And the people
that give you listings are the people selling their house!”.
Sadly, for Foxtons, the Jon Hunt culture has started to wilt. Post-listing, a top heavy and
expensive C-suite has overseen a continuous ceding of market share to more nimble private
players. Where Foxtons used to be the number one agent by a large margin, it has started to
3
lose ground in key central London postcodes, despite having some of the best branch locations.
This has led to falling sales and profits. Shortly after its IPO in 2013 the share price peaked at
376p, representing an enterprise value of £1 billion – a multiple of around 20x the £45m of pre-
tax earnings. Fast forward to today and the business is on track to earn £15-20m of pre-tax profits
with the enterprise value shrinking to c. £100m. We are cognisant of the challenges facing the
group but see the £900m of value erosion post-IPO as an opportunity. Over the past two years
we have acquired c.13% of the company, doubling our stake during a Covid-related share issue
at 40p in May 2020.
Source: Hosking Partners, FactSet. Share price from 20 Sep 2013 to 09 Nov 2021. The portfolio holds this security. Not all purchases have been
included. This does not represent all the securities purchased or sold. Further details of the calculation methodology and a list showing every holding’s
contribution to overall performance during the period is available upon request. Past Performance is not a reliable guide to future performance.
Driving Board change
The market share losses, profitability declines and £900m of equity shrink post-IPO appear to
have had little impact on the board of Foxtons or the executives it oversees. The Board actually
increased CEO Nic Budden’s pay over this period, and in 2020 Mr Budden (in situ since 2014)
earned £1.6 million in total compensation – an extraordinary perverse reward structure that has
been overseen by a complicit board which collectively own less than 1% of the outstanding
shares. The incentive alignment issues are clear as day and we venture that no private equity
firm would have permissioned such rewards for failure.
4
Motivated by the inequity of management compensation, Hosking Partners engaged with the
board of Foxtons; the aim being to re-set the incentive framework. In early 2021 we started a
robust campaign of board lobbying. Initially this took the form of discussions with the (then)
chairman. An underwhelming response led us to write to the board in its entirety on three separate
occasions, setting out our view of the unacceptable nature of the CEO rewards and questionable
capital allocation. These letters are available upon request. Concurrent with this board pressure,
we reached out to other shareholders and encouraged them to censure management. At the
AGM over 40% of shareholders voted against the CEO’s remuneration report. In a letter of 17
May 2021, we called for the chairman to conduct a full review of Mr Budden’s tenure as CEO.
This was closely followed by a letter on 4 June where we expressed our disappointment at a
Foxtons capital markets event which failed to address our concerns over market share and
profitability erosion.
Having been frustrated by the lack of board responsiveness, we entered into a full-scale
collaboration with a group of other large shareholders accounting for around one third of the share
capital. 2 This was notified to and discussed with the UK Takeover Panel to avoid so-called concert
party rules – rules that put off most public equity investor engagement in such dialogue. In this
letter, dated 30 June, we requested an opportunity to discuss replacements for the chairman and
non-executive appointments. On 7 July, chairman Ian Barlow announced his decision to resign
and two months later it was announced that veteran property executive Nigel Rich would take
over as the new chairman.
2 Platinum Asset Management, 3G Capital Management, Catalyst Partners.
5A new chapter
As a former CEO of Hong Kong Land, chair of Hamptons International and also Segro PLC, Mr
Rich brings vast experience and a value creation mindset. He has already moved to appoint a
new non-executive in the form of Peter Rollings, a former Foxtons executive from the Jon Hunt
heyday, who joined on 1 December. This appointment should lead to an aggressive focus on
regaining market share. There are encouraging signs Mr Rich sees value in the business. He has
bought 500,000 shares in the past 6 weeks alone, whilst Mr Rollings has also recently bought
shares. Should Mr Rich succeed in reinvigorating Foxtons, the return on his investment could be
substantial. Pruning of the excessive central costs (a major feature of the Blob) together with a
return to historic transaction levels in the sales and rental sector could see the business achieve
pre-tax earnings north of £60 million. With a net cash balance sheet and current enterprise value
of just £100m the upside is clear. Not least, given the huge digital customer acquisition costs
required to replicate over 700,000 MyFoxtons portal users; conservatively we believe the
embedded value of the customer base alone accounts for more than the current equity value.
We think the value of this customer set will not be lost on potential acquirors of the business,
representing probably the best digital footprint in UK residential real estate. Whilst it is unlikely
the business would return to its prior peak multiple of 20x, an 8x multiple of the recovered
earnings would see the investment return near fivefold.
Victory is not assured. But without robust and concerted engagement, the value present in
Foxtons, and many mid- and small-cap equities, will continue to pass into the private equity
sphere. With the private equity boom showing no sign of slowing, public equity investors will be
required to be ever more active. We stand ready for that task, motivated by the prospect of
retaining for our clients the significant upside rewards.
Django Davidson and Sam Traill
December 2021
6Hosking Post
Tandem – At Length, or How
Long is the Cycle
1As we write, in the final quarter of 2021, the world is waking up from Covid-induced lockdowns,
global leaders are meeting at the COP26 Conference, and newspaper headlines are dominated
by the twin topics of supply chain disruption and energy price spikes. The inside pages meanwhile
are engaged in endless debates about inflation - what it means, how to measure it and whether
it is “transitory” (as Federal Reserve Chair Jerome Powell puts it) or longer lasting.
Against this backdrop, a number of stocks in the Hosking Partners portfolio have enjoyed some
long-awaited strong performance. In particular this applies to capital intensive companies,
whether those in “old economy” industries or, similarly reliant on their balance sheets, banks.
They include names such as Pacific Basin and Diana Shipping (both in dry bulk shipping), mining
names such as Teck, Freeport, First Quantum and Alcoa, oil stocks such as ConocoPhillips,
Apache and Canadian Natural Resources as well as a collection of companies in such disparate
areas as car rental (Avis Budget even before its meme explosion) and silicone (Ferroglobe).
Among our banking exposure, Bank of America and Wells Fargo have made strong contributions.
There might be a temptation to reach for today’s news topics of inflation (transitory or not),
disruption from the energy transition or logistics bottlenecks to provide the reasons why these
stocks have done well, but as students of behavioural finance we should be alert to the false
allure of availability bias. Rather what all the aforementioned stocks have in common - whether
they sit within shipping, mining, oil and gas or banking industries - is that they have suffered long
periods of poor returns on capital. This has led to investment being turned off, and now those
returns on capital are picking up sooner, to the surprise of the market. This can all be foreseen
by rudimentary capital cycle analysis.
Briefly described, the capital cycle framework predicts that an industry with high returns on capital
attracts new entrants, enticed by the prospect of enjoying those high returns. The consequence
2of this is that the rising competition causes returns to fall, eventually in some cases to below the
cost of capital; investment declines, capital stock becomes obsolescent, firms consolidate,
withdraw or close down. In time, an improving supply side causes returns to rise above the cost
of capital and the cycle begins again. At the same time, the equity market is tracking its own
cycle: investors are optimistic when returns are high, but share prices fall as industry returns
suffer from rising competition, reaching a nadir as returns bottom and capital exits, and finally
share prices pick up in anticipation of rising returns again. The opportunities for capital cycle
investors arise in two broad areas. Firstly, where the market anticipates the high returns of certain
companies will turn down sooner than in fact they do. Secondly, where the market underestimates
the likelihood of returns recovering in beaten up industries, when the supply side is already
improving.
Chart 1: The Capital Cycle
Source: Hosking Partners
3This chart highlights the two valuation anomalies which capital cycle analysis helps identify. We
have started with the example of capital intensive industries surprising the market with attractive
returns following historic underinvestment. While the Hosking Partners portfolio contains a
greater share of such capital intensive stocks than is the case with many of our competitors, a
glance at the largest positions in our portfolio will see names such as Amazon, Alphabet, Tinkoff
Credit, Costco and TSMC, all showing higher and more stable returns. As any contrarian needs
to be, we are foxes rather than hedgehogs1. What makes the capital cycle so versatile as a tool
is that as well as providing a framework for investing in companies with low but volatile returns
which are likely to recover sooner than the market credits, it also highlights the opportunity in
companies with high and stable returns which enjoy barriers to the supply of new capacity which
will mean that those returns will resist the gravity of mean reversion for longer than their share
price suggests. What we are less good at is investing in companies without positive returns in the
past and only the prospect of positive returns at some distant point in the future: we leave those
to cleverer investors.
Considering the example of our capital intensive stocks which have recently performed well, the
reasons for the historic poor returns on capital date back in many cases to the years before the
Global Financial Crisis, when the combination of cheap and plentiful capital, the emergence of a
China-driven commodity “supercycle” and wasteful capital allocation by many management
teams led to massive overexpansion and the creation of excess capacity. This was later cruelly
exposed by the ensuing worldwide recession. Asset lives are long: it may take a decade for a
mine to receive necessary permissions and complete necessary capex before any revenues are
generated, followed by decades of production, and at least a couple of years will pass between
an order being made for a ship to be built and it being delivered, following which it will have a
Archilochus, via Isaiah Berlin: πόλλ' οἶδ' ἀλώπηξ, ἀλλ' ἐχῖνος ἓν μέγα - a fox knows many things, but a hedgehog
knows one big thing.
4useful life of 20 years. Shipping provides a vivid example of the length of time it has taken for the
supply demand equation to have balanced: the size of the global order book for new shipping in
relation to the scale of the fleet already on the water has been in decline for ten years (from a
peak as high as 50%), but in absolute terms the size of the fleet has continued to grow, and it is
only in recent years that new shipping has been growing at a rate which is the same or less than
demand for shipping.
Chart 2: Orderbook for World Merchant Fleet
Source: Clarksons Research – in million compensated gross tons (CGT)
In other cases, overcapacity comes from state actors such as China prioritising investment as a
strategic objective for reasons of economic self-sufficiency. Aluminium is the stand-out example,
with the energy generated by stranded coal assets in Western China being converted into
aluminium which can both be consumed locally and exported globally, destroying the returns on
capital of international competitors for the past two decades. China’s recent announcement that
it is committed to CO2 emissions peaking by 2030 and carbon intensity reducing by 65% over the
same period provides some comfort that a turning point may be on its way. In the meantime, the
energy crisis being experienced in China is providing a short-term benefit to Hosking Partners’
5portfolio constituent Alcoa, as less Chinese aluminium is dumped on world markets. Viewed
through the capital cycle lens, however, it becomes clear that the China power squeeze is the
result of longer-term underinvestment in traditional energy markets globally, in the mistaken belief
that renewable capacity would be able to scale quickly to create replacement capacity more
cleanly and with lower prices.
In this way, the capital cycle and an ESG focus work together: industries are punished for poor
historic investment performance in the former framework and they are also rationed for excessive
emissions according to sustainability criteria. The result is the same - an extended period of
higher returns. Restricted supply of reliable power generation meets recovering demand post-
Covid, resulting in high returns for LNG and coal, as well as for what aluminium smelting capacity
in developed markets has managed to survive two decades of dumping by Chinese competitors
who have now been turned off (for a while at least). A similar dynamic is at play in silicone
markets, expressed through our investment in Ferroglobe.
Faced with examples of such obstinate overcapacity it is no surprise that over the last decade
capital has been attracted to opportunities in less capital intensive industries. Here, intangible
assets cannot be replicated so easily and the prospect of increasing demand is enough to offset
worries about capacity surpluses. Investment pundits may characterise this flow of capital as the
triumph of “growth” over “value”, or of “quality” over “cyclicals”. In reality it is simply the
punishment of certain industries and their management teams for squandering investors’ capital,
and the rewards being handed instead to other industries which have either earned higher
valuations through careful stewardship of capital, or at least the promise to do so.
Such punishment takes the form of starving the capital base of the investment needed to grow,
or at least maintain, production in old economy industries. Equity valuations are depressed, and
access to the capital markets is restricted as prospective returns on new investments are
6extrapolated from rock-bottom levels. The cure for low prices is low prices, however, and in time
the structural underinvestment leads to higher returns for what capital that remains.
A key question for investors, then, is how long returns remain in the doghouse, in effect what is
the (wave)length of the capital cycle? For Hosking Partners specifically, the question is whether
and how quickly we should be taking profits in these winners, or how much further is there to
run? The answer varies from industry to industry, depending in large part on asset lives, as the
passage of time is needed for capital stock to be depreciated, but other factors can extend the
time in the doldrums. In the case of shipping, for example, the arrival in the middle of the last
decade of private equity investors trying to anticipate the inflection in returns resulted in a self-
defeating wave of new capacity. This extended the downcycle by several years, the stocks
continued to trade at a discount to replacement cost and the investment tap has only flowed at a
trickle.
In contrast to these examples of excess capacity, supply constraints can cause returns to recover
sooner than priced by the market and to be sustained higher and for longer. For example, a lack
of suppliers to equip new entrants may hold back new capacity. As a case study: since the
bursting of the US housing bubble and the collapse in demand for lumber, there are now only two
manufacturers of sawmill equipment, resulting in long lead times for new sawmills to come on
line. In Europe, paper manufacturers such as UPM-Kymmene have finally realised there is little
point chasing volumes in the face of secular demand decline and have been closing down paper
mills ahead of time.
Alternatively, the supply constraint may derive from funding being withheld. Depressed equity
valuations rule out the issue of shares to fund expansion, while lenders have long memories and
may restrict credit for expansion long after industry returns have recovered: in the case of
shipping, many of the northern European speciality lenders who fuelled the pre-Lehman boom
7have gone bust while others have closed their shipping desks. Other stakeholders may impose
supply constraints, particularly in the case of capital intensive industries which face emission
challenges: governmental authorities’ cancellation of oil pipelines in North America and
imposition of restrictions on new drilling have held back oil production and brought on industry
consolidation.
Even the prospect of future regulations can have an impact upon supply: shipowners are reluctant
to order new ships if they do not know what future technology specifications will be needed to
comply with changing emissions regulations over the course of their economic life. Geopolitics
plays its part too: as tensions lead to local supply chain networks replacing global ones, capacity
is reduced by such displacement.
Chart 3: Historic return on capital for selected capital intensive companies
Alcoa CFROI % Pacific Basin Shipping CFROI %
10.0 20.0
17.5
7.5
15.0
5.0 12.5
10.0
2.5 7.5
5.0
0.0
2.5
-2.5 0.0
2008
2019
2001
2002
2003
2004
2005
2006
2007
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2020
2017
2021e
2022e
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2018
2019
2020
2021e
2022e
Anglo American CFROI % Bank of America CFROE %
15.0 30.0
12.5 25.0
20.0
10.0
15.0
7.5
10.0
5.0
5.0
2.5 0.0
0.0 -5.0
2004
2009
2001
2002
2003
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021e
2001
2002
2003
2004
2005
2006
2007
2008
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2022e
2021e
2022e
Source: Holt.
8The key benefit of using the capital cycle as an analytical framework through which to view
industries’ returns and valuations is not only that it explains the link between supply of capital,
future returns and asset valuations, but also that by doing so it creates the necessary confidence
for us as investors to accumulate ownership positions in companies when returns are at trough
levels. Being contrarian is by definition lonely, and being contrarian merely for its own sake leads
almost inevitably to value traps. However, combined with a bottom-up approach, the capital cycle
provides a rationale for making a bet against consensus just when the odds are most attractive
and the course of play is about to switch. Of course, timing is never perfect (and anyway, perfect
is the enemy of the good), but with respect to those commentators who say that to be right too
early is to be wrong, we say that you will never own a stock at the bottom unless you are prepared
to be early. Our diversified portfolio and our long-term performance fee help to provide scope for
such behaviour and to reinforce the merits of focusing on the longer horizon.
Leading on from this, the capital cycle also gives us the confidence to say that while the high
returns currently being enjoyed by these capital intensive companies are not permanent and will
in time be eroded as new capacity is inevitably attracted in pursuit of those high returns, they may
not be as short-lived as some valuations suggest. Market participants who measure their own
performance over the shortest of time periods are quick to characterise the earnings power
currently being enjoyed by these companies as a one-off blip due to the transient factors in
today’s newspapers (inflation fears, energy prices, port delays etc). At Hosking Partners, on the
other hand, we have an eye on the bigger picture: what are the constraints on the entry of fresh
capital and so what are the implications for capacity expansion? Analysts may try to estimate
future demand to the last decimal point, but we are happy making broad estimates of supply
based on more easily observed phenomena such as capital markets activity, capex projects and
hiring announcements, all of which give forward notice of the arrival of new supply, or lack thereof.
9Chart 4: Capital spending-to-depreciation ratio for developed market mining stocks
4.5
4.0
3.5
3.0
2022 E
2.5
2021 E
x
2.0
1.5
1.0
0.5 Parity
0.0
52 56 60 64 68 72 76 80 84 88 92 96 00 04 08 12 16 20
Capital Spending : Depreciation
Source: Empirical Research Partners Analysis. Metals & Mining stocks - U.S. stocks used as a proxy for developed markets prior to
1987. Capital Spending-to-Depreciation - aggregate data smoothed on a trailing six-month basis.
The noise which results from false connections being made between daily price movements and
companies’ intrinsic values throws up opportunities. If profits really are one-offs then a low
valuation multiple should be applied, which is why cyclical industries often experience tiny p/e
multiples when profits are at their peak, and nose-bleed multiples when profits are lowest, if not
actually losses. But if supply constraints (also known as barriers to entry) mean that returns will
persist a while longer before they revert to the mean - and no doubt then overshoot to the
downside - then a valuation anomaly is waiting to be exploited.
By way of vivid portfolio example, Pacific Basin, a dry bulk shipping company, is trading on a
forward p/e of 3.2 and its chairman has just spent half a million dollars adding 9% to his existing
ownership of the stock. This kind of insider behaviour should be catnip to the patient outside
investor, and is to the four portfolio managers who own this within your portfolio.
Luke Bridgeman
November 2021
10Hosking Post
The Green Energy Revolution
Trying to see the wood for the trees
1Fund managers receive a lot of advice from the “sell-side”. During the serial lockdowns of the
past 18 months the proportion of that advice which obtains to improving the “ESG” scores of
fund managers has leapt, as far as this writer can tell, to about 70% of all incoming material.
Almost all of it relates to the E of ESG, that part of the acronym which is most difficult to pin
down. Whereas the Hosking Partners investment team has always been motivated by a belief
in the positives of a cleaner environment, sustainability of business models and engagement
with management that improves outcomes, for us this was a behavioural activity motivated
by the likelihood that these objectives enhanced client outcomes. However, ESG is now A
Thing, and as with all nouns this thing should be capable of description in specific terms, just
as a carrot is an orange vegetable with a green top. Notwithstanding ESG’s new “Noun”
status, definitional issues still abound (for example, scope and basis adjustments to CO2
emission measurements, or ambiguity related to the externality that is represented by the
Chinese thermal power industry), not to mention political questions of how to settle multi-
dimensional trade-offs, leading to extra levels of uncertainty, complexity and confusion.
Although the two premises of climate change – (1) global warming and (2) the degree of
responsibility of CO2 emissions for this – are more the product of empirical observation and
inductive reasoning than objective proof, they have increasingly been adopted as such by
society. More relevant to us is the growing acceptance of this diagnosis and associated
prescriptions by our clients, as well as by investee companies. Commercially then, a firm like
Hosking Partners needs to make certain adjustments to its processes and these, as you
would expect, are being made. However, as thoughtful investors we like to think about this
development in conceptual terms, such as what are the likely consequences of the current
paradigm, can we predict some of them and how can we ensure a firm like Hosking Partners
enjoys a competitive advantage along the way. On the face of it this is not a straightforward
task; for example, many of the alternative technologies associated with the need to address
the threat of climate change by reducing carbon emissions are as complex as those which
have underlain the digital transition in business practices. These would appear to require
detailed attention from focused specialists rather than generalist all-rounders with
backgrounds in the social sciences. On the other hand, the ability to see connections which
are not visible to a more focused study is an advantage: who would have predicted that the
high price of gas would cause the UK government to offer subsidies for the production of CO2
(vital for the food industry and a by-product of ammonia plants idled due to high feedstock
costs)? The ability to hop between silos and find opportunities in the cracks between them
should present us with an advantage here.
2But wait a second, the climate change revolution is different from previous technological
revolutions. One recent corporate presentation invoked the transition from fixed line
telephony to a mobile framework in India as a useful analogy for the present required
transition. What this fails to reflect, however, is that most waves of innovation represented
leaps forward in efficiency, and were exercises which involved consumer choice and
competitive markets. The energy transition is not quite the same, representing a cultural shift,
for sure, but also drastic interventions from public authorities which distort pre-existing price
structures via taxes, subsidies and other constraints and incentives. Whisper it quietly, but in
moving towards ditching fossil fuels (albeit for understandable reasons) countries are
replacing a highly efficient energy supply system with a less efficient alternative. It is an
alternative which is undefined in terms of activity mix, but which in any event will require far
more inputs from an equally long supply chain, all the links of which involve economic activity
and their own associated emissions. The fact that the supply of the majority of the world’s
solar panels involves the burning of large quantities of Chinese-sourced coal is simply an
extreme example of a general phenomenon. It is entirely possible that one unintended
consequence of the energy transition may be not just more expensive energy, but also
actually accelerated CO2 emissions. Already electricity prices in the UK are 40% higher than
in the counterfactual absence of “green” policies. And that price premium is before the recent
explosion in the gas price and the consequently greater relative attractiveness of coal as a
source of cheap backup power!
Partly as a result of pressure from institutional investors, our universe of investable
companies find themselves in two transitions simultaneously, namely both the digital
technology and climate transformations. The former is voluntary/commercial, the latter is not.
The oil company BP has embarked on a 50 GW renewable energy investment (by 2030) and
Daimler AG envisages being all electric vehicle based by 2030, having ceased all investment
in internal combustion engine vehicles as early as 2025. The pitch to investors by both these
firms is that this mix shift will be accomplished seamlessly and will be associated with
business quality improvement, i.e. higher normalised ROCE and lower cyclical volatility. If
either were achieved this would undoubtedly produce much higher valuations. The problem
is that this forecast does not pass the sniff test. After all, BP and Daimler didn’t produce cost-
of-capital-earning businesses when they had just one technology to manage! For a company
like BP a dual analysis is appropriate. Investors should value the growth-oriented renewable
expansion (8%-10% returns according to the company, less according to other observers) on
a different spreadsheet to the harvesting of returns from the depleting fossil fuel asset base.
It is likely that any shareholder value gains will be produced not by the new investments but
3by the massive free cash flows produced by (definitely) low capex and (possibly) higher oil
and gas prices in the fossil fuel division. Already BP has raised its dividend and started share
buybacks. This pattern is likely to be repeated elsewhere, in our opinion, with shareholder
value creation via supply-constrained mature activities turbo-boosted by inelastic consumer
demand for the product in question.
While previous technology revolutions produced lower selling prices for consumers via
operating efficiency (who can forget the Federal Reserve’s hedonistic quality adjustments for
improved product capabilities?), the energy transition is likely to have the opposite effect.
Firstly, as the Jevons paradox works backwards, there will be higher levels of inflation due to
reduced production (relative to demand) of price inelastic products. Second, the energy
transition will be funded by price distortions introduced from Government enthusiasm to
identify a new source of excise revenue and impose “green taxes” on consumers on the basis
that this will change behaviours (on the assumption that alternatives to those behaviours are
available, not always the case). It also seems likely that over time more geopolitical attention
will shift to China’s relentless expansion of its domestic coal industry. This has the potential
to reverse the globalisation to which most companies and investors have become addicted,
most likely as a result of “carbon border adjustment tax” imposed by developed markets on
Made in China products.
It is clear that the energy transition and its consequences will play out over many years. These
consequences will often be unintended and produce a significant number of investible shocks.
Many of them are likely to arise from the price instability caused by unintended shortages or
surpluses, and will be difficult to predict via specialist-type analysis. The corporate ecosystem
has become much more unpredictable and complex, and with government-imposed targets,
quotas, taxes and the changes made to them via political expediency, the environment that
investors have to navigate will be dominated by the only safety valve in place, namely
unexpected price moves, many of which may be in commodity type products, and the growing
prevalence of temporary spread-based corporate profits from price arbitrage activity.
Jeremy Hosking
October 2021
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