JB Next Generation Investing Beyond ST July 2014

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Julius Baer Investment Solutions Group | Please find important legal information at the end of this document.

SPECIAL STUDY | 30 JULY 2014 1/9

NEXT GENERATIONINVESTING BEYOND THE SHORT TERM

The Next Generation investment philosophy at JuliusBaer focuses on structural changes and fundamental im-balances within the economy and society at large. Theobjective is to seek out sustained growth opportunitiesby identifying competitively advantaged companieswithin structurally growing markets.

In its core Next Generation is a holistic approach tothematic investing which places greater emphasis oncomprehensive risk assessment, namely by incorporatinga companys forward-looking strategy, innovation capa-bility and exposure to social and environmental issues.

Thematic investing entails above-average risks which we

recommend to manage with the following measures: di-versification within a themes value chain, portfolio tilt toquality and active risk management by responding swift-ly to short-term market dynamics.

Warren Kreyzig+41(0) 58 886 2440, [email protected] Ruecker+41(0) 58 886 2107, [email protected]

Introducing the Next Generation philosophyThe Next Generation investment philosophy at Julius Baerfocuses on structural changes and fundamental imbalanc-es within the economy and society at large and thus looksbeyond short-term fads in markets. In its core Next Gen-eration is a holistic approach to thematic investing whichplaces greater emphasis on comprehensive risk assess-ment and management. On the surface, defining thematicinvesting as investing in a theme or future trend is fairlysimple. However, communicating its benefits compared toother strategies such as value, growth or sector investingremains challenging. If one phrase could be best used todescribe and differentiate thematic investment, it wouldbe capturing structural growth. Structural change is along-term and persistent shift in an economy that trans-forms the way industries and markets function. Conven-tional investing generally places constraints on business-

es, sectors, and geographies and analyses growth withinthe context of the business cycle. Thematic investinghowever looks beyond the business cycle to exploit for-ward-looking opportunities.

The process follows a logical sequence. Where do we seestructural growth? Which companies are likely to benefitfrom the growth? How can we manage the uncertainty andinvestment risks? This overview aims to not only outlinethe analysis process but also to disclose some of the po-tential pitfalls in thematic investing. In conclusion, key riskmanagement techniques are introduced for consideration

in implementing an effective investment strategy.

Thematic investing looks beyondthe business cycle.

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Analysing megatrends and structural growthA megatrend can be defined as a gathering wave ofchange that is slow to form, nearly impossible to reverse,significantly influences the future, possesses an aura ofinevitability and has a far and wide-reaching impact onsociety. Megatrends result from a convergence of differ-

ent underlying trends including innovation, technology,natural events, politics, demographics, social attitudesand lifestyles. Globalisation and the ageing population arewell-defined examples of megatrends. Megatrends drivestructural change and consumer behaviour, impactingeconomic growth, governments, and industries. Structuralchange is most visible by observing the change in goodsand services consumed over time.

The first steps in thematic analysis are to identify mega-trends and validate their potential for structural change.That said, megatrends remain generally too broad to becoherently analysed for investment purposes. Instead, wefocus on opportunities where the impacts from one ormultiple megatrends amplify structural growth along eco-nomic value chains and industries, producing observablebusiness winners. Once a structural change and its conse-


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SPECIAL STUDY | NEXT GENERATION | 30 JULY 2014 2/9

quences have been identified the economic effects are

mapped across markets, industries, and geographies tooutline the investment themes. An investment theme actsas a framework, identifying the underlying fundamentaldrivers which support the sustained growth of the associ-ated industries. Next Generation investment themes areoutlined on the following page.

Mapping an investment theme (example energy transition)

Source:Julius Baer

Mapping an investment themeAfter defining an investment theme, a core competency inthematic analysis is mapping the economic impactsthrough associated industries and plotting the strategical-ly positioned companies. Lateral thinking is encouragedduring this process and industry attractiveness is analysedvia different scenarios. Where industry competition is low,favourably positioned companies able to exploit the struc-tural growth opportunities are selected. Not to be over-looked, distinguishing losers during this process is im-portant in scoping the magnitude of disruption within aninvestment theme. Disruptive innovation can erode lead-

ers market share through an accelerated transfer of com-petitive advantage to emerging entrants. Bearing this inmind, identifying losers is not as simple as recognisingpoor management. To the contrary, many losers may beindustry leaders with good management who, faced withdisruption, are unable to transition away from progressive-ly redundant business models as the case study of Kodak(not covered) reveals.

In addition to assessing industry competition and con-

firming market growth trends in excess of broader eco-nomic growth, a valid theme must ultimately be investible,preferably across multiple industries. However, time de-voted to invalid themes is seldom wasted as the analysismay prove valuable in identifying emerging risks in associ-ated industries or enhancing the strength of adjacentthemes.

Case studyKODAK: A CASUALTY OF DISRUPTIVE INNOVATION

Kodak held a monopoly position in the photographic-filmindustry throughout most of the 20th century. At its peakit employed more than 140,000 people and its slogan wasfamous You press the button, we do the rest. In 1997,Kodaks market value stood at over USD 30 billion. In 2012and worth only USD 265 million, Kodak filed for bankrupt-cy. The problem was not that the company did not recog-nise the shift to digital photography, it was actually a pio-neer. Kodak always sold cameras, but its real business wasdoing the rest, supplying and processing film. DuringKodaks decades of dominance, the company verticallyintegrated its supply chain, building a vast and specialised

infrastructure of equipment, skills, research, and distribu-tion networks for film and photographic paper. Largeeconomies of scale and unique skillsets drove high barriersto entry for new players considering the film processingindustry. It took Fujifilm (not covered) several decadesbefore they became a serious threat to Kodak.

So what happened? Management was reluctant to em-brace its own digital technology at the expense of disrupt-ing their highly profitable photo film business model. Al-though initially inferior, emerging market entrants im-proved digital technology and grew market share. After

finally accepting the inevitable and broadening its digitalpresence in 2003, it was too late. Kodaks competencealong the digital photography value chain was behind thecurve. Although Kodak had always innovated, the focustransitioned towards sustaining their business model ra-ther than exploiting innovation and steering structuralchange. Termed the innovators dilemma, this conundrumis faced by many of todays businesses.

NanotechnologyClimate changePopulation growthAir pollutionSustainability

Megatrends shapeour society

shifting Consumerbehaviour.

driving economicStructural change

Utilities

Fossil fuels

Battery

storage

Cars

Coal power

Solar

power

Consumer


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Julius Baer Next Generation investment themes

Themes Topics Description

ArisingAsia

Emerging markets, growing middle

class, passion investing

The worlds wealthy are growing in number and Asia is at the forefront of this wave, supported by

its economic transformation. Wealthier Asian consumers and increasing discretionary incomes willhave an effect on global consumer demand.

Digitaldisruption

Digital commerce, manufacturing,

social media, internet of things

The phenomenon of digitisation led by the proliferation of computer power in connection with the

internet is affecting every corner of our lives, not only transforming the way we consume data and

work, but also how society interacts.

Energytransition

Shale boom, clean energy,electric mobility, smart grid

Fossil fuel dependence, high prices, climate change and pollution are some of the challengesspurring energy investments and innovation. We are in the midst of transition where new technol-

ogies move the world towards a cleaner, more efficient use of all available resources.

Feedingthe world

Virtual water, biotechnology,precision farming

By 2050 the world will require food for an additional 2.4 billion people. Sustainable production willnecessitate overcoming finite natural resources and adverse impacts of climate change, whilst

ensuring availability and affordability.

FrontiermarketsAfrica, South-East Asia Economies that start from a low base have the opportunity to realise above-average growth. The

potential lies in a young and growing population and the shift from an agriculture-led economy to

one led by manufacturing and services.

Growingurban

China sprawl, ageing infrastructure,

urban mining

By the middle of the decade, more than two-thirds of the global population are expected to live in

cities. While productivity in urban areas is higher than in rural areas, there are nevertheless limits

to how big a city can grow.

Shiftinglifestyle

Global ageing, silver consumer,

education, health awareness

Ageing is increasing stress on social security systems and altering expenditure. Life-long learning

is becoming critical in addressing societys challenges. Youthful minds, active lifestyles, health andeducation are more important than ever.

Source:Julius Baer

Integration of Next Generation into the Julius Baer investment selection process

Source:Julius Baer


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Identifying advantaged companies

After validating the growth potential of an investmenttheme using top-down analysis, a bottom-up approach isemployed to establish those key companies who are bestpositioned to outperform their respective industry peers.There is no one-shoe-fits-all approach. The key objectivesare to ensure that companies retain adequate earningsexposure to the theme and demonstrate financial andorganisational strength alongside a sustainable competi-tive advantage. Competitive advantages may be achievedthrough qualities such as superior technology, intellectualproperty, economies of scale, extensive distribution net-works, and sustainable management practices taking along-term view. Consequently, our analysis is based notonly on conventional financial metrics but also non-financial metrics such as environmental, social and gov-ernance (ESG) ratings. As a key objective indicator in as-sessing corporate strategy, ESG ratings have becomeincreasingly mainstream, not least since being promotedby the United Nations Principles of Responsible Investing.In short, profitability and financial health provide the basisfor company investments in innovation and the creation ofcompetitive advantages. Sustaining a competitive ad-vantage requires strategic flexibility and continuous re-sponse to changing conditions.

Companies should demonstratesustainable competitive advantages.

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Concluding the assessment, companies are given a the-matic rating. This rating describes the exposure to aninvestment theme, ranging from negative for probablelosers to high for companies which we believe are likely tofully capture an investment themes growth potential.Although new market entrants and disruptive innovatorstend to have superior growth potential, they are generallyundercapitalised, lack an operating track record and are

prone to greater business risk. Consequently, new marketentrants require additional analysis to determine thosebest positioned and incentivised to capture marketgrowth. As a rule, high-rated new market entrants willexhibit higher risk than high-rated established companies.

The following diagram illustrates how high-rated compa-nies leverage their market position and competitive ad-vantage to transition structural change. This may beachieved through internal investment in innovation orstrategic mergers and acquisitions. Meanwhile, losersbecome redundant. Successful disruptive innovators typi-

cally outperform incumbent market leaders. In a final stepof analysis we also consider liquidity risks to ensure thatthe thematic rating also reflects how investible a companyis. Capitalisation and turnover are metrics we consider.

Winners and losers of market undergoing structural change

Source:Julius Baer

Case studySOLAR INDUSTRY:LOW BARRIERS TO ENTRY CLOUD PROFITABILITY

Driven by evidence of climate change, rising oil prices anda trend towards sustainability, the growth outlook for solarenergy was assured. In 2008 the worlds largest solar panelmanufacturer enjoyed profit margins of 40% and industry-wide profitability amongst approximately 100 manufac-turers was high. A flood of government subsidy pro-grammes accelerated demand for solar panels and pro-duction rapidly expanded.

However, low barriers to entry saw entire solar-energy

sectors sprout, practically overnight, in China and Taiwan.By 2010, the number of manufacturers had mushroomedmore than fivefold to somewhere between 500 and 800.Aggressive price reductions drove profit margins to zeroas manufacturers ramped up production in order to re-main competitive. The result was chronic oversupply fol-lowed by years of consolidation, prolonged by protection-ism. The sectors pain was compounded by the globalrecession and governments reducing the number of appli-cants eligible for the generous subsidy schemes. Whilstgrowth of the investment theme boomed, annual produc-tion grew sixfold from 2008 to 2014, unanticipated indus-try dynamics exposed investors to significant businessrisk. Post 2010, the number of manufacturers consolidatedto below 200 as a consequence of low profitability.

time

High rating (new market entrant)

Old industry

model

Structural

change

New industry

model

High rating (established company)

Loser rating (established company)

Industryperformance


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Managing thematic risks

Promising above-average returns, thematic investing isalso an above-average risk investment strategy. In fact,predicting a future outcome is difficult and prone to error,particularly for more disruptive themes. The risks of the-matic investing are broad and not solely limited to tech-nology and innovation. Significant challenges usuallycomprise uncertainties surrounding government policies,environmental and legal impacts. That said, the risk is notso much that a theme fails to materialise, which is actuallyseldom, but rather that the pace or magnitude of struc-tural change is misjudged. This may prove advantageousor detrimental for an investment themes performance.Most difficult to estimate is how structural and competi-tive forces, both between and within associated industries,are likely to evolve and impact business participants. Therapid rise of the solar industry provides a useful overviewand introduction to these uncertainties.

The Next Generation investment process proposes a com-bination of measures to manage or mitigate the invest-ment strategys above-average risks, namely:

Diversification: Investing along an investment themesvalue chain broadens thematic exposure and enhancesdiversification, reducing both industry specific and com-

pany specific risks.

Portfolio tilt to quality:Adequately balancing expo-sure to established companies with exposure to new en-trants to lower the overall risk of the investment themesportfolio. The latter are usually exposed to higher risk asthey lack an operating and financial track record.

Active risk management:Maintaining an eye on themarket and swiftly responding to shifting dynamics re-mains a key prerequisite of thematic investing despitethe strategys apparent long-term horizon. Investmentthemes are more prone to regulatory and valuation risksthan other investment strategies.

Investment themes are long lasting and rarely unique.Attention-grabbing stories and public focus tend to inflateexpectations, encouraging hype and momentum trading.The risk of inflated expectations occurs predominantlyduring the early stages of innovation, only to be followedby the inevitable underperformance, industry consolida-tion and investor apathy. In reference to Gartners hypecycle, broad market growth occurs during the trough ofdisillusionment and slope of enlightenment phases.

To conclude our risks overview, investors should be aware

that successful thematic investing ultimately requiresplacing a bet on structural change and they must be com-fortable with accepting the corresponding higher risks.Managing risks as described above and maintaining expo-

sure to the investment theme require careful balancing.

Over-diversification might dilute the exposure to the in-vestment theme. That said, investors should also acceptthat some investment themes, despite their importanceand attractiveness, are difficult to invest as the case studyof water reveals on the following page.

Hype cycle of technical innovation

Source:Gartner, Julius Baer

IS NEXT GENERATIONCONSIDEREDSUSTAINABLE INVESTING?

Next Generation enhances its thematic investment ap-proach by integrating environmental, social and govern-ance (ESG) issues into the analysis process. IncorporatingESG issues in accordance with the United Nations Princi-ples of Responsible Investing (UN PRI) is core to the JuliusBaer investment approach. In satisfying both the respon-sible and thematic investing elements, Next Generationconforms to the general framework for sustainable invest-ing which comprises the following four areas:

Responsible investing:Focused on comprehensivelong-term risk assessment by incorporating ESG issuesalongside financial metrics and actively engaging withcompanies about these issues.

Thematic investing:Focused on structural change, i.e.encouraging opportunities and solutions resulting fromenvironmental and social issues, new technology, orpopulation growth.

Socially responsible investing:Focused on doing noharm either by applying ethical or value based inclusionor exclusion (such as weapons) investment criteria.

Impact investing:Focused on doing good by demand-

ing a measurable social or environmental benefit along-side of financial returns.

timeTechnology trigger

expectations

Peak of inflated expectations

Trough of disillusionment

Slope of enlightenment

Plateau of production


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Case study

WATER: SECTOR INVESTINGMASQUERADING AS THEMATIC

Over the last decade, investor interest has fuelled growthin the marketing and offering of water themed managedfunds. Globally, water as a commodity remains highlysubsidised with scarcity and quality issues intensifying thestress nexus between agriculture, energy and industry.Water remains a strategic resource which is heavily regu-lated. Consequently investability and thematic exposureremain challenging. Nonetheless, the top actively man-aged funds are promoting their expertise in exploiting thewater theme.

This begs the question, just how effective have thesemanagers been? Standard and Poors Global Water Indexcomprises 50 global companies that are involved in waterutilities, infrastructure and equipment. Over the last 5years, none of the top managed funds have outperformedthis Index (17% p.a.). Additionally, only one companymanaged to match the broad MSCI World Index (15.6%p.a.) over the same period. The results indicate that topthematic water funds are likely over-diversified acrossselected industries, focusing less on capturing broadstructural growth and more on investability. Consequent-

ly, this strategy is more representative of a sector-basedapproach and not thematic investing.

Conclusion

The Next Generation investment philosophy at Julius Baerfocuses on structural changes and fundamental imbalanc-es within the economy and society at large. The objectiveis to seek out sustained growth opportunities by identify-ing competitively advantaged companies within structur-ally growing markets. In its core Next Generation is a ho-listic approach to thematic investing which places greateremphasis on comprehensive risk assessment, namely byincorporating a companys forward-looking strategy, inno-vation capability and exposure to social and environmen-tal issues. Thematic investing entails above-average riskswhich we recommend to manage with the followingmeasures: diversification within a themes value chain,portfolio tilt to quality by adequately balancing exposureto established companies with exposure to new entrants,and active risk management by responding swiftly to shortterm market dynamics. Last but not least, investmentthemes are rarely unique. Attention-grabbing stories andpublic focus tend to inflate expectations and encouragehype, which provides a fertile soil for excessive valuationsand aggressive marketing of investment products. Inves-tors should avoid being misguided by hype and shouldverify the chosen investment products deliver the expo-sure they promise.


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IMPORTANT LEGAL INFORMATION

This publication has been produced by Bank Julius Baer & Co. Ltd., Zurich, which is authorised and r egulated by the Swiss Financial MarketSupervisory Authority (FINMA). This publication series is issued regularly. Information on financial instruments and issuers is updated irregu-larly or in response to important events.

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AuthorsWarren Kreyzig, Commodity Research, [email protected] 1)Norbert Rcker, Head of Commodity Research, [email protected] 1)

1) This analyst is employed by Bank Julius Baer & Co. Ltd., Zurich, which is authorised and regulated by the Swiss Financial MarketSupervisory Authority (FINMA).

APPENDIX

Analyst certificationThe analysts hereby certify that views about the companies discussed in this report accurately reflect their personal view about the companies and securi-ties. They further certify that no part of their compensation was, is, or will be directly or indirectly linked to the specific recommendations or views in thisreport.

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for subscription or purchase, of securities or investment funds (i.e. collective investment schemes) may not be circulated or distributed, nor may suchsecurities or investment funds be offered or sold, or be made the subject of an invitation for subscription or purchase, whether directly or indirectly, topersons in Singapore other than (i) to an institutional investor under Section 274 or 304 respectively of the Securities and Futures Act, Cap. 289 of Singa-pore (SFA), (ii) to a relevant person (which includes an accredited investor), or any person pursuant to Section 275(1A) or 305(2) respectively, and inaccordance with the conditions, specified in Section 275 or 305 respectively of the SFA; or (iii) otherwise pursuant to, and in accordance with the condi-tions of, any other applicable provision of the SFA. In particular, for investment funds that are not authorised or recognised by the MAS, units in suchfunds are not allowed to be offered to the retail public; any written material issued to persons as aforementioned in connection with an offer is not a pro-spectus as defined in the SFA and, accordingly, statutory liability under the SFA in relation to the content of prospectuses does not apply, and investorsshould consider carefully whether the investment is suitable for them. Please contact a representative of Bank Julius Baer & Co. Ltd., Singapore branchwith respect to any inquiries concerning this publication.Spain: Julius Baer Agencia de Valores, S.A.U., authorised and regulated by the Comisin Nacional del Mercado de Valores (CNMV), disseminates researchto its clients.Switzerland: This publication is distributed by Bank Julius Baer & Co. Ltd., Zurich, authorised and regulated by the Swiss Financial Market SupervisoryAuthority (FINMA).The Bahamas: This publication has been distributed by Julius Baer Bank & Trust (Bahamas) Ltd., an entity licensed by the Central Bank of The Bahamasand also regulated by the Securities Commission of The Bahamas. This publ ication does not constitute a prospectus or a communication for the purposesof the Securities Industry Act, 2011 or the Securities Industry Regulations, 2012. In addition, it is only intended for persons who are designated or who aredeemed non-resident for the purposes of Bahamian Exchange Control Regulations and rules.United Arab Emirates: This publication has not been approved or licensed by the UAE Central Bank, the UAE Securities and Commodities Authority orany other relevant authority in the UAE. It is strictly private and confidential and is being issued to a limited number of sophisticated individual and institu-tional investors upon their request and must not be provided to, or relied upon, by any other person.United Kingdom: This publication is a financial promotion for the purposes of Section 21 of the Financial Services and Markets Act 2000 (FSMA) and hasbeen approved for distribution in the United Kingdom by Julius Baer International Limited, which is authorised and regulated by the Financial ConductAuthority (FCA). Rules made by the FCA under the FSMA for the protection of retail clients do not apply to services provided by members of the JuliusBaer Group outside the UK and the Financial Services Compensation Scheme will not apply.Uruguay:In the case this publication is construed as an offer, recommendation or solicitation for the sale or purchase of any securities or other financialinstruments, the same are being placed relying on a private placement exemption (oferta privada) pursuant to Section 2 of Law No18,627 and are notand will not be registered with the Financial Services Superintendence of the Central Bank of Uruguay to be publicly offered in Uruguay. In the case of anyclosed-ended or private equity funds, the relevant securities are not investment funds regulated by Uruguayan Law No.16,774 dated September 27,1996, as amended. The securities and financial instruments contained in this publication do not constitute a deposit with IFE Julius Baer (Uruguay) S.A.(IFE Merrill Lynch Bank [Uruguay] SA in process of name change) (so are not subject to the coverage under the Deposit Guarantee Fund managed by the

Bank Savings Protection Corporation) and accordingly you should bear the risk of the issuer of the securities and financial instruments. If you are locatedin Uruguay, you confirm that you fully understand the language in which this publication and all documents referred to herein are drafted and you have noneed for any document whatsoever to be provided in Spanish or any other language.

United States: NEITHER THIS PUBLICATION NOR ANY COPY THEREOF MAY BE SENT, TAKEN INTO OR DISTRIBUTED IN THE UNITED STATES ORTO ANY US PERSON.

This publication may contain information obtained from third parties, including ratings from rating agencies such as Standard & Poors, Moodys, Fitch andother similar rating agencies. Reproduction and distribution of third-party content in any form is prohibited except with the prior written permission of therelated third party. Third-party content providers do not guarantee the accuracy, completeness, timeliness or availability of any information, includingratings, and are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, or for the results obtained from the use ofsuch content. Third-party content providers give no express or implied warranties, including, but not limited to, any warranties of merchantability orfitness for a particular purpose or use. Third-party content providers shall not be liable for any direct, indirect, incidental, exemplary, compensatory, puni-tive, special or consequential damages, costs, expenses, legal fees or losses (including lost income or profits and opportunity costs) in connection with anyuse of their content, including ratings. Credit ratings are statements of opinions and are not statements of fact or recommendations to purchase, hold orsell securities. They do not address the market value of securities or the suitability of securities for investment purposes and should not be relied on as

investment advice.

Julius Baer Group, 2014

JB Next Generation Investing Beyond ST July 2014

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Transcript of JB Next Generation Investing Beyond ST July 2014