July 7, 2024

Dear Sustainable Equity Strategy Clients and Friends:

Tailwinds are a metaphor commonly used by investors to describe external, usually temporary, reinforcers of their core investment thesis, but on a recent Sunday I am benefiting from the real thing. Midway through my crosscountry flight, the pilot happily announces that we will land 25 minutes early. The expediting tailwinds have added enough turbulence that the flight attendants are unable to safely perform a standard drink service, but thirst is a small price to pay for the found time. On arrival, however, the pilot announces that we’re so early that there is no gate open to pull into and we will need to wait on the tarmac for — you guessed it — about 20-25 minutes. The moral of my prosaic flight story: tailwinds can be valuable, but should never be mistaken for the whole story, even when they dominate cheery pilot announcements or exuberant financial headlines.

Let’s torture the metaphor a bit. You need a sturdy aircraft to power the journey and withstand inevitable turbulence ― in investing, we might think of this as the fundamental quality of the company. You need a runway landing slot and an open gate, which we might relate to a company’s product / market fit and customer acceptance ― neither of which can be assumed at any given moment in congested airports or competitive markets, respectively. As for the tailwinds, the real-life version can weaken or even turn into crosswinds or headwinds at different altitudes based on local weather systems or seasonality, even in defiance of the persistent west-to-east jet streams. The same applies to investing tailwinds, such as falling interest rates or supportive policy, which can weaken or reverse situationally based on Fed decisions or elections, even in defiance of long-term secular trends.

With half of the global population voting in elections in 2024, some clients have asked whether government policies could reverse from tailwinds propelling our companies to outright headwinds.¹ The rightward shift in the European Parliamentary elections in early June, including the loss of Green Party representation, is expected to weaken support for the EU Green Deal, which we’re monitoring for potential impacts on our EU-domiciled holdings though all of them sell into globally diversified end markets. The National Rally was denied victory in France after a strong first-round showing, reducing risks that the country will backslide on environmental policy. Labor’s victory in the UK is expected to strengthen its net zero policies. Here in the U.S., where approximately 65% of our current holdings by weight are domiciled, the Presidential election has injected uncertainty into the near future of environmental policy, including potential reversal of climate provisions in the Inflation Reduction Act. It’s worth noting that during the four years of the deregulatory Trump Administration, which featured withdrawal from the Paris Agreement, our Strategy returned an annualized 24.8% gross (23.8% annualized net of fees), compared to the S&P 500’s return of 16.0% and MSCI World’s return of 13.4% over the same period – a substantial outperformance that speaks to our portfolio’s resilience but also to the fact that many other factors beyond policy tend to drive the intrinsic and market value of companies.²

But here's the key point: by careful design, and as the evidence above suggests, our investments do not depend on the tailwinds of supportive policy but rather on our assessment of the fundamentals of each company (i.e., the jet) as well as its ability to navigate secular trends (i.e., the jet streams underlying short-term turbulence and variable tailwinds / headwinds). We will discuss each in this letter. But first we report that the Strategy returned 12.09% gross / 11.64% net of fees in the first half of 2024. More relevantly, given our long-term horizon, our annualized return over the 7.5 years since inception is 16.79% gross /15.74% net of fees, ahead of our reference indexes. See page five for the performance table. (Past performance is no guarantee of future results.)

Fundamentals First: The Quality of the Jet

We are fundamental investors first. This means we select high-quality, conservatively capitalized businesses that command dominant and typically growing shares of their markets due to competitively advantaged products and services, and enduring business models. Our companies tend to have higher revenue and Earnings Per Share (EPS) growth rates than the S&P 500, in part because they are selling solutions to the world’s intensifying challenges or capturing other material E-Advantages. Our holdings have favorably lower debt leverage, on average, than the S&P 500, enhancing their financial resilience through economic cycles. Their revenues tend to feature a significant recurring portion, boosting earnings consistency. Many are entrenched in their customers’ lives and enterprises through network effects, integration into workflows or by meeting essential needs (energy, food, water, waste management, etc.). All are selected for their compelling opportunities to reinvest profitably in further growth.

Our companies’ average market share is 43% of their primary revenue segment, with 2/3rds having greater than 30% market share. Six have a share above 80%,³ endowing them with rare pricing power, profit margins and cash flow to reinvest in sustaining their dominance and extending it to select adjacencies. Several other holdings have lower absolute market shares, but still the largest in fragmented industries they are adeptly rolling up. Our research focuses on competitive dynamics: 75% of our companies hold the #1 market share, while 91% hold the #1 or #2 position, in their primary segments. And speaking of jets, we own Airbus, a leader in advancing the lightweighting, efficiency and low carbon fueling of aircraft, which has surged to a 62% share of the narrowbody aircraft market, due in part to Boeing’s unfortunate stumbles.

The Jet Streams: Secular Trends and Long-Horizon Investing

Putting our metaphor back on the torture rack to stretch, note that there are four primary jet streams – a polar and sub-tropical stream in both the Northern and Southern Hemispheres, each of which can branch and join again, creating swirling eddies along the way. Like jet streams, primary secular environmental trends such as climate change, water stress, agricultural degradation, ecosystem impairment and biodiversity loss also branch into many sub-trends — of a policy and non-policy nature. Climate change has driven increasing, if belated, policy stringency as the seriousness of the problem has become more tangible and severe.⁴ But elections and resulting policy outcomes often turn on many other issues: as referenced above, post-COVID inflation and the “affordability” crisis have contributed to populist advances in Europe that imperil the policy progression to address climate. But such electoral reversals cannot stop the non-policy sub-trends that also emanate from the same underlying secular trends, such as: physical climate impacts; rising public concern with droughts, floods, wildfires, and microplastics pollution (which, in turn, sometimes lead consumers to incorporate sustainability into their purchasing criteria); and the momentum of technology innovation. To paraphrase Jeff Goldblum’s comment on the irrepressibility of life in Jurassic Park, secular trends “will find a way.”

Plus, many sustainable products and services simply offer superior economics because of their energy and resource efficiency, or their winning customer value propositions that have absolutely nothing to do with policy subsidies, such as: greater convenience, lower total cost of ownership, reduced health risks and so on. Here is an illustrative selection of secular trends that we factor into our investment process, some more directly rooted in fastmoving environmental objectives like decarbonization, and others accelerating based primarily on nonenvironmental secular drivers but also interconnected in fascinating ways to meeting environmental challenges.

• The Inevitability of Clean Electrification: Electricity is the most versatile, efficient, high-quality energy carrier we have, especially when generated by renewables. We believe its continuing march to displace fossil fuels and outcompete overhyped alternatives like hydrogen is inevitable based on first-principle physics and the favorable economics that ensue.⁵ Electricity’s superior value proposition is clear not just in its amenability to clean, low-carbon generation at the front end, but in nearly all its end uses: electric vehicles (instant torque / “insane” pickup, lower total cost of ownership); induction stoves (faster heat transfer than gas ranges without the indoor pollution and asthma risk); reversible heat pumps (up to 300% efficiency — that’s not a typo — since it moves existing heat to warm and cool spaces, rather than needing to generate all of it); electric lawn mowers and leaf blowers (no noise or local air pollution); and electrification of industrial processes such as electric arc furnaces for steel-making. Portfolio exposures: Brookfield Asset Management, NextEra Energy, Siemens, Schneider Electric, Uber (Uber Green)
• Artificial Intelligence’s Sustainability Leverage: Beyond its revolutionary semantic intelligence for consumer applications, the sustainability benefits of AI promise to be transformational across nearly all verticals – enabling breakthrough designs (recall our Q3-2023 letter on AI-powered biomimicry) and precise optimization of resource use in real-time. AI gives us a fighting chance to bring non-linear leaps in ingenuity to counter the non-linear threats of ecosystem collapse presented by climate change. Our exposures here are two of our four top year-to-date performance contributors: ASML and Taiwan Semiconductor, for whom ~6% of revenue came from AI chips in 2023, but which we expect to rise to 20+% of revenue by 2028 as it continues to be the indispensable chip manufacturer for Nvidia, AMD and the large cloud AI providers we own that have also surged, Microsoft, Alphabet and Amazon. Industrial holdings like Siemens are poised to be beneficiaries of AI’s next wave, partnering with Nvidia to boost industrial productivity through digital twins.⁶
• E-Commerce’s Unbeatable Value Proposition and E-Friendly Scaling: While its growth rate has slowed, ecommerce will, we believe, continue to steadily gain share of overall retail sales based on its superior value proposition (i.e., massive catalogues to choose from with delivery converging from next-day to same-day to even faster). We believe its significant and growing environmental advantages will accelerate this uptake as climate concerns grow. E-commerce offers up to an estimated 50% reduction in end-to-end greenhouse gas emissions relative to brick-and-mortar retail (no stores to light or heat, fewer customer trip- miles, electrification and route optimization of last-mile delivery fleets).⁷ As e-commerce densifies its footprint with more users, more can be delivered in one box and on one trip down a neighborhood street. Boxes are lighter and even being eliminated. Exposures: We have leaned into this trend, adding Coupang (dominant in South Korea) and MercadoLibre (dominant across Latin America) in 2024 to our Amazon holding, which has been our 6th highest year-to-date performance contributor and is poised, we believe, for accelerating free cash flow generation.⁸
• Keeping People and Food Cool in a Heating World: We are unfortunately on track for 2024 to break 2023’s record as the hottest year in the instrumental record. April 2024 was the 11th consecutive month of unprecedented global temperatures and global sea surface temperatures have been at record highs for 13 consecutive months.⁹ Please forgive one final turn on our metaphor, and this one will require some concentration (more than the Sports section but less than the crossword): climate change is now altering the polar jet stream in the Northern Hemisphere in ways that extend the duration of heatwaves such as we’ve been experiencing across the U.S. lately. The Arctic is warming faster than other latitudes, reducing the temperature difference between the poles and the equator and weakening the polar jet stream, allowing it to meander and set up an Omega blocking pattern that entrenches dangerous heatwaves. As such, one of the investable offshoots of our secular climate trend is the increasing need for efficient space cooling and refrigerated trucking to move food and medicine. In a sense, our real-life jetstream has merged into our metaphorical one. Exposures: Trane and Carrier, the former our third highest year-to-date contributor and the latter a position we boosted in size this year as it completed a successful portfolio transformation and saw rapid growth in its datacenter cooling addressable market and backlog, driven significantly by the AI buildout.

We study and invest into many other secular sustainability trends, from the sharing economy to climate-resilient infrastructure renovation to circularity solutions that avoid plastics. All are in their early innings, making them integral to our long-horizon investing philosophy. We certainly hope that humanity will succeed in mitigating negative secular trends such as an overheating world, while seizing the positive, life-enhancing value propositions we’ve touched on above. Investing in companies offering solutions or enhanced resiliency does not mean avoiding the systemic risks that climate change poses to global wealth — that is impossible. But it does offer, we believe, the prospect of attractive, above-market risk-adjusted returns as well as a way for impact-oriented investors to align their capital with their aspirations for a better world. An estimated $150 trillion needs to be spent by 2050 to finance the transition to a low-carbon economy, making this one of the biggest investment opportunities of our — or any — generation.

Performance

We appear to be in a somewhat benign macro environment in the U.S., with low unemployment, solid wage growth, relatively healthy consumer and corporate balance sheets, and moderate though still elevated inflation (the last monthly core inflation reading was 3.4%). All this supports the mid-2% GDP growth expectations we’re hearing from economists for the year, and a plausible rate cut in the balance of 2024. This Goldilocks environment must nonetheless contend with the continuing risk of war escalations, election year uncertainty and a highly valued U.S. equity market that could persist and broaden beyond its narrow tech outperformers or pull back in a rush to safety. We believe this backdrop reinforces the value of somewhat more diversification into non-U.S. holdings, as we’ve done in recent years, and of allocating to active equity strategies like ours that strive to look through the headline turbulence and variable headwinds / tailwinds to focus on owning quality companies poised to benefit from longterm secular trends. Finally, please note that we sold longtime holdings Autodesk and Trimble in Q2, both of which were unable to complete their regulatory filings on time, creating new black box risks that we could not responsibly underwrite on your behalf.¹⁰ We also parted with Nike on the last trading day of the quarter, after having trimmed it earlier in 2024.¹¹ Performance is below.

Thank you, as always, for entrusting us to steward your capital. If you’d like to set up a call, please be in touch with either Dan Abbasi at dan@douglasswinthrop.com or Bowdy Train at bowdy@douglasswinthrop.com.

Best regards,
The Douglass Winthrop Team