There are ways to find companies that are both good corporate citizens and cash flow generators, writes Morningstar Investment Management's Peter Bull.

Sustainability is a pre-requisite of ethical investing, but the term's meaning extends well beyond the realm of environmental, social and governance considerations of investing.

The growth in ethical investing has been led by people wanting to allocate more of their portfolios to companies that operate in line with their individual values. Either they don’t want to profit from damaging the environment, or they would like to benefit from moving to a more fair or sustainable industrial economy.

This trend has prompted investors to more carefully consider what they really want from their investments, and the steps they're willing to take to achieve their goal.

But ethical investing, sustainability and the more fundamental considerations of selecting stocks, funds and other assets don't exist in isolation – they're intrinsically linked.

A core goal of most investors is to achieve meaningful capital growth over the medium-to-long term in a way that is as reliable as possible. This is a key consideration in constructing the underlying portfolio for the Morningstar International Shares Active ETF (ASX: MSTR).

Crushing rocks for a living is hard

Buying shares in companies that consistently generate free cash flow – the cash that is left over after a company pays its bills and covers its costs of doing business – is one of the more dependable ways to achieve this goal.

This may sound simple, but the list of companies that cannot do this is surprisingly long, and such companies often occupy large positions in the portfolios of investors large and small.
Commodity businesses are hard to profit from. They have lots of competition, and they usually require big ongoing capital and infrastructure investments, which subjects them to cyclicality on both the supply and demand sides.

Traditional energy companies are primarily concerned with pulling resources out of the ground. They have to find them, dig them up or pump them out, transport them, refine them and then sell them in a market that has an almost unlimited number of competitors.

They're not only competing against other companies in similar industries, but against substitute products that are being actively developed – renewable energy technologies, for instance.

As such, it can be difficult for energy companies to even become profitable, let alone maintain and grow profits over several years.

Financials adrift in sea of uncertainty

Banks also suffer from balance sheet risks. They are not high profit-margin, self-financing businesses.

Rather, they profit from highly -geared balance sheets that are subject to the whims of market values and interest rates, in an economic reality in which assets are opinions and liabilities are facts.

Consider banks and their customers’ deposits – or liabilities – versus mortgages – or assets.
The deposit liability is an immutable obligation for the bank, and any equity shareholder’s claim on the bank follows the payment of all such liabilities.

Compare this with a bank’s asset in the form of a mortgage, whose value is ultimately backed by an estimated property value.

This estimate is inherently subject to normal market fluctuations, despite its value appearing as fixed as the liability’s.

Because bank balance sheets are often geared 20 times or more, as measured by a simple balance sheet assets-to-equity ratio, small movements on the asset side can easily overwhelm the thin slice of shareholder equity. This is built into the process, and isn’t simply a result of shady accounting, banking, or valuation practices.

Opportunity lies in scarcity, permanence

We like profitable niche companies that are polar opposites to those in the commodities sector.

Instead of trying to differentiate themselves from other companies that also dig up and crush rocks, they profit from hard-to-replicate intangible assets such as:

  • intellectual property
  • brand identity, or
  • distribution networks that are built up over decades or generations.

They are less vulnerable to economic uncertainties, but they aren't entirely risk-free.
Examples are everywhere.

Think about the brand of instant coffee in your office and why it would change. Of course it could change, but it has a certain amount of distributional inertia on its side – there would have to be a very good reason.

Acclaimed investor Anthony Deden, chairman and co-founder of Edelweiss Holdings, has termed this the “scarcity” and “permanence” of businesses that makes them the best investments.

He cites the example of specialised whiskey distillers and their distinct glass bottles. But even more specialised and distinct is the individual maker of the equipment that makes the glass bottles.

A similar line of thinking is to assess where customers are willing to pay a premium. Medical devices? Yes. Commodities? Not so much.

Specialised silicon technology

Niche Japanese technology firms Shin-Etsu Chemical Company and Tokyo Ohka Kogyo Company are two examples from within Morningstar Investment Management's global equities portfolio.

Among other things, they specialise in the manufacture of liquid photoresist. This is a light-sensitive material that is applied to silicon wafers to create microprocessors.

The manufacture of photoresist is a highly specialised process with an astronomically small tolerance for impurities, and also few competitors.

Our view is that the little flow of electrons in microprocessors is going be a critical part of the solution for the big flow of electrons in overall energy consumption.

We would rather be in the durably profitable niche of the supply chain than in its price-taking endpoint.

Whether it’s in the control systems of energy distribution networks, the ever-growing and energy-smart Internet of Things, or in the computers of researchers communicating their best ideas, we only see upside in the adoption of microprocessors.