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Self-reflection and Change from Within for the Investment Research Industry: the Real Impact of MiFID II

Self-reflection and Change from Within for the Investment Research Industry: the Real Impact of MiFID II

By | General

When the European Union enacted MiFID II, the aim was to increase transparency and accountability in an opaque, aging market. 

The theory was that larger investment banks would stop bundling research fees together with financial service charges. Investment research would be free of resulting conflicts, like Investment Bank A pushing positive research on company B because A is in business with B.

It would lead to better-quality research instead of repetitive, low-value notes, at which no one raised an eyebrow since they didn’t have to pay for them.

The changes triggered a quake in the global investment research market – even far beyond the EU’s jurisdiction – and the dust has yet to settle. The clarity of vision the legislation aimed for remains elusive.

It’s clearer than ever that meaningful change in the market can only come from completely different models. 

Questionable Progress

In terms of MiFID II successfully changing the industry for the better, a consensus is equally hard to find. There are some who claim it has been a boon to end investors, i.e. the people who pay funds to seek great returns for them. This view is, to put it mildly, widely disputed.

Instead, several voices argue that the regulation has been to the market’s detriment. Not only has it failed to improve the quality of research and break the large investment banks’ stranglehold on the bulk of research coverage, but there is now less research to go around overall.

A survey among CFA Institute members earlier this year found that most respondents aren’t thrilled with how things are panning out. Buy-side respondents overwhelmingly reported less research demand on their part, while sell-side analyst job cuts continued apace.

More worryingly, a large segment of respondents thought that small- and mid-cap research dropped in both quality and quantity. They also said research budgets have decreased, more so for larger firms. This is the exact opposite of what MiFID II was supposed to achieve.

Self-reflection and Change from Within for the Investment Research Industry: the Real Impact of MiFID IISell-side Identity Crisis

Where the legislation seemed like it would benefit independent analysts, the market went a different way. A report by Greenwich Associates late last year found that, by mid-2018, more than half of research and advisory budget allocation went towards global investment banks – 60 percent of it in the case of larger asset managers.

All this points to more fundamental problems in the market than lawmakers perhaps anticipated. 

Instead of the market opening up more, turning towards independent analysts for truly objective and conflict-free research, it remains steadfast in its preference for large investment banks. 

Instead of the unbundling of research and advisory service pricing leading to more transparency, it has resulted in the buy-side refusing to take meetings or calls from the sell-side to avoid running afoul of regulations or being charged each time. 

And instead of the traditional sell-side refining their processes in terms of the research they provide, they slashed jobs and cut costs while delivering the same old research offerings, leading to several analysts leaving the industry altogether.

Could it be that there was no real there there, and that unbundling has revealed the sell-side never was delivering such great investment ideas in the first place? 

The fact that the uncertainty extends beyond the borders of the European Union, only stresses the need for further change. But at the same time, the true value of MiFID II may yet be to shine a floodlight on those problems, rather than solve them with the stroke of a pen.

Read more on our blog: Beyond Europe: How MiFID II Spurs Regulatory Change Across the Globe

Untapped Research Value

The rise of “research-tech” during this time is not an accident, as several stakeholders realise how fundamentally technology can change their processes. “Fintech across the value chain is supporting the reinvention of research via an explosion of data, tools, and distribution methods,” writes Celent’s David Easthope. 

Technology platforms can give the buy-side full control over what research it consumes, how much it pays for it, and how it interacts with analysts as well as corporates. Compliance, transparent pricing, and a slew of actionable data are just a few of the benefits that research-tech brings to the table.

Independent analysts, for their part, get a direct channel of distribution that was not available before. This gives them greater control over their output but even more importantly, it allows them to pursue the research they deem valuable and important, without a higher power calling the shots.

Traditional sell-side still largely follows the “everything and the kitchen sink” approach, in the hopes that clients will find value in at least some of its offerings. A tech-enabled platform, on the other hand, understands and adapts to the needs of the user. 

It can deliver research on the sectors, companies, and topics the user is truly interested (and invested) in. It can connect the user to a network that could previously only be accessible through the traditional establishment.

As the market keeps coming to terms with MiFID II and any amendments to the law that might follow, perhaps the true impact of the legislation is this: It has forced the investment research industry to take a long, hard look in the mirror – and evidently, it did not like what it saw. Instead of raging at its reflection, it’s time to look elsewhere to find the change it needs.

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Slack direct listing on NYSE

5 Takeaways from Slack’s Direct Listing

By | General

Photo credit: NYSE

Slack is the latest tech hopeful foraying into the public markets through a direct listing. It comes hot on the heels of famous names like Uber and Lyft and not-so-famous like Crowdstrike and Chewy. Software companies command a huge part of the market’s interest, and Slack is no exception.

The direct listing is the other reason the workplace chat app maker is getting so much attention. In such a listing, the company doesn’t go through traditional underwriters or issue new shares. Rather, existing shares start getting traded directly on an exchange. 

Only the second notable company in recent years to do that, after Sweden’s Spotify, Slack has caused unrest in markets with this unorthodox approach. Now that the stock is out there and trading, let’s see what it means for Slack and the public markets.

There Will Be More Direct Listings

Slack’s share price shot up 50 percent at listing. While it has slid since then, this may signal to other companies that they don’t need to go through the whole process of an IPO (involving underwriters, exorbitant fees, time-consuming roadshows, etc.) when they can just go straight to the markets. 

While the last few years have seen only two high-profile direct listings, some predict the trend will catch on. Among them are Morgan Stanley’s Colin Stewart and veteran VC Bill Gurley. They think that not only there will be more such listings in the near future, all of them should be done this way.

Stewart expects five or more direct listings in 2020, while Gurley writes, “This is how 100 percent of IPOs should be done. And hopefully will one day.”

But It’s Unlikely to Dominate as a Listing Path

While the direct listing route sounds attractive, especially for tech firms – what’s more aligned with Silicon Valley thinking than cutting out the middleman? – it’s not as practical for every company out there.

Slack and Spotify are both well-known, recognisable brands. This helps when you have to convince investors to buy your shares, rather than have underwriters who will give you that initial boost. Smaller companies in more obscure sectors seeking to list will have a harder time pulling that off.

The Role of Banks in IPOs Is Changing

While Slack didn’t have traditional underwriters, it worked with major banks Allen & Co., Goldman Sachs, and Morgan Stanley as advisers. 

This signals different ways for banks to work with companies that seek to go public. Online networks and tech-enabled connectivity can help investors discover promising companies, while founders can educate the market without the need for traditional roadshows.

In fact, Slack chose to hold its own remote “investor day“, eschewing the usual pitching sessions that would take up valuable time and resources.

In an ecosystem where company management can interact directly with investors and analysts and build such relationships over time, the role of large investment banks would be further changed – giving the advantage to those who can adapt to the new paradigm.

Slack Would Likely Do Well Regardless of Its Path to IPO

Tech IPOs have been plagued by a lot of common issues: companies that are popular but wildly unprofitable, dual-class share structures complicating the relationship between shareholders and management, and a host of complications in their path to profitability.

Read our blog: Lyft’s IPO May Be Oversubscribed but Investors Are in for a Bumpy Ride

Slack shares a lot of those characteristics but it’s in a better shape than others. Yes, it did post an annual loss of US$140 million for 2018, but this is nothing compared to the billions Uber still bleeds. 

In his assessment of the company, both before and after its listing, Douglas Kim applied a nine-point checklist that he uses to determine the viability of a tech IPO. He found that Slack fulfilled all nine criteria, including having a reasonable timeline for profitability, a first-mover advantage, and proven management.

Read Douglas Kim’s full Insight: Slack Investment Strategy Post Direct Public Offering

It’s also important to note that Slack didn’t raise additional financing through this listing. Unlike, say, Lyft, it doesn’t seem like it will need it. According to public data, Slack has raised around US$1.4 billion in private funding, which would presumably keep it going on its road to profitability.

Companies Could Stay Private for Longer

Companies like Slack increasingly forego the public markets in favour of staying private. The abundance of private capital, combined with the freedom it grants management who don’t have to deal with shareholders besides direct investors, makes a lot of founders think twice before they pull the trigger.

Prominent tech names like Airbnb and Palantir have expressed interest in going public (even through a direct listing, in the former’s case) but have yet to make major moves. If direct listings are indeed becoming a trend, allowing them to have more control over the process, it could bring about a new batch of public companies abandoning traditional approaches to go forward on their own terms.

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Chinese Pharmas Move to Claim a Piece of the Global $37b CRO Pie

Chinese Pharmas Move to Claim a Piece of the Global $37b CRO Pie

By | General

China’s tech sector still commands most of the attention when it comes to headlines – particularly in light of the ongoing trade war and the plight of industry figurehead Huawei. But the country’s pharmaceutical firms are now starting to make their mark. A number of IPOs are either kicking off or completing their arc, adding to China’s growing footprint in the CRO (contract research organisation) market.

CROs are companies that take on research and development (R&D) jobs for pharmaceutical, biotech, and medical device firms. Their services include anything from clinical research and trials to commercialisation and drug development. Through CROs, large firms can reduce R&D costs and explore smaller markets with less risk.

CRO Boom

The model seems to be working. The global CRO market was worth US$37.1 billion in 2018, having grown at 8 percent over the last few years, according to research published by ReportLinker. A study by Grand View Research expects the market size to grow to US$54.7 billion by 2025.

Meanwhile, an earlier report by market research firm ISR forecast an increase in R&D spending of 15.5 percent for the period between 2015 and 2020, from US$262.9 billion to US$303.7 billion.

Out of around 1,100 companies worldwide, ten of them hold over 50 percent of global market share. They include names like IQVIA, Covance, and LabCorp.

Among them is China-based WuXi Apptec, which bills itself as Asia’s top pharmaceutical R&D service provider by total revenue. The Shanghai-based firm went public at the end of 2018, raising US$1 billion.

At the time, independent Insight Providers publishing on Smartkarma noted that WuXi was one of the companies who would benefit greatly from Big Pharma’s international shift towards outsourcing.

Now, a fresh batch of China-based CROs are gearing up for, or going through the final stages of their IPOs.

Pharma Hopefuls

Most notably, generic drug manufacturer Hansoh Pharmaceutical is about to list this week in Hong Kong. Valued at US$10.4 billion, the firm has amassed some impressive cornerstone investors, including Singapore’s GIC and China’s Hillhouse Capital and Boyu Capital.

Aequitas Research analyst Ke Yan was optimistic in a recent note on Smartkarma, particularly praising the company’s R&D capability as well as its ability to be first-to-market with its generic drugs.

Both Ke Yan and Arun George of Global Equity Research thought that Hansoh’s valuation was not on the cheap side, but felt the upside would be worth it on the low-to-mid-end of its price range. The discount “reflects the trade-offs between Hansoh historical solid financial performance and the mixed prospects for its drugs and a huge pre-IPO dividend,” George wrote.

The analysts were less keen on IPO hopefuls MabPharm and Viva Biotech, whose listings are currently at different stages of their lifecycle.

MabPharm focuses on R&D and production of cancer and autoimmune disease drugs. Ke Yan was left unimpressed by the company’s product pipeline, which faces intense competition from patent drugs and biosimilars.

In addition, the lack of specialised biotech investors in its shareholder line-up raised some flags. “It appears that the company is assembled by private equity to cash out,” the analyst wrote.

 

 

Viva Biotech, a CRO also based in Shanghai, last month raised US$194 million in what was Hong Kong’s most popular IPO before Hansoh came along. Viva’s unique twist is an “equity-for-service” business model, taking an equity stake in drug discovery startups in exchange for cash or its specialised services.

This factored into analysts’ views on Viva. Arun George was bearish pre-listing, noting the company’s guidance of a negative free cash flow in 2019, while Ke Yan warned that most of the company’s valuation depended on future earnings from investments into other companies.

China’s Biotech Moment

Overall, favourable policies and an abundance of capital will contribute to the development of more Chinese CROs, according to the report published on ReportLinker.

Following in the footsteps of international CROs like IQVIA, Parexel, and Charles River, rising Chinese players will likely look to grow their arsenal through acquisitions. WuXi, which has a 10 percent market share in China’s CRO market, announced last month it acquired US based Pharmapace, which specialises in biometric services for clinical trials.

“In the future, CRO companies will try to expand their service scope […] and they will establish a comprehensive service platform covering the entire drug development value chain by enriching their product portfolio constantly through investment in new technologies and new facilities,” the report states.

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Rare earth mining

China’s Rare Earths Threat Means Business for These Two Companies

By | General

Much of the trade war talk recently has concentrated on China’s threat to stop exporting rare earths to the US, as the tit-for-tat between the world’s two biggest economies marches on.

This has not only rattled the markets and prompted mass “rare earths” searches on Google; it’s also driven investor interest towards rare earth processing companies outside of China.

As things stand, China accounts for roughly 80 percent of global rare earth mineral supply and one-third of the world’s rare earth reserves. If the country decides to curb the supply of these minerals, it’s bad news for sectors running the gamut from automotive to consumer electronics.

But there are players around the world ready to seize the opportunity.

The Struggle for Light Rare Earths

In the event that China battens down the hatches, other countries and processing companies will try to pick up the slack. But it’s also important not to underestimate the significance of China’s contribution to the sector.

“Most investors completely misunderstand the potential predicament surrounding a [rare earth element] embargo,” writes Gaius King on Smartkarma. “The myriad causation effects it would inevitably have on modern life, and the impact on certain industries, such as non-Chinese made [electric vehicles] and wind turbines, would be calamitous.”

According to King, pundits tend to liken the abundance of elements like chromium and nickel to that of light rare earth elements (LREE) like yttrium, lanthanum, and neodymium. This leads many to think China has much less leverage in this regard, as global demand could be covered elsewhere.

Read the full Insight by Gaius King: PM8 – The Perfect Foil to a Xi LREE Embargo

However, given the market’s increasing needs for certain applications, such as the production of magnets for electric car motors, global LREE supply will have trouble keeping up in less than a decade, King warns.

He further points out that a potential moratorium on LREE supply from China lends to volatility for elements like neodymium, whose price jumped more than 33 percent last week as the market got more jittery.

From Angola to Australia

So what are the alternatives for the US if China makes good on its threat? Currently, the largest deposits can be found at three other places: Longonjo, Angola; Mount Weld, Australia; and Mountain Pass, California.

The first two locations are being exploited by two companies: Pensana Metals (PM8) and Lynas Corp respectively. The two deposits can “partially make up some additional supply outside of Chinese sources,” according to King.

Looking at PM8’s viability, King notes that the Longonjo deposit is approximately half the grade of Mount Weld and not as attractive financially. Still, the analyst believes the company is making a lot of the right moves, even though it won’t be ready to start selling concentrates until end of 2021, if not later.

Pensana (PM8) rare earth deposits

Lynas, the Australian company managing the Mount Weld deposit, seems to be best placed to capitalise on a Chinese LREEs curb. The company is capable of processing concentrates – the other two locations need to rely on Chinese state-operated companies for processing, which complicates things. For California’s Mountain Pass especially, tariffs in place by the Trump administration are already raising costs.

On 20 May, Lynas announced a joint venture with US-based Blue Line, with the aim of building a rare earths processing facility in Texas. The partnership will “see that US companies have continued access to rare-earth products by offering a US-based source,” according to the official announcement.

But while there are plans for the proposed plant to include LREEs, the initial focus would be on heavy rare earth elements.

In a note about Lynas, Travis Lundy is optimistic about the company based on the opportunities the continuing trade war presents and on the expectation of renewing its operating licence in Malaysia (where Lynas does rare earth refining) – which happened early this week.

Read the full Insight by Travis Lundy: Trump Trade Means Lynas Capex Easier

While the fruits of the joint venture with Blue Line will take a while to ripen, a non-Chinese player with the right capacity and expertise could be attractive to western and Japanese companies looking to step around the trade war fallout, Lundy believes.

In fact, Lynas can benefit from customers and investors who want it to succeed and grow as a viable alternative to Chinese firms.

Whichever way a full-on ban of rare earth supply by China goes, the mere possibility will likely make the markets think harder about the viability of alternative rare earth sources.

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Luckin Coffee IPO - Luckin coffee cup on a counter

In Hot Coffee: Where the Luckin Coffee IPO Went Wrong

By | General

China’s great Starbucks rival, Luckin Coffee, hit on the nerves of a lot of investors last week – and the coffee wasn’t to blame. A precipitous share price drop of 39 percent from its previous peak seems to have dampened the market’s thirst for java. But it wasn’t always this way.

A few weeks ago, Luckin’s story was one of promise and potential: a young upstart brewing a revolution against multinational coffee overlord Starbucks.

With an oversubscribed public listing in the US, the company raised US$651 million. Its rapid growth continues, with Luckin aiming the top of the market by year’s end, opening 4,500 coffee shops across China.

So what went wrong?

Luckin built itself up using the formula of China’s hyper-growth tech startups: grab market share from a Western incumbent through aggressive growth, heavy subsidies, and a unique tech-focused approach.

Unfortunately, this playbook works better for perennially private tech firms than young upstarts with public market ambitions.

Smartkarma Insight Providers have tracked the company on the lead-up to its IPO, and their early concerns echo the market’s current misgivings pretty accurately.

A Nascent Coffee Culture

From the outset, LightStream analyst and Smartkarma Insight Provider Oshadhi Kumarasiri noted some of the challenges in a note published on 2 May. For one, coffee is just not that huge in China yet.

While the overall Chinese coffee market grew at a CAGR of around 30 percent from FY 2013 to 2018, it still makes up just about 2 percent of the global market.

“Even if this rapid growth continues, we expect it will take another 15-20 years minimum for the Chinese coffee market to reach the size of the US coffee market,” said Kumarasiri.

In that light, Luckin’s shop-opening spree doesn’t look promising. In less than two years, the company has opened 2,300 stores in China, and is looking to almost double that by the end of 2019.

To compare, Starbucks reached 3,800 stores in the country over a steady and measured approach over the past 20 years.

Luckin Coffee vs Starbucks stores in China

By splurging on rapid growth, Luckin has very little room to maneuver on costs like store rentals, operations, payroll, and more.

“Our base case assumptions forecast Luckin’s gross loss to reduce over time. However, even after the improvements, we expect the gross margin to remain negative in 4Q2021,” Kumarasiri pointed out.

Read Oshadhi Kumarasiri’s Insights: Spilling the Coffee: Rapid Expansion Without Much Due Diligence Could End in Disaster and Luckin Coffee: Top Line Growth May Not Be Enough to Generate Positive Operating Margins

Coupon Craze

Then there are those aggressive discounts and subsidies.

“Presently, Luckin’s average revenue per unit of a brewed drink is less than half of the listed retail price (starting at RMB 21), thanks to massive discounts and free coupons that are on offer,” said Investory analyst and Smartkarma Insight Provider Devi Subhakesan in a report.

Coffee delivery is also highly subsidised, with fee charges for delivery covering only one-fifth of delivery expenses.

Meanwhile, Insight Provider Zhen Zhou Toh of Aequitas Research found that, among other costs, 89 percent of Luckin’s revenue goes to “ads, free promotion, and delivery.”

Read Devi Subhakesan’s Insight: Luckin Coffee: Looking at the Good, the Bad, the Unsure, and the Future

A History of Cash Burning

In a different Insight, Toh explored Luckin’s pedigree, especially regarding Founder Jenny Qian’s connection with automotive startups UCAR and CAR. Both companies, founded by Qian’s mentor Charles Lu, followed the exact same cash-burning strategy to achieve growth against incumbents like Didi Chuxing and Uber.

As Toh noted, Lu is an active player within Luckin as well, attracting some of the same investors to the new venture. And looking at CAR and UCAR’s IPOs, which both fizzled after an initial high, it’s hardly surprising that Luckin’s listing went a similar way.

To further drive the point home, Aequitas compiled 30-day stock performances of recent Chinese IPOs in the US, including Pinduoduo, Tencent Music, and NIO. Most of them dropped off after a first-week high, and Luckin was not going to be an exception, Toh warned.

Luckin Coffee IPO

Chart by Aequitas Research

“We think that after the first week, the market will adopt a wait-and-see approach until the next quarter announcement to see whether management can deliver the growth that they have promised,” he wrote.

Read Zhen Zhou Toh’s Insights: Luckin Coffee (瑞幸咖啡) IPO Trading Strategies, Luckin Coffee (瑞幸咖啡) Vs. Starbucks (星巴克) – Still Has a Long Way to Go, Luckin Coffee (瑞幸咖啡) – The Art of Burning Cash for Market Share

Future Brew

It’s not all over for Luckin. The big bet will be achieving sustainability, or even profitability, before the cash runs out.

“A long-term sustainable coffee shop/chain business model cannot afford to run like a fashion brand,” said Subhakesan.

The analyst expects the company to phase out aggressive discounts, which will improve average realised revenue. If it manages to stabilise volumes as stores mature, offsetting the fall in discount-powered demand, net operating margins should improve to 20 percent, she calculated.

Luckin will still need to keep an eye on the competition, however. For example, Starbucks China now offers both online ordering and delivery – two of Luckin’s unique selling points.

“We feel the risk is too high with Luckin Coffee, especially when there’s a much safer investment option into the Chinese coffee boom by way of Starbucks,” Kumarasiri concluded, two days before the NASDAQ listing.

Read more IPO coverage on Smartkarma!

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Nuclear power plant

Is Nuclear Power Too Radioactive to Be ESG-Friendly?

By | General

For investors who want their money to make more impact in addition to rich returns, ESG is an ever-popular avenue – especially the “E” part. As environmental concerns, climate change, and overreliance on fossil fuels grow more pressing, ESG investors consider renewable energy just a sound deal, but a moral imperative.

To most people, environmentally-friendly investing in the energy sector usually involves wind farms, solar panels, and similar renewable energy sources. Rarely does anyone include nuclear energy in that list.

Toxicity

It’s interesting that the sector is so radioactive for ESG investors, considering that nuclear is one of the cleanest forms of large-scale energy at the moment.

In fact, defenders say that absent the current global backlash and decline, nuclear energy would easily satisfy that aforementioned “E” part due to lower amounts of toxic waste (relative to carbon and solar) and its capacity/cost ratio.

But the current climate is not surprising – the nuclear industry has a public image problem to overcome. High-profile disasters like Fukushima and Chernobyl have made things significantly worse for proponents of the atom as a power source. The word association between “nuclear” and “weapons” doesn’t help either.

According to Michael Shellenberger, environmental policy writer and founder of clean power advocacy Environmental Progress, nuclear energy has declined 7 percent from its peak since the 1990s, while solar and wind have not grown enough to make up the difference.

A report by Environmental Progress, meanwhile, shows that global public and private investment in solar and wind between 2008 and 2016 was US$2.1 trillion, whereas investment in nuclear between 1962 and 2016 was US$1.8 trillion.

While supporters of renewable energy question the motives and findings of pro-nuclear analysts and authors like Shellenberger, real-world examples of nuclear usage demonstrate its impact on clean, affordable energy – and even that doesn’t seem to help nuclear make its case.

Half-life

Gaius King, an independent Insight Provider who publishes on Smartkarma, has written about the decline of nuclear power and its consequences. “France currently generates approximately 72 percent of its electricity needs via atomic means, coupled with wind power, which results in 80 percent from renewable sources, the highest level in the Developed World,” he notes.

This is how France offers the cheapest domestic electricity prices in Western Europe, plus exports “its surplus to a number of its neighbours, earning <€3 billion per annum.”

And yet, the country has undertaken to “close 14 of its nuclear reactors by 2035 (in addition to its last four coal-fired power stations) reducing its atomic reliance target to approximately 50 percent of domestic needs.”

“Any energy comparisons deal with substantial levels of bias,” King warns. “Some [low-carbon] options such as nuclear and hydro are not acceptable to many – for reasons I cannot fathom at times. In regards to ESG attractiveness, its a political battle. Facts are largely irrelevant, solar is green, nuclear is not… why?”

One of France’s major energy buyers, Germany, started moving away from nuclear power post-Fukushima and now covers 40 percent of its energy needs with lignite – perhaps the dirtiest type of coal.

Read Gaius King’s full Insight on Smartkarma: Uranium – About to Enter Its Own Nuclear Winter

And in South Korea, the nuclear part of the country’s total power generation decreased from 30 percent in 2016 to 23.4 percent in 2018, even as the percentage of coal usage in the country’s total power generation rose from 38.7 percent to 41.9 percent in 2018. Renewable energy sources rose as well, but only accounted for 4.9 percent of total power generation in 2018.

Read Douglas Kim’s full Insight on Smartkarma: A Pair Trade Between Doosan Heavy Industries & Doosan Corp: (미세먼지, Nuclear Power, & 0.42 Million)

It’s clear that no matter where one stands on the argument, the decline of nuclear energy due to public distrust and political issues is not conducive to cleaner forms of energy – if anything, the opposite seems to be happening.

Fallout

This presents ethically-minded investors with a conundrum: do they try to put their money behind nuclear energy, or does the industry’s global decline and ill reputation augur poor returns? Even worse for ESG investors, does an investment in nuclear power conflict with their impact mandate, despite it being a much cleaner source of energy than any fossil-based fuel?

Perhaps one key challenge is that investors might not know enough about the challenges and opportunities of the sector. A study by BNP Paribas showed that access to data is the greatest challenge ESG investors face when called upon to make decisions.

The debate around the pros and cons of nuclear energy has been raging for years now, with both sides making detailed arguments to support their point of view. Investors could be forgiven for having difficulty parsing all the information out there.

Read more on Smartkarma: Why ESG Investing Is No Longer the Buy-side’s Top-Performing Cliché

What’s hard to deny is that relying solely on renewable energy is not enough to get us to reduce greenhouse emissions by 2030, our current milestone to help alleviate climate change effects.

“There is an enormous volume of data out there suggesting that solar power is the cheapest thing but doesn’t take into account the lack of battery technology, cost, or the enormous amounts of land required, replacement times, and toxic waste afterward (an estimated 65 metric tonnes by 2050),” King stresses.

“Current infrastructure resources [for electric power] are wholly inadequate, and are already facing shortfalls. If we are ever going to break out of the hydro-carbon economy, it can only be via two methods: (a) nuclear power or (b) unconventional geothermal (but the technology isn’t there yet).”

Whichever way the pendulum swings, more scalable solutions and investment will be vital.

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Why ESG Investing Is No Longer the Buy-side’s Top-Performing Cliché

Why ESG Investing Is No Longer the Buy-side’s Top-Performing Cliché

By | General

It doesn’t take a genius to figure just how dire things are in this world we call home. These flashpoints offer a sense:

Environmental

Climate Change – The Killer Thaw

“Climate change is likely to cut Antarctica’s 600,000-strong emperor penguin population by at least a fifth by 2100, a study suggests.”

BBC, 30 June 2014

Less than five years later…

“Thousands of emperor penguin chicks drowned when the sea-ice on which they were being raised was destroyed in severe weather.”

BBC, 25 April 2019

Social

Child Labour – Still Rife in the 21st Century

“Car and tech companies are scrambling for supplies of cobalt, a mineral they need to power electric vehicles and smartphones… A CNN investigation has found that child labour is still being used to mine the valuable mineral at some operations in the Democratic Republic of Congo.”

CNN, 3 May 2018

Governance

Corruption – There’s an Economic Cost

“The annual costs of international corruption amount to a staggering US$3.6 trillion in the form of bribes and stolen money, United Nations Secretary-General António Guterres said…”

World Economic Forum, 13 December 2018

In truth, the aforementioned examples represent only the tip of the ESG (Environmental, Social, and Governance) issues requiring urgent resolution.

But the unfortunate reality is such: Governments, with their finite resources, face hard choices in prioritising how they allocate budgets. And, as a result, end up leaving problematic gaps unaddressed.

Evidently, there exists a yawning gap between the resources needed to effect change and what’s (actually) available.

All is not lost.

Private Capital to the Rescue

While a shortage of funds and, to some extent, the lack of political will, has been pinpointed as common obstacles, they also create an enormous investment opportunity for private capital to be deployed to great effect.

Nine in 10 respondents of BNP Paribas’s ESG global investor survey are predicting that “impact” allocations will form more than a quarter of their funds by 2021.

And it’s already happening.

Take Norway’s US$1 trillion sovereign wealth fund, the world’s largest, for example. In March 2019, it made a firm choice to cut oil and gas exposure from its portfolio.

“Although the proposal has not stated that it is driven by climate risk, it mentioned the lack of renewable energy prospects as a rationale for shortlisting the stocks it plans to divest. This may trigger other investor groups to follow suit, impacting sector valuations further,” Investory’s Devi Subhakesan wrote in a research Insight published on Smartkarma.

Read Devi Subhakesan’s full research Insight on Smartkarma: Climate Action – School Strikes Hit a Spot, Carbon Emitters Face Heat. Investors Take Note

Promising signs, no? Hold that thought.

Beneath the Greenwashing

On the surface, ESG investing appears to be catching on. But beneath that facade, structural challenges remain.

BNP Paribas’s study has revealed that the greatest impediment to ESG integration isn’t a lack of conviction of its potential to improve long-term portfolio performance, nor the risk of greenwashing, nor inadequate backing from senior leadership.

It’s access to data!

Barriers to ESG adoptionSource: BNP Paribas

“I believe data on sustainability is now viewed in a similar way to how financial data was treated around 75 years ago,” notes Andreas Feiner, founding Partner at sustainable asset manager Arabesque.

“This has resulted in a situation where some companies avoid disclosing some information that would potentially show them in a negative light.”

Heap and Keep the Pressure On

Feiner couldn’t be more right.

Earlier this year, Exxon Mobil wrote to the US Securities and Exchange Commission, attempting to solicit the regulator’s help in blocking an investor proposal that called for the firm to set emissions targets.

Exxon clearly felt the heat from investors!

From this case, we can see how the power to alter corporate practices (for the better) stems not from ESG investing itself, but through its resulting activism.

Investors often look to bigger investors for direction and validation. And who better to lead (and influence) this proactive push for change than the world’s largest institutional investor – BlackRock:

“Profits are in no way inconsistent with purpose – in fact, profits and purpose are inextricably linked…

Companies that fulfil their purpose and responsibilities to stakeholders reap rewards over the long-term. Companies that ignore them stumble and fail. This dynamic is becoming increasingly apparent as the public holds companies to more exacting standards. And it will continue to accelerate as millennials – who today represent 35 percent of the workforce – express new expectations of the companies they work for, buy from, and invest in.”

Larry Fink’s 2019 Letter to CEOs

The time has come for custodians of private capital to reexamine their patchwork approach to investing sustainably.

Their investees, on the other hand, also face a pivotal decision: Genuinely embrace the tenets of ESG, or be prepared to be isolated by the broader investment community.

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LNG natural gas

Something’s Burning. It Smells Like a Future Powered By Natural Gas

By | General

Climate activists frequently lead debate on what nations must do to fulfil their Intended Nationally Determined Contributions (INDCs), as enshrined in the 2015 Paris accord. More often than not, they cite classic greenwashing prescriptions, demanding the swift replacement of fossil fuels with renewable sources of energy.

Sure, that could be easily implemented if they played SimCity, the utopian virtual city-building game. But reality isn’t as straightforward.

Languishing in a labyrinth of socio-economic issues, some governments face more urgent spending priorities, such as welfare and education. Others have to contend with natural obstacles, like a lack of land and/or sea space to install solar and wind farms.

Such real-world circumstances create a pressing need for a transitional energy source that not only reduces a nation’s near-term carbon footprint, but supports the economic growth required to improve its citizens’ livelihoods.

For that, the world is turning to natural gas – or LNG, its liquefied form.

Natural Gas Is Catching On, Fast

What energy potential!

“Global demand for natural gas is forecast to increase at an average of 1.6 percent over the next five years with emerging Asian markets as the main engine for demand,” says the International Energy Agency (IEA).

The IEA adds that “China alone accounts for a third of global demand growth to 2022 thanks in part to the country’s ‘Blue Skies’ policy and the strong drive to improve air quality.”

Natural gas consumption 2023 - IEA

Too Much Supply Can Be a Bad (and Good) Thing

More LNG projects have begun to sprout in recent years as oil and gas giants pounced on the potential of these upward projections.

However, no amount of demand is infinite. Once (projected) oversupply sets in, the laws of economics re-tilt the balance by way of downward price adjustment.

Data compiled and published on Smartkarma by independent analyst Massimo Bellino show that “Asian LNG spot prices are now [as of 5 April 2019] at their lowest level since May 2015 (US$4.60 per mmbtu) and close to the lowest records going back to 2010 of US$4.00 per mmbtu.” The acronym “mmbtu” refers to one million British thermal units, standard measure for a million units of heat energy produced by natural gas.

Asian LNG Prices Drop Below the TTF

Asian LNG prices drop below the TTFSource: Capital IQ, Tellurian
Compiled by: Massimo Bellino

 

“The race to gain market share in the projected LNG demand-supply gap has produced an aggregated capacity of proposed new projects of up to 475 mtpa (metric tonnes per annum), a number larger than the total LNG traded volume in 2018 of 319 mtpa, and way above the capacity required to meet the future growth in LNG demand,” Bellino says.

A prolonged slump in LNG prices would likely force oil and gas companies to curtail investments in new projects, thereby mitigating the oversupply risk.

This has happened before: Further analysis reveals that since the last downturn in 2015, firms have cancelled or put on hold about 400 mtpa in total proposed global capacity.

Bellino’s key point is the inherent cyclical nature of the energy markets.

The peak in LNG prices during 2018, together with expectations of future supply gap, has produced a massive wave of new proposed projects.

LNG markets could suffer from periods of oversupply (like now) as a result, followed by periods of a supply gap, giving rise to increased bouts of price volatility.

Read Massimo Bellino’s full reports on Smartkarma:

How Cheaper Gas Fuels Social Good

Economically, the current price plunge arrives at the right time for price-sensitive users in fast-emerging nations.

Cheaper natural gas creates new structural demand, which catalyses an eventual switch away from coal. That not only helps to bring developing nations a step closer to meeting their INDCs, it offers some of their cities an effective solution to address severe air pollution.

“Air pollution steals our livelihoods and our futures… In addition to human lives lost, there’s an estimated global cost of 225 billion dollars in lost labour, and trillions in medial costs,” quips Yeb Sano, Executive Director at Greenpeace South East Asia.

PM2.5 concentration - 2018 world air quality report
Source: 2018 World Air Quality Report by IQAir AirVisual

The Long Versus Short View

What’s been discussed so far would likely prompt any reader to ponder the future viability of natural gas as an energy source.

In the longer-term, demand for LNG will continue to climb as nations and industries balance the transition to renewables with the immediate realities of delivering economic and business growth.

Besides, of the three main fossil fuels (coal, oil, and gas), gas is the still the cleanest burning fuel of them all.

In the near-term, brace for more price volatility from LNG markets!

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Hong Kong’s Slap to Investment Banks Solves Nothing for Future IPOs

By | General

Hong Kong’s regulator has a tough job.

On the one hand, their primary mandate – like other regulators – demands the preservation of financial-market integrity and trustworthiness.

On the other, they tow a fine line in ensuring their actions don’t tie free-flowing markets in regulatory straitjackets.

But sometimes, market players intentionally breach the rules. When that happens, the onus falls on the regulator to crack the whip and set them back on the straight and narrow.

This is because a reluctance to act often perpetuates further questionable behaviour by other players, which could lead to a spiralling decline in overall investor confidence, spurring capital flight.

Incurring the Wrath of Hong Kong’s Securities Regulator

The clear and present danger of meeting this undesirable fate should explain why Hong Kong’s Securities and Futures Commission (SFC) handed its harshest fines ever to three internationally renowned investment banks on 14 March.

The reason: Investigations by the SFC had revealed severe due diligence failings on past IPOs undertaken by them.

Swiss bank UBS received the heftiest penalty at US$375 million, “for failing to discharge their obligations as one of the joint sponsors of three listing applications.”

Next in line for the whip was Morgan Stanley (US$224 million), followed by Merrill Lynch (US$128 million). But unlike UBS’s three applications, the SFC reprimanded these two entities for just one listing: Tianhe Chemicals (2014) – the common thread tying all three banks together.

To get a sense of stewardship failings at play with Tianhe’s case, see the excerpt below from the SFC’s official statement:

Failure to address red flags in an interview

[UBS, Morgan Stanley, and Merrill Lynch] had initially requested to interview the largest customer of Tianhe, Customer X, at its office, but eventually accepted Tianhe’s explanation that since an anti-corruption campaign in Mainland China was underway, Customer X, a large state-owned enterprise, would normally turn down any third-party request to visit its premises.

[UBS, Morgan Stanley, and Merrill Lynch] then agreed to interview Customer X at Tianhe’s office. At the end of the interview, the representative of Customer X refused to produce his identity and business cards and stormed out of the meeting room. He told UBS and other parties that he would not have agreed to be interviewed under Customer X’s internal procedure, and he only attended the interview to help the family of Tianhe’s chief executive officer.

Nonetheless, [UBS, Morgan Stanley, and Merrill Lynch] did not conduct any follow-up inquiries to ascertain that the person it interviewed was the representative of Customer X and that he had the appropriate authority and knowledge for the interview.

The apparent lack of governance was plain for all to see.

Companies that score well on corporate governance tend to perform better in IPOs. Read more: What a Popular Hollywood Film Tells Us About the Symbiotic Link Between IPO Performance and Corporate Governance

Identified: Clear Correlation Found Between Sponsor Selection and IPO Performance

Independently, this latest imposition of fines by the SFC could be easily viewed as a one-off event. As to whether it materially impacts future deal-making business, though, is another question altogether.

If only companies with intentions of listing on the Hong Kong Stock Exchange had a reliable way of benchmarking sponsors.

But, they do!

Deep analysis conducted by Aequitas Research has found a distinct link between the average share returns of Hong Kong-listed companies and the sponsors of their listings.

In the First Week After Listing

“In terms of one-week deal performance post-listing, Bank of America Merrill Lynch (BAML) ranked best overall, as a sponsor, with… an average return on 17.2 percent,” according to Aequitas. “The next-best sponsor was Credit Suisse (CS), with an average return of 11.4 percent.”

1-week deal performance of Hong Kong IPO sponsors

Three Months After Listing

BAML and CS maintained their top two positions in this time frame, averaging deal gains of 22 percent and 11.6 percent respectively.

3-month deal performance of Hong Kong IPO sponsors

The irony: It appears that, based on these findings, Merrill Lynch’s latest run-in with the SFC might be a mere statistical outlier after all.

Sign up or sign in to read the full study: IPO Analytics: Corporate Governance – Alpha Generator, Shortlist of Bookrunners to Avoid/Keep Happy

Uprooting the Root Cause

Studies like the one above undoubtedly go a long way to help inform sponsor selection.

But that’s not the point.

Slapping those massive fines on the guilty three – UBS, Morgan Stanley, and Merrill Lynch – was still a reaction to grave wrongs that had already run their course.

Even though “the sanctions send a strong and clear message to the market,” the misconduct shouldn’t have occurred in the first place, not least in one of Asia’s premier financial capitals.

Yet somehow they did. And that’s because conflicts of interest persistently exist in the due diligence process: Sponsors stand to gain financially and in reputation if their IPOs perform well.

Perhaps the SFC could learn a best practice or two from the UK’s Financial Conduct Authority to nip these failings at the bud.

For a start, why not consider adopting the new UK regime for equity IPOs that allows independent analysts to scrutinise soon-to-be-listed companies?

Smartkarma covered the first listing (Aston Martin) under the UK’s new disclosure rules. Read the Insight: Aston Martin Lagonda Pre-IPO Under the New IPO Process – Lots to like Apart from R&D Capitalisation

That introduces vital checks and balances at the pre-listing phase, which could pressure the sell-side to conduct proper due diligence, or risk losing credibility.

Something for the SFC to think about, eh?

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A Lyft car in San Francisco, as Lyft prepares for IPO

Lyft’s IPO May Be Oversubscribed but Investors Are in for a Bumpy Ride

By | General

After all the anticipation, it’s Lyft that has kickstarted the year of ride-hailing IPOs, much to the enthusiasm of investors. The market has been waiting for the ride-hailing startups to go public for years, perhaps more Uber than its US rival, but that hasn’t stopped Lyft’s listing from being oversubscribed, according to media reports.

And that’s despite Lyft (or Uber, for that matter), not being anywhere near profitability and actually reporting significant losses. Where have we heard this before?

Cast your memory back to March 2017, when Snap Inc, another tech darling, held its own oversubscribed public offering despite iffy financials. People were looking for the next Facebook, and Snap looked like it might be it. 

Three days after listing, Snap’s stock price plunged more than 12 percent and never really reached anywhere near its initial value again.

Obviously, this is comparing apples to automobiles but there are common elements here. For one, both Snap and Lyft are unprofitable tech startups entering the public markets with oversubscribed IPOs.

Also, they are both up against a much more powerful and deep-pocketed incumbent: Facebook proved to be Snap’s ultimate nemesis, while Uber commands a much bigger market share and has a much larger war chest than Lyft.

It’s hard to think market history won’t repeat itself, looking at Lyft’s numbers. It’s enough pressure even without considering the fact that Uber may be after a US$120 billion valuation on NYSE.

Lyfting the Veil

In a comprehensive note on Smartkarma, Insight Provider Douglas Kim asks a question that should be on the mind of every investor looking into Lyft:

“Is US$2-2.5 billion enough for Lyft to last in the next two to three years without concerns about additional secondary offering during this period?”

In his analysis, Kim points out the company will need at least US$2 billion to make ends meet in the next two years. If it manages to raise roughly that much through its IPO, chances are it needs to raise more funds in two or three years. That would potentially mean a secondary share offering, diluting existing shareholders’ stakes.

Lyft revenue, profits and losses, base case scenario

Chart by Douglas Kim

Like several tech hopefuls who believe in super-fast growth, Lyft seems like it will be posting losses for a while yet – Kim’s base case scenario doesn’t expect the ride-hailer to turn a profit before 2025. This increases the possibility of more fundraising in the meantime, with everything that entails for shareholders.

It doesn’t help that Lyft fails to disclose some pretty vital numbers for the analysts to properly evaluate the business. “Without the quarterly active driver numbers and the full picture of the extent of shared rides, one can’t develop an accurate picture of the business,” points out Sumeet Singh of Aequitas Research in a pre-IPO analysis on Smartkarma.

Future Promise

So how can Lyft reduce costs and improve the bottom line? Autonomous cars seem to be a big part of the narrative – after all, much of Lyft’s revenue has to go to the drivers who, well, make ride-hailing services possible. Fewer drivers to pay, more money for the company.

The problem is, truly autonomous cars that will allow Lyft and Uber to do away with drivers altogether still have a ways to go before they take to the streets in large enough numbers.

It’s not just that there isn’t a clear consensus on when full self-driving technology will go mainstream. There is uncertainty in how the technology will be regulated and what it will mean for companies operating fleets of self-driving cars. There is also distrust from the public, not to mention the POTUS himself.

Diversifying the business seems to be a better strategy for Lyft. “Management seems to be aware of the need for business diversification as Lyft has pitched itself as an inter-modal transport network,” says Insight Provider Johannes Salim in a recent piece on Smartkarma. Salim highlights moves like Lyft’s acquisition of bike-sharing provider Motivate as an example.

It remains to be seen whether Lyft will follow Uber into sectors like food delivery to boost revenue – it certainly worked for Uber – or whether it will seek to expand to more markets outside the US and Canada. Unfortunately for Lyft, many markets in Europe and Asia now have their own well-established and well-funded incumbents with their own ambitions for growth.

Ride-hailing companies private valuations - Uber, Lyft, Didi, Grab

Private valuations of ride-hailing companies based on their latest funding rounds

Tech IPO Angst

So is Lyft’s IPO bound to disappoint investors like other tech IPOs before it? Citing data by Jay Ritter from the UF Warrington Faculty at University of Florida, Rohinee Sharma of Investory notes in a brief article on Smartkarma that only 16 percent of the 38 US tech IPOs of 2018 were profitable – a figure that hearkens back to the dotcom bust of 2001.

It’s not uncommon for investors to finance tech companies’ fast growth in hopes of stellar future returns. But it’s trickier to ask public markets to do the same. “Barring very few profitable IPOs marked for this year – AirBnB for example – would the market be subsidising profits for future growth potential?” Sharma asks.

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