Portfolio Manager's Commentary

Second Quarter 2014

Performance Review

The type of investing pioneered by Portfolio 21 Investments thirty years ago is gaining momentum as more investors now understand the importance of the risks and opportunities that companies face or pose in their interactions with the natural environment and society. As more investors look for companies that perform well on environmental, social and governance (ESG) characteristics, public companies throughout the world work to improve public perception of their ESG performance. In some cases it is just optics; in many other cases companies are reacting not just to investor demands, but to the realities of a changing world and to the pressure on natural resources that is increasingly visible in our lives and news everyday.

We find two important concepts related to these trends. We have evolved from saying, in the face of broad investor skepticism, that issues of ESG performance may matter in the future. Today, most investors are attempting to “get up to speed” on ESG performance. Second, we continue to find that a relatively small percentage of companies, even those that look good in their public image, are actually doing an excellent job on the critical ESG metrics that Portfolio 21 bases its analysis upon. In one market sector we recently analyzed, we began with 116 companies we thought had merit, got down to 17 companies that were subject to our in-depth research, and ultimately approved just two for potential investment. Granted, Portfolio 21 is known to maintain a high bar of selectivity.

We find the increased investor interest in ESG to be a positive, but we worry that not all investors will exercise the intensive selectivity that Portfolio 21 has honed over the decades and that the potential impact from the efforts of responsible investors may become watered down.

Just as we are selective regarding ESG criteria, we are also selective regarding the financial quality of the companies in which we invest. Despite the fact that the companies in our portfolio produced stronger earnings growth than the average for the market benchmark, our investment performance trailed behind the indexes during the recent period. Despite our strong absolute results, we are disappointed in our results relative to the market overall.

We have analyzed our investment activity and remain confident that our approach of investing in companies that exhibit what we believe to be excellent ESG practices and that also have high quality fundamentals has the potential to produce the type of competitive results found in our longer-term track record. We have simply had a period of unfortunate stock picking—good companies purchased at the wrong time—in a portion of the portfolio over the recent past. We are committed to producing competitive results and owning leaders in environmental, social and governance business practices. Again, we appreciate your loyalty and patience during this period.

Finding Acceptable Companies From Portfolio 21’s ESG Perspective

One of our most important investment goals is to find the companies that are actually superior in their business practices in terms of how they impact society and the environment. We conduct our own in-depth research into each company that we consider for the portfolio and we find that our approach results in a set of criteria that constitute a “high bar” for socially and environmentally responsible investors. We believe we own the highest quality companies in terms of ESG criteria, the true global leaders.

A key aspect of this portion of our work is the “sector thesis” that our research team establishes for every economic sector. We identify the major impact areas that are present in each sector, the specific impacts that companies in this sector may have on the environment or society, and the associated risks and opportunities. As you would imagine, there is a great difference between the issues posed by a company in the computer software business as compared to a company in the steel manufacturing business. By taking a detailed sector by sector, or when appropriate a sub-sector by sub-sector approach, we are able to concentrate our research efforts in the areas that we believe really matter to the environment and society, as opposed to taking a broad brush approach.

We make every effort to focus our research time and attention on companies that we believe have a chance of making it through our process, companies that we believe may be global leaders. We use industry leading external ESG research services in order to focus on companies they have deemed to be high quality. And we have developed our own proprietary scoring system that allows us to use publicly available information, often provided by the companies we are researching, to conduct a moderately detailed review of companies before we take a deep research dive.

However, once we go in depth and apply our sector thesis and proprietary criteria, we find significant differences between companies’ actual business practices and behaviors. In this stage of our process the list of potential investments shrinks dramatically and many of the companies given good marks by ESG research services drop by the wayside.

Overall, in the year ended June 30, 2014, Portfolio 21 did intensive research on 38 companies and only 16 of them made it through and became potential investments.

Recently, in what may be an extreme example, we examined the Chemicals industry group within the Materials sector and went from 116 companies to consider to just two companies as acceptable potential investments. The Chemicals industry group includes companies within the following sub-industry groupings:  Commodity Chemicals, Diversified Chemicals, Fertilizers & Agricultural Chemicals, Industrial Gases, and Specialty Chemicals. In total, 116 companies were identified for research. Next, Portfolio 21 applied its proprietary ranking system in which we identified the companies with what we view as strong financial and environmental key performance indicators, resulting in just 17 companies for in-depth ESG research.

To analyze the remaining 17 companies in the Chemicals industry group, Portfolio 21 analysts conducted detailed comparative analysis honing in on whether the company met our ESG thesis. For this industry group, we were especially attentive to companies’ raw material and product portfolio—were they comprised of predominantly toxic substances that pose significant human and environmental risk that could be targeted by future chemical restrictions? Similarly, we analyzed companies’ chemical management and substitution strategies as well as initiatives aimed to significantly reduce pollution. In the end, of the 17 companies analyzed against Portfolio 21’s ESG thesis, just two companies were approved for inclusion in our investable universe.

The quality of Portfolio 21’s holdings relative to the benchmark can be gauged by reviewing MSCI IVA ratings for the companies in the Fund compared to the index.

MSCI ESG IVA Ratings as of 6/30/14

Portfolio 21 (%)
% of holdings covered by MSCI IVA7898
Figures may not total to 100 due to rounding methodology.

MSCI ESG IVA ratings service does not cover all companies. The coverage percentage is included to indicate the availability of information on holdings. There is no "Not Rated" category.

MSCI ESG Intangible Value Assessment (IVA) analyzes companies' financially material risks and opportunities arising from environmental, social, and governance factors. The company rating is expressed on a seven-point scale ('AAA–CCC'). Through a quantitative analysis of a company's exposure to ESG-driven risks and opportunities and in-depth comparison against sector peers on how well companies are managing their exposures, the IVA ratings model differentiates companies' positioning on medium- to long-term value or risks that may not be considered by conventional financial metrics. For a more detailed explanation of methodology, please visit MSCI IVA's website.

Just as we diligently strive to own the world leaders in terms of ESG characteristics and performance, so too do we strive to own companies with high quality business fundamentals. As noted in our introduction, our investment results have recently lagged the market returns, despite the good fundamental results from the companies we have selected.

In some cases, companies we had selected recently produced impressive results, but Wall Street was disappointed with the companies’ more conservative comments about the potential for near-term improvement and the stocks dropped. A good example of this is Silver Spring Networks, which produced quarterly results that were in line with our expectations but its forward guidance was below Street expectations as contract conversion cycles lengthened, leading to a sharp selloff in the stock. The stock dropped more than 30% following the results and ended 23% lower for the quarter, despite revenues growing 34% year-over-year and earnings per share (EPS) nearly doubling. The company is a leader in networking technologies that modernize today’s power grid. Silver Springs’ solutions improve energy management and efficiency; these technologies are useful in helping utilities to optimize the timing of power generation, resulting in improved efficiency and reduced emissions. The smart grid provider’s open standard and asset-light model is still attractive to us but the company needs to rebuild credibility by consistent execution. We sold our shares but will continue to monitor the name and the space.

Another detractor from performance was due to many of our higher-growth mid-cap stocks declining in price as other investors took profits after recent strong gains, despite solid fundamental results and stable outlooks. Generac Holdings, a leader in the production of efficient electric generators and SVB Financial, a bank known for its socially responsible lending are two examples. Shares of Generac dropped 17% during the second quarter after rising 60% during the previous three quarters. The company has grown its earnings per share by 85% over the past year and sports industry leading margins and returns on equity. We believe the company may continue to grow at above-market rates on increased penetration in residential backup power, commercial and industrial market share gains, and expansion into new markets and geographies. SVB Financial lost almost 10% after climbing 55% in the previous three quarters, despite beating earnings expectations by 25%. Earnings jumped 117% on solid loan growth and securities gains. SVB’s distinction in the innovation space, coupled with a target market that has continued to expand, should enable above-average balance sheet and EPS growth. We are maintaining our positions in these companies.

Selected Fundamentals as of 6/30/14

Portfolio 21
Historical 5 Year
EPS Growth (%)
Net Income Growth 1-Year71.3612.82
Long Term EPS Growth
Estimate (%)
5 Year Average
Return On Equity (%)
Current Return
on Equity (%)
Long Term Estimated
Return on Equity (%)
Debt/Capital (%)33.9340.61
Historical 5 YR
Average P/E (x)
Current P/E (x)19.6616.45
P/E based on
next 12 months (x)

We continue to believe that the combination of strong fundamentals and high quality ESG characteristics has the potential to produce competitive investment returns, despite the recent soft results. Again, we appreciate your loyalty and patience.

In fact, many of our holdings that have powerful ESG stories did quite well during the period.

New Britain Palm Oil (NBPO) has risen steadily since the start of the second quarter as rumors began to swirl that Felda Global Ventures was interested in acquiring Kulim (Malaysia) Berhad’s 49% stake in the company. NBPO’s plantation assets in Papua New Guinea are coveted as they have higher yields than those in Malaysia and Indonesia. The stock gained more than 20% during the second quarter and is up 25% since the position was established last September. Palm oil’s low cost has led it to rapidly grow to become the most used vegetable oil, though it comes at a high environmental cost because of tropical deforestation impacts on biodiversity and land use changes that release significant amounts of greenhouse gases. NBPO has joined forces with World Wide Fund for Nature, Greenpeace and other non-governmental organizations to form the Palm Oil Innovation Group, which is seeking more action from growers to tackle carbon dioxide emissions and buyers to move quickly toward more sustainable palm oil production.

SunOpta rose after reporting strong first quarter results that were well ahead of Street expectations, following a period of transition that kept a lid on earnings upside, driven by strong sales growth in consumer products, which is its highest margin business. Shares gained nearly 20% in the second quarter and are up more than 30% since we purchased the stock in October. Investors warmed up to the stock as the company exceeded internal targets to move aggressively up the value chain into higher value-added consumer products. We believe potential further sales gains and margin expansion in coming years as the company advances on its strategic plan and consumer demand for natural and organic foods remains strong. Further potential upside could come from acquisitions as the company’s propensity to do so has been supported by a strong balance sheet.

Novo Nordisk shares performed very well over the past twelve months, appreciating 40%. Long-term performance since the position was initiated in 1999 is even more impressive.  Novo Nordisk is the only drug maker for which growth in sales since 2001 has outstripped rising research and development (R&D) costs; the latter category has grown the most of all large pharma peers. We believe Novo Nordisk’s R&D emphasis has the potential to continue paying dividends. Late-stage trial results presented recently to the American Diabetes Association shows a combination of new insulin with its established Victoza therapy lowered blood sugar to unprecedented levels and should be an important diabetes treatment once approved.

First Solar stock has risen more than 30% during the past six months and nearly 60% during the past one-year period on strong demand for solar energy. The opening of new markets and industry consolidation has resulted in increased revenues and profitability for the sector, and anti-subsidy tariffs and impending carbon regulation in the U.S. may drive profits and sales growth further. First Solar exited 2013 with about 6% share of global photovoltaic unit shipments and nearly 15% share of industry-wide revenues, buoyed by the firm’s services business. The company’s thin-film technology is anticipated to position the company to increase its module-level cost per megawatt lead versus poly-silicon based solutions in the utility market, allowing it to sustain leadership in the large-scale solar market. Additionally, First Solar plans to introduce the TetraSun product in 2014, which should open up potential growth opportunities in the commercial, residential, and community-scale markets, doubling the estimated addressable market.

Apple shares are up 60% over the last twelve months and more than 20% over the past three. The stock has been on the rise since the company announced plans to return $100 billion to shareholders through dividends and share buybacks in April 2013 and reported a surge in second quarter iPhone sales. Investors are processing Apple’s strategy for competing in the cloud-based world and anxiously awaiting details on new products still expected to be released this year. We remain keen on the company’s strategy of producing new and innovative devices and services designed to keep users happily ensnared in the iTunes ecosystem for years to come.

We strive to meet three criteria at all times in the companies of our portfolio:  world leaders in terms of ESG performance, high quality operating fundamentals, and competitive investment results. We believe the first two goals are somewhat within our control and are the result of our disciplined day-to-day research effort. Over the long term, adhering to our discipline has produced the competitive results we desire. Once again, thank you for your patience during this period of soft investment results.

The information provided herein represents the opinion of the Portfolio Manager of the Fund and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

Past performance does not guarantee future results.

Holdings are subject to change and are not recommendations to buy or sell any security. See complete fund holdings information.

The MSCI ACWI (All Country World Index) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 44 country indices comprising 23 developed and 21 emerging market country indices. An investment cannot be made directly in an index. Returns reported reflect the net total return index, which reinvests dividends after the deduction of withholding taxes, using a tax rate applicable to non-resident institutional investors who do not benefit from double taxation treaties.

Standard deviation  is applied to the annual rate of return of an investment to measure the investment's volatility. Standard deviation is also known as historical volatility and is used by investors as a gauge for the amount of expected volatility.

Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.

Information Ratio is a ratio of portfolio returns above the returns of a benchmark (usually an index) to the volatility of those returns. The information ratio (IR) measures a portfolio manager's ability to generate excess returns relative to a benchmark.

Earnings Growth is a measure of growth in a company's net income over a specific period, often one year. This is not a forecast of the Fund's future performance. Earnings growth for a Fund holding does not guarantee a corresponding increase in the market value of the holding or the Fund.

Earnings per share (EPS) is calculated by taking the total earnings divided by the number of shares outstanding.  EPS Growth and Earnings Growth are not forecasts of the Fund's future performance.

Return on Equity is the amount, expressed as a percentage, earned on a company’s common stock investment for a given period.

The Price to Earnings (P/E) Ratio reflects the multiple of earnings at which a stock sells.


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