INTEROFFICE MEMORANDUM

TO: ZACH EGAN, ANTHROPOCENE CAPITAL MANAGEMENTFROM: JOHN P. MCCARTHYSUBJECT: TWENTY GOOD QUESTIONSDATE: AUGUST 9, 2021CC:

1. You left a very large mutual fund company, to start a small money manager. Why?

As often happens in large organizations, my role had evolved over the almost twenty years I was at the same firm and encompassed increasingly more managerial oversight duties. This took me away from what initially attracted me to the field, namely fundamental research on smaller companies overseas. The project of starting a small money manager was about focusing on the work I enjoyed most and controlling the situation so that I could keep things simple and ensure the culture was foremost oriented towards investment performance.

2. You were CEO of a large investment firm. What are a few major business challenges that larger firms face?

Maintaining excellence and a coherent firm culture is the central challenge as investment firms grow large. While the operating leverage available to investment management firms can be fantastic, growth in assets under management introduces a series of problems, particularly in less liquid market niches where one is more likely to find mispricing. The problems only start with putting sufficient dollars to work without undue market impacts.

Eventually managers are running over diversified, two-hundred stock portfolios that require an army of analysts to monitor and refresh with new ideas. The economies of scale make feeding the army easy. It becomes increasingly difficult, however, to coordinate the research activities of many individual analysts, and to provide the degree of portfolio manager engagement required to keep them focused on the portfolio’s needs, while remaining creative and operating at the upper end of their abilities.

In funds holding many companies across disparate geographies and industries, analyst productivity and judgment are key success drivers since portfolio managers cannot possibly get their heads around the complexities of each of these businesses, whose fortunes are oftentimes shaped by local circumstances.

3. If you were looking to invest in an investment management firm, in the firm not the service, what characteristics would you seek?

I would look for:

• a differentiated investment philosophy and strategy executed by creative risk takers who have skin in the game, understand that markets are constantly evolving, and are sufficiently self-aware of their own methodologies and biases to remain ahead of the curve.

• a fee structure that reflects clients acknowledge the differentiated nature of the strategy and skill of the managers.

• clear a priori articulation of strategy capacity and variables that may affect that.

4. You have made security selections as part of a large group, and by yourself. Any general pro/cons to each?

The organization in which I learned to invest, and ultimately led, was unusual in its commitment to decentralized investment decision-making, albeit with very data-driven oversight. This flowed, I think, from Ralph Wanger’s observation that there ought to be a principle of “Conversation of Stress” in investment management, presumably following from Newton’s Conservation of Mass.

This principle holds that while it is permissible for anxiety about risk in individual investments to flow around an organization, it should nonetheless always reside somewhere, and ideally with the individual who is closest to the portfolio company and best understands the investment. Otherwise, the stress gets dissipated within an organization, the locus of accountability is ambiguous, and mediocrity ensues.

Owing to that experience of decentralized decision-making, selecting securities within a large group, or on my own, therefore very much feels very similar. With positions on which I was the analyst, I always felt personally accountable for the outcome, even if it was held in another strategy where I was not PM. Similarly, for positions selected by other analysts, while my role as PM was always to be a sparring partner and bring to the decision process perspective they might not have considered, it was always important to me that the analyst reached his or her own conclusions. To underscore who was driving on the idea, I then asked the analyst to write the trade.

What is different about selecting securities largely on my own (I have one securities analyst and one colleague doing policy research), is that I no longer have the advantage of sitting in the same office with a repertoire of experienced investors – some with very specialized industry knowledge – who have seen myriad situations and business models, and who retained their seats owing to demonstrated good judgment.

I now replicate access to this sort of knowledge through personal networks I have built over more than two decades with other fund managers, local brokers and analysts, and company management teams in Europe and Asia.

5. As you build your firm, any characteristics in associates or partners that you generally seek?

The following are important to me:

• intellectual honesty and curiosity as evidenced by life choices

• an above average ability to construct/deconstruct an argument

• a good sense of humor and comfort with decision-making under uncertainty

• reasonable numeracy and good estimation/forecasting instincts

• a hard won second language and experience living outside of one’s country

6. You seek companies that offer a sustainable market solution that may enhance earnings prospects. Is this more than just “quality earnings”?

Under the rubric of quality, I look for high returns on capital relative to cost of capital, and an ability to reinvest cash flows at similarly high rates of return. This strikes me as different from “quality earnings”, which often connotes stability or visibility of earnings, regardless of capital intensity.

7. What are “sources of quality”?

High returns on capital relative to cost of capital stem from frictions in the marketplace that make it hard for competitive rivals to steal market share or drive down prices. The sources of these frictions are myriad and vary by industry and business model but include high regulatory standards; requisite scale from the outset; geographic constraints; the benefit of brand, reputation, or demonstrated project competence; intellectual property or know-how; cost of failure vastly exceeding cost of the product; and close collaboration with customers.

In already industrialized, mature economies with low GDP growth, the ability to reinvest cash flows at high rates of return generally stems from a sudden shift or dislocation in the product or service end market, which either expands the value of the market, or allows better-positioned competitors to take market share.

The causes of these shifts are various but include regulation; technology; changing consumer preferences; and the relentless drive for efficiency. The environmental and social thematic strategy around which I have launched my business contains all these variables.

8. You have mentioned that ESG “scores” or “box tickers” have negative screens, meaning one should not own for a portfolio seeking ESG goals. How is your approach different?

I am foremost focused on positive inclusion criteria, and specifically looking for businesses whose products and processes represent high-value solutions to recognized environmental and social challenges.

I am focused here because I believe these companies constitute a target-rich subset of companies possessing the quality attributes I mentioned above.

9. For Environmental, Sustainability, or Governance Impact, what type of accountability do you seek?

While acknowledging that it is laudable that more and more corporations seek to deliver on articulated ESG goals, I focus my energy on how companies generate a positive impact directly through the solutions to social and environmental problems offered by their products and processes.

I draw a distinction between this sort of impact, and an impact that merely accompanies a production process. For example, sugary beverage producers are now focused on reducing energy and water consumption, which reduces their negative environmental impacts. But their core product is still contributing to a diabetes epidemic globally and is therefore hard to construe as a solution to anything.

By contrast, a supplier to this industry that has figured out how to recycle process water, or has developed a more sustainable packaging technology, would be of interest.

This distinction allows me to assess the value assigned to a company’s impact by its customers, who are paying for a solution to a social or environmental problem. Solutions highly valued by customers command premium economics, and these are reflected in company fundamentals.

10. Any hallmarks of “good governance”?

Long-term owners of businesses have always had to be concerned with governance as it is an important risk factor. I look foremost for alignment with shareholders’ interests, which requires transparency and openness to dialogue; attention to capital structure; reasonable management compensation; and a strategic orientation to addressing – through the product pipeline – long-term challenges in economies and societies.

11. Any “principal and agent” conflicts you tend to see and thus avoid?

I am frequently surprised to see management incentive schemes based on earnings targets that fail to incorporate considerations of capital intensity, including with respect to dilutive stock issuance.

International investors also must recognize that there are different forms of capitalism at work. In certain economies, such as Japan, many companies may be managed with goals beyond compounding value for owners of the business.

12. What are some of the better definitions of “growth” and “value” in your view?

I like to think about growth in terms of economic value added, rather than high revenue growth. This allows one to recognize growth in situations where the topline may be static, but profitability is rapidly improving. Or where profitability is static but capital intensity is declining with a business model change.

It also allows one to avoid rapidly growing enterprises where there is no underlying value creation owing, for example, to an ongoing appetite for fresh capital.

The growth/value distinction has never made a lot of sense to me, as equity investing seems inherently about buying a company at a discount to the value of its future cash flows. And even self-described “value investors” tend to emphasize the need for a catalyst, which is typically a positive change in fundamentals. In my mind, this could just as reasonably be construed as a growth situation.

There are situations, however, where perceived risk in an asset – as embedded in the share price – is simply too high, and where the discount rate falls as investors better understand the risk, even without a change in company fundamentals. That would qualify as a pure “value” investment for me.

13. What are some of the more effective governance practices that you seek?

Perhaps counterintuitively, I like situations where the supervisory board is controlled by a strong shareholder – sometimes a founding family, sometimes an industrial group, but hopefully not a European foundation run by entrenched non-family bureaucrats.

While the absence of a majority independent board sets off whistles at proxy voting advisors, the right set of insider owners can keep executive management focused on the long arc of value creation – investing, for example, in growth initiatives that may be near term earnings-dilutive but make long-term sense.

14. Why bother with Japan?

Japan constitutes a large part of the developed market small- and mid-cap opportunity set – more than one quarter by market capitalization.

In addition to a relative abundance of poorly understood, under-researched companies on Japanese exchanges, valuations in this part of the world are in our view presently compelling, particularly if company fundamentals were to improve on a sustainable basis as management teams become increasingly attentive to good capital allocation.

Rising overseas ownership, and policies initiated by former Prime Minister Shinzo Abe designed to pressure underperforming companies, suggest this could happen.

15. Europe tends to have a reputation of a “value trap” in recent years. True?

European equities have indeed meaningfully underperformed US equities over the last 10 years, though some of this performance can be explained by a strengthening USD.

I would not agree that Europe has been a value trap, however. As I write this in August of 2021, the MSCI Europe index has in euro-terms returned almost 11% annualized over the last 10 years, which compares favorably to very long term returns to equity, including in the US.

Particularly in the small- and mid-cap space, Europe is full of dynamic companies that have been tremendous beneficiaries of globalization, and now appear poised to also do well out of initiatives to green the economy.

16. Any business models that you tend to find usually attractive?

The winning business model over my career has undoubtedly been “the high value component”.

This model can be found across a range of sectors including industrials, specialty chemicals, building materials, IT, and healthcare. Companies pursuing this model supply B2B customers with an input that represents a very small part of their overall production costs, but where the component’s performance is a meaningful differentiator in the customers’ end-product, or where the cost of component failure would be catastrophic.

In specialty chemicals, examples might include a flavor component in a food item, or an additive to concrete which confers flow characteristics or speeds cure time.

In industrials, it might be a power supply component going into a device used in a surgery room, where the tolerance for failure is zero, or an inexpensive but critical automotive component, where the cost of a product recall dwarfs any savings a purchasing department might gain sourcing from a lower-cost supplier.

In these situations, suppliers set prices not on the basis of their own production cost, but on an estimation of the value delivered, which they share with the customer.

17. Any evolution in your own investment philosophy over the last 10 years?

For many years I thought of my portfolio in two parts: 70% should be invested in demonstrably great business models, and 30% invested in average or sometimes even scruffy businesses that were for various reasons too cheap, but where I thought I had identified a catalyst that would change the price.

This two-track approach struck me as necessary since great business models are often recognized by the market as such – and priced accordingly. Achieving a targeted excess return across the portfolio therefore seemed to require hot-dogging around in higher risk ideas.

While that proved exciting at times, I have in the last 10 years come around to the recognition that there’s often plenty of outperformance potential in excellent business models since the investment community generally makes the error of assuming premature mean reversion – on growth rates, on margins, on return-on-capital.

Looking back at the positions that had contributed the most to my performance selecting stocks over many years, it struck me as obvious that these excellent businesses had always been good value. One only recognizes this in advance, however, by genuinely adopting a long-term time horizon, and valuing businesses on that basis.

Owing to the annual bonus cycle and other reasons, that’s clearly not going on in many international equity strategies, where portfolio turnover routinely exceeds 100%.

Because the thematic orientation of my strategy entails understanding long-duration shifts in economies and societies I am able, I believe, to make longer term assumptions with a reasonable degree of confidence.

18. Do you have any common “deal killers”, or things you see, you will stop researching an investment?

I go the other way when company management is overly focused on how capital markets assign value to their business. This often adversely shapes capital allocation and other decisions.

In my experience, great management teams are instead focused on delivering value to their customer at a price also favorable to the company, knowing that this will be reflected in company fundamentals, and eventually in the share price.

19. Are international developed markets, smaller caps, generally inefficient, i.e. are there usually opportunities for all security selection approaches?

Industry data show that a modest majority of active international small cap managers have outperformed benchmark indexes over the long run, suggesting that this is indeed a comparatively inefficient part of the market.

Some of this excess return may be compensation for bearing liquidity risk. In my view, investors are often well-compensated for holding individual securities through their multi-year transition from undiscovered and somewhat illiquid to well-known and institutionally investable.

As they gain sell side coverage and trading liquidity improves, trading multiples often expand.

20. You seek companies that have a high return on capital relative to the cost of capital. Any sectors or geographies that tend toward more consistency here?

This characteristic is often found among European industrial (and to a lesser extent healthcare) exporters that dominate various global niches.

As high-growth Asian and other developing markets attained critical mass with the globalization of production and consumption over the last 20 years, European competitors were often better positioned than American counterparts.

This might be attributable to the fact that American companies enjoyed access to a large domestic market, whereas European players, in order to grow, were forced to internationalize early, with all that that entails, including meeting global and local overseas standards, providing service support across many geographies and languages, and adapting products to local requirements.