Guns n’ roses

Some managers have taken this to show how energy security, and the ‘S’ in ESG, needs to come to prominence. Several managers whom we speak to have been actively allocating to holdings in the defence sectors on ESG grounds.

For example, James de Uphaugh, manager of Edinburgh Investment Trust (EDIN), has highlighted the importance of the defence sector to preserve democracy against aggressors. He has a position in BAE Systems, which he notes benefits from the capital-intensive nature of the industry that leads to high barriers to entry and the focus on government contracts provides significant visibility on longer-term order books.

Peter Ewins, lead portfolio manager of the Global Smaller Companies Trust (GSCT), is another to see the opportunity in the sector and has been increasing positions in defence holdings, including North American component manufacturer Curtiss-Wright and UK-based multinational defence company QinetiQ. Meanwhile, City of London (CTY) portfolio manager Job Curtis also holds BAE systems within the top ten holdings, and it was the biggest contributor to returns for the 12 months to 30/06/2022. Co-portfolio manager David Smith cited longer-term fundamental improvements in the operations of the business which are related to the management team’s activities and improved Western defence spending, with the war in Ukraine being the stimulating factor for the company’s re-rating.

Another aspect of defence is cyber warfare. Not only is it important for companies, which are more vulnerable through the ever-increasing amount of investment in IT networks to support remote working and enhance customer experiences, but it is also a concern for governments and national security.

A study published in March 2022 by McKinsey and Co. projected that $101.5 billion will be spent on cybersecurity service providers by 2025. Alongside this, governments continue to invest in the sector with the UK government having allocated additional funding to improve cyber resilience across government as part of the National Cyber Security Strategy and the National Cyber Force.

This Force is supporting UK firms not just to grow and scale up, but also to maintain and extend the UK’s competitive edge as a ‘responsible, democratic’ cyber power on the world stage. The sector has been, increasingly, an area of focus for technology-focussed trusts, including Herald (HRI). They are investing through companies such as GB Group, a global leader in digital identity which helps companies and governments to fight fraud and cybercrime.

At the other end of the market cap spectrum, Walter Price, lead manager for the Allianz Technology Trust (ATT), cites the use of cyber warfare by the Russians in response to sanctions as an example of the threat. Companies that feature in the top ten of ATT’s portfolio include the world’s largest cloud-based information security provider, Zscaler, and Okta which uses cloud software to help companies manage and secure user authentication in applications.
 

Conclusion

 
What constitutes a credible ESG-investment solution has evolved considerably and we believe that it will continue to do so. We are not quite so cynical as to say that the huge wave of interest in ESG in 2020/2021 was caused by its outperformance, but there was undoubtedly a sweet spot in which investing seemed easy: investors could have their cake and eat it.

It can’t be a coincidence this was the period of the Johnson premiership! Now the decisions seem harder and the trade-offs more apparent. Climate change is going to continue to be a key ESG concern of many investors, but it is likely that in the aftermath of the Russian invasion of Ukraine, more will be sympathetic to the argument that fossil fuels will be necessary during the transition and managers will be looking for alternative ways to display their ESG credentials.

We do not believe investors are giving up on ESG, however it will remain up to the investor to consider the opportunity cost of investing in strict ESG mandates which may underperform during certain economic environments.

In the end, there is no substitute for investors examining whether a manager’s ethical stance mirrors their own enough for them to be happy to invest in their funds. Perhaps we should hedge our bets and say whether it is ‘sustainable’ or not to invest in defence, our societies may be, literally, unsustainable if nobody does.
 
We asked our audience “Should investing in the defence sector be considered good for ESG purposes?” and 65% voted no.