July 2019
Meticulous service is “icing on the cake” at Hamilton Point, but our primary focus is the management of investment risk. Clients look to us, without guarantees, to preserve their wealth — whether built up throughout a career, following the sale of a valuable company, after receiving a family inheritance, or when setting up and managing a nonprofit endowment or family foundation. While diversification is an important start, we argue it is critical to pay close attention to factors many investors ignore or by default embrace because they invest somewhat arbitrarily in products such as index funds. This newsletter draws attention to just one particular risk area – the potential hazards in company-specific supplier relations. What we share may be disturbing to any reader, especially one, say, driving their Tesla while eating a piece of chocolate.
Run!
At Hamilton Point, it is not so much what we buy in client investment portfolios that matters, but what we avoid that is critical. More broadly – and in strong contrast to index funds owning all large companies and industries – we bypass many investment sectors entirely when, for example, regulatory issues are uncertain or the competitive environment is unhealthy. We also insist that our Global Core companies sell what we believe to be a “value-added” product which genuinely helps their customers (think toothpaste versus soda and tobacco).
It is not enough, however, to own companies selling value-added products like elevators or contact lenses. As we evaluate the 35 or so companies on our Global Core buy list – and hundreds we track who may one day replace a current holding – we evaluate the health of a particular company’s supplier relationships before we decide to invest. We believe companies must utilize reliable and healthy suppliers in order to have a reasonably predictable business.
While not as relevant for companies providing services like internet search, hotel bookings or advertising, supplier relationships are absolutely meaningful to traditional manufacturers or consumer products companies who source globally and face legal action and/or public relations backlash from issues like excessive pollution or slave/child labor. Unfortunately, it is near impossible to find a company with a completely pristine supply chain, and such issues are subjective, but we endeavor to steer clear of the worst areas.
Garbage In, Garbage Out
For the balance of this newsletter, we draw attention to sources of supply for two heavily consumed products that pose risks to investors: electric cars and chocolate. In both cases, global operators are well aware of glaring, negative issues in these areas. Management teams may be doing all that they can to address supply-chain challenges, but genuine fixes are mostly out of their control. As has been true with Middle East oil for decades, sophisticated companies may be willing to extract goods and use labor in developing areas (i.e. Africa, Central America, India) but local governance is such that humanitarian and environmental controls are generally lacking.
In the case of chocolate, West Africa produces around 65% of the world’s cocoa beans. Well-documented cases of child and slave labor practices in cocoa-producing countries were historically ignored by large chocolate companies.1 Fortunately, expositive media reporting and a general desire by big corporations to act more sustainably led to the 2007 formation of the International Cocoa Initiative (ICI) in Switzerland which works to ensure that growers are more protective of child labor rights. Their annual report cites a goal to help another 375,000 children in the next few years which likely means that millions of young workers are still being overlooked.
We turn our attention now to the popular lithium rechargeable batteries for phones, laptops and especially electric cars which are ultimately powered by one’s local electric utility. Worth noting is about 64% of the electric grid in America is still using fossil fuels, of which 43% is coal, so, depending upon where you power up, the cars themselves run “clean” but may actually be partly coal-fired by the utility.2 Moreover, electric vehicle popularity has made the demand skyrocket for lithium (which is harvested by the ton from giant salt bogs in places like Chile), as well as for a much rarer ingredient needed for batteries – the element cobalt.
More than 60% of cobalt is mined in the Democratic Republic of Congo (DRC), a near lawless country that has witnessed millions of deaths due to conflict in the last few decades.3 Child/slave labor and environmental concerns in DRC are well chronicled and concerning to any company using lithium batteries – especially on the scale anticipated by electric vehicles.4 We do not own any actual miners of cobalt or manufacturers of electric cars but we do own many technology companies whose suppliers rely on cobalt, some of whom have good disclosure about how they are managing this issue. It is an area where we hope innovation and new discoveries may one day lead to an improved humanitarian, environmental and investing landscape.
No Surprises
To conclude, we are making risk management decisions by limiting direct exposure to cocoa and cobalt currently. We attempt to avoid the negative surprises certain companies and industries may suffer from lawsuits and/or changes in customer preference. There are many other industries where sourcing of supplies is troublesome – such as with tea, tobacco, palm oil and sugar – so when looking at the full scale of a particular company’s operation, it is wise to identify the weak links in the operating chain, even if not discussed openly by the companies themselves.
Unless hiding in a bamboo yurt eating berries and leaves, one is going to encounter the perils outlined herein living a modern life. We consider the moral or sustainability aspects of our decisions an unsurprising “bonus” as there is no reason relatively good behavior and profits can’t mix – if you look hard enough. Our aim is to avoid the most obvious uncertainties, minimize surprises and, without offering guarantees, maximize returns. If our approach is deemed more sustainable than most, we gladly oblige.
1) Whoriskey, Peter and Rachel Siegel. “Cocoa’s Child Laborers.” The Washington Post. 5 June 2019.
2) https://www.eia.gov/tools/faqs/faq.php?id=427&t=3
3) West, Karl. Carmakers’ Electric Dreams Depend on Supplies of Rare Minerals. The Guardian. 29 July 2017.
4) Shah, Sachin. “What the New Mining Code Can Mean for the Congo.” The Market Mogul. 18 June 2018.