McGill International Portfolio Challenge 2020 - Oskar Morgenstern Capital

Strategy Proposal BNSF

In honor of Oskar Morgenstern.

An Austrian-German mathematician.

Co-founder of Game Theory.

Executive Summary A Dual Structure Focused on ESG Investing and UK-based Companies

1 Our main convictions are ESG framework investing and a strong bullish stance on UK equities. The fund follows a dual structure and is split into the Social Fund and the Performance Fund.

2 Convictions and Fund Structure

Social Fund

2

1

BNSF 4

The Social Fund is solely exposed to UK investments and addresses the first two mandates by focusing on socio-economic issues and ESG themes.

3 The Performance Fund represents a globally diversified multiasset portfolio. Its aim is to maximize risk-adjusted returns according to the third mandate, while excluding sin stocks in line with our conviction.

3

4 Board of Director Viewpoints

Š Oskar Morgenstern Capital

Performance Fund

The dual approach to a long-term investment allocation strategy with a socially oriented complementary fund allows to meet the majority of requirements set by the board members.

Page 2

Our Convictions

Š Oskar Morgenstern Capital

Page 3

Conviction I: ESG – More Relevant than Ever Lower Systematic Volatility Meets Profound Positive Effect on Economy Our Vision – Separating Winners from Losers ▪

Economic Benefits of ESG Investing

obligation to the British people and its commitment to strengthen the British economy in the long-run ▪

ROIC ESG Q5 vs. Q1

We are convinced BNSF should act as an impact investor given its 25% 20%

ESG investing is a suitable forward-looking approach that ensures longterm sustainable financial return in a fast-changing world, while at the same

15%

10%

time promoting economic development

2013

2014

Performance Analysis

2015 ROIC Q5

MSCI World Index: ESG Q5 - Q1

▪

40%

2016

2017

ROIC Q1

Companies with higher ESG scores (Q5) demonstrate substantially higher return on invested capital (ROIC) indicating more effective use of capital

30%

▪

20%

Additionally, high rated ESG companies tend to have lower cost of capital due to lower exposure to systematic risk

10%

▪

0%

Ultimately, the combination of low cost of capital and high ROIC leads to higher economic value added for ESG-friendly companies

-10%

WACC by ESG Rating

-20% 2006 2007 2008 2009 2010 2011 2012 2013 2015 2016 2017 2018 2019 2020

ESG-Score

E-Score

S-Score

7%

G-Score 6%

▪

Stocks with a higher ESG rating generally outperform those with a lower score

▪

Outperformance is stronger when the combination of scores is used.

Source: MSCI, OMC calculation

© Oskar Morgenstern Capital

5% Q1

Q2

Q3

Q4

Q5

Source: MSCI, OMC calculation

Page 4

Conviction II: UK Investments Undervaluation Makes UK Investments not a Bad Deal After All Stocks

Currency GBP vs. USD

P/E Indexed on Brexit Referendum 0,8

180 160 140

0,7

120 100

0,6

80 60

0,5

40 20

0 2016

0,4 2017

2018 UK

US

2019

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019

2020

Exchange Rate

Europe ex UK

Indexed EPS on Brexit Referendum 250 230 210 190 170 150 130 110 90 70 50

PPP

Our Vision ▪

Post-Brexit discount makes UK companies stand out compared to European and US firms, thus a favourable outlook

▪

Earnings of UK equities outperformed US and EU earnings post-Brexit

▪

British pound is undervalued compared to US dollar, based on the FX/PPP (purchasing power parity) ratio

▪

We expect the mean reversion of the FX rate and therefore, are bullish on GBP/USD

UK Source: Capital IQ, OMC calculation

© Oskar Morgenstern Capital

US

Europe ex UK Source: OECD, OMC calculation

Page 5

BNSF Fund Structure The Dual Structure is Tailored to Best Fulfil the Triple Mandate Goals separation within the Fund

Recommended BNSF Fund Structure BNSF Target Return: 4.9%

Social Fund: Active impact investing into stable and efficient companies that respect their partner ecosystem according to ESG criteria

Performance Fund (70%) Target Return: 6.1%

Social Fund (30%) Target Return: 2.0%

Support of UK-based SMEs to encourage their growth Reduction of social inequality via direct lending to domestic businesses in regions with lower Gross Value Added (GVA)

35% Equities

Active Impact

COVID

Regional

25% Fixed Income

Performance Fund:

Source: OMC

Š Oskar Morgenstern Capital

Other

VC/PE

Private Debt

Dynamic VaR-based protection strategy for equity allocation that effectively limits downside risk exposure

10% Gold

Private Debt

Higher return target to compensate the lower returns of the Social Fund

20% Real Estate

(HY) Bonds

Geographically diversified multi-asset strategy combined with a negative screening approach for ESG factors (e.g. excluding sin stocks)

ESG Investing

5% Private Equity

5% Infrastructure

Source: OMC

Page 6

The Social Fund

Š Oskar Morgenstern Capital

Page 7

Social Fund Due to the Heterogeneity of Tasks We Propose a Further Division into 3 Sub-Funds I. Regional Investment Fund

II. Active Impact Investing Fund (AIIF)

▪

Our main target is to reduce regional inequality around the UK

▪

The focus lays on regions with below average prosperity (measured by

AIIF

Gross Value Added per head) ▪

The fund is expected to provide debt financing to

Public

companies that have strong local ties with priority given to SMEs that fulfill certain criteria in the sustainability of their financial and business model ▪

Allowing SMEs to expand delivers a positive societal impact by creating jobs and moving people up the social scale

▪

Private

Venture

The main target for the Public and Private sub funds is to address socioeconomic issues and to promote ESG themes

▪

The VC part aims to support start-ups and early-stage enterprises. UK-

based applicants will be screened and evaluated in-house

III. COVID Fund ▪

The Social Fund Breakdown

Since COVID-19 will have a long-lasting impact, we suggest setting up a £1 billion fund to help companies that are suffering from the crises the most

(all numbers are in billions)

Stage 1

Stage 2

Stage 3

Total

Regional

£3

£2

£1

£6

Public

£1

£3

£1

£5

Private

£0.5

£0.5

£0.5

£1.5

Venture

£0.5

£0.5

£0.5

£1.5

Indexed UK GDP per scenario

Active Impact

100 90 80 70

COVID

£1

Total

£6

£1 £6

£3

£15

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2019 2019 2019 2019 2020 2020 2020 2020 2021 2021 2021 2021 Further Outbreak Scenario

Contained Spread

Source: ons.gov.uk, OMC calculation

© Oskar Morgenstern Capital

Page 8

The Performance Fund

Š Oskar Morgenstern Capital

Page 9

The Performance Fund Globally Diversified Multi-Asset Strategy Securing Long-Term Financial Sustainability The Target Rate

Investment Categories

Return mandate: „30Y yield on UK government bonds plus a 2.0% premium“ (p.a.)

30Y GILT Yield 6,0% 5,0% 4,0%

Implied Weights

Category

Sectors Covered

Listed Equities Private Equities Fixed Income Cash Tangible Assets Commodities

UK, US, EU, Asia, EM, Global VC, Growth Capital, LBO, Distressed Debt Gov. and Corp. Debt, HY Credit T-Bills, Deposits Real Estate, Infrastructure Gold

30%-50% 0%-10% 20%-30% 0%-10% 10%-30% 0%-10%

Broad investment categories reflect top-down views on the global economy, financial markets, political risk, and historical data.

3,0% 2,0%

Asset Allocation

1,0%

Gold 5%

Infrastructure 5%

0,0% 2012

2013

2014

2015

2016

2017

Trend and yield curve indicate bond yields to stay low.

Margin of safety 2 std. dev. (calculated over 10 years)

2018

2019

2020 Equities 35%

Current 30Y yield: 0.7%

Real Estate 20%

PE 5%

Target return BNSF: 4.8%

Social Fund (2.0%)

BNSF 4.8%

The Social Fund contributes 2.0%; the Performance Fund 6.1% (before Mgmt. costs) respectively 6.0% (after costs) to offset lower returns from social investing

Source: The case study, Thomson Reuters, OMC calculation

© Oskar Morgenstern Capital

Fixed Income 30%

Performance Fund (6.0%)

Equities

• • •

Fixed Income

PE

Real Estate

Infrastructure

Gold

Volatility minimized in a mean-variance framework for a target return of 6.1%.

Indicated asset weights between established top-down boundaries Consensus estimates based on external research providers and own views.

Source: JPM, Blackrock, SSGA, Invesco, Research Affiliates, OMC calculation

Page 10

The Performance Fund Risk-Adjusted Outperformance Indicates Robustness of the Suggested Portfolio Active Risk Management for Public Equity Exposure

Backtest of Current Asset Allocation Category Return Std. Dev. Worst Year Sharpe Ratio Calmar Ratio VaR (95%)

VaR (95/10) - Equity Portfolio 450 400 350

Global 60/40 7.0% 8.2% -11.5% 0.85 0.60 6.6%

BNSF 7.1% 6.9% -4.3% 1.03 1.64 4.3%

BNSF VaR 7.2% 5.9% -2.3% 1.21 3.18 2.6%

BNSF Performance Fund vs. Global 60/40

300 250

450

200

400 350

150

300

100

250

50

200 150

0 2002

2004

2006

VaR (95/10) Portfolio

2008

2010

2012

2014

2016

B&H Portfolio

2018

2020

Floor (95/10)

100 50 0 2001

2003

VaR Overlay Protection:

•

Annual “risk budget” – aims to prevent losses exceeding 10% (confidence interval of 95%)

•

The Exposure to equity is reduced when: • Probability of reaching the floor increases • Current portfolio volatility exceeds the maximum portfolio volatility indicated by the VaR (The volatility is calculated on a daily basis)

•

Freed capital will be invested in money market securities

Source: GFD, OMC calculation

© Oskar Morgenstern Capital

2005

2007

2009

2011

BNSF Risk Overlay

2013 BNSF

2015

2017

2019

Global 60/40

The portfolio allocation outperformed the benchmark portfolio on both, a riskadjusted (Sharpe ratio 0.85 vs. 1.03) and on an absolute return base.

Outlook of Current Asset Allocation Category Return Std. Dev. Sharpe Ratio VaR (95%)

Global 60/40 4.2% 9.4% 0.45 10.7%

BNSF VaR 6.0% 8.4% 0.73 7.7%

7.2% 5.9% .

1.21

Source: OMC calculation

Page 11

Outlook on the Board Vote

Š Oskar Morgenstern Capital

Page 12

Outlook on the Board Vote If You Run After Two Hares, You Will Catch Neither Board`s Requirement

Implementation of Board`s Views

Save declining Industries

Impact investments

Aadi Singh

✘

✓

Lewis Hughes

✘

Infrastructure investments

✘ ✘

✓ ✓

Impact investments: by skewing our investments towards ESG, we show that we do not only focus on returns. We also recognize the need for BNSF to act as a guiding light for the British economy and society to longterm prosperity and a better future

•

✓ ✓

Support UK-based businesses: by having the Social Fund solely targeting UK-based businesses, with a higher priority given to SMEs from underdeveloped regions, we aim to reduce regional inequality and close the funding gap between large and small-sized businesses in the UK. Our bullish stance on British equities acts as a secondary channel we use to support companies that operate in Great Britain. Our views on UK stocks make them a considerable part of the Performance Fund.

•

Take on Venture risk: innovation drives the economy. By providing venture capital to promising UK businesses we bet on their capability of becoming national champions and creating a better future.

✘

Elizabeth Shelby Oliver Edwards Robert Grey

•

Support UKbased businesses

✓

✓

Anna Aylmer

Take on Venture risk

✘

✓

Laura Spencer

✓

Final Asset Allocation Promote economic independence, by investing to support economic stability, growth and self-sufficiency within the UK

Venture 2.5%

Private 2.5%

Infra 3.5%

Infra 3.5%

PE 3.5%

PE 3.5%

Gold 3.5%

Fixed Income 21%

Gold 3.5%

Maximize risk-adjusted returns to ensure the fund’s long-term sustainability

COVID 5%

Promote the long-term well-being of the British population, by addressing socio-economic issues such as income inequality and unemployment through investments

Source: Case Study, OMC

© Oskar Morgenstern Capital

Page 13

Summary What Makes our Proposal Stand Out Dual Structure Investment mandate separation between Performance and Social funds, with the latter divided into smaller sub-funds with non-monotonous capital inflow schedule

Convictions Strong ESG skew of the investment decisions combined with a bullish view on UK equities.

Outperformance Robust asset allocation for the Performance Fund that demonstrates risk adjusted outperformance vs. the 60/40 benchmark based on both: historical data and forward-looking assumptions

Risk Management Conservative and dynamic risk management strategy for public equity investments in the Performance fund

BoD Viewpoints Asset allocation strategy that is in line with both the viewpoints of the majority of the board of directors and the triple-mandate

Š Oskar Morgenstern Capital

Page 14

Appendix Source: ABC, XYZ

Š Oskar Morgenstern Capital

Page 15

Appendix Global Risk Matrix

Š Oskar Morgenstern Capital

Page 16

Appendix Systematic Volatility in ESG Quintiles Systematic Volatility of ESG Quintiles (z-scores) 0,30

0,20

0,10

0,00

-0,10

-0,20

-0,30

Q1

Q2

Q3 Current

Q4

Q5

Mean

Systematic volatility (or common factor risk) is calculated as the volatility predicted by all the factors of the GEMLT model. Data from January 2007 to May 2017. The vertical bars represent the 5% to 95% range of observed values.

Source: MSCI, UBS

Š Oskar Morgenstern Capital

Page 17

Appendix Comparison of ESG Scores of Third-Party Providers (MSCI and FTSE) 450

R² = 0,1651

Low evaluation ← FTSE → High evaluation

400

350

300

250

200

150

100

50

0 0

50

100

150

200

250

300

350

400

Low evaluation ← MSCI → High evaluation

Source: CLSA, GPIF

© Oskar Morgenstern Capital

Page 18

Appendix Country/Region Valuation Country/ Region UK US Europe ex UK

CAPE

P/E 14.1x 19.6x 32.1x

Forward P/E 26.3x 35.5x 26.4x

16.3x 22.9x 18.3x

EV/Sales

Forward EV/Sales 1.5x 2.9x 1.8x

EV/EBITDA 1.5x 2.8x 1.8x

9.0x 15.2x 11.9x

Forward EV/EBITDA 8.6x 14.6x 10.5x

DY

RS 52W 3.7% 1.6% 2.6%

RS 26W 0.98 1.05 1.03

0.89 1.06 0.98

CAPE Ratio by Country 50 45 40

35 30 25 20 15 10 5 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 UK

USA

Europe

Source: CIQ, OMC calculation

© Oskar Morgenstern Capital

Page 19

Appendix Social Fund Methodology of Allocation for the Regional Investing Fund

Allocation of the Social Fund Capital

1.

Regional prosperity gap per head is calculated by subtracting regional GVA per head from the UK GVA per head. The result then is multiplied by the region’s population to receive regional prosperity gap.

2.

Regional prosperity gap is multiplied by the fund size adjustment multiplier to determine the allocation for the region. The fund size adjustment multiplier is calculated by finding such a value of it that would allow all the regions to receive the same per cent of the regional prosperity gap restricted by the size of the fund.

The example of calculations for Southern Scotland is represented in the table below: Southern Scotland

First part

1) Regional GVA per head

17,028

2) UK GVA per head

28,729

3) Regional prosperity gap per head (2 – 1)

11,701

4) Region`s population 5) Regional prosperity gap (3 * 4)

Second part

6) Fund size adjustment multiplier 7) Allocation for region (5 * 6)

1,168,061 13,667,481,761

0.977% 133,561,820.74

Source: Office for National Statistics, OMC calculation

© Oskar Morgenstern Capital

Page 20

Appendix Impact of COVID and Brexit Investment Environment ▪

UK economy was one of the hardest hit by COVID among the OECD countries and contracted by 20.4% in Q2 2020

▪

Among other industries, hotel, transport and food service were hit hardest with many businesses closing

▪

The recovery to the pre-lockdown level is expected in Q4 2021 earliest under a COVID-19 contained spread scenario

▪

Brexit transition period that will last until December 31st, 2020

▪

EU and UK did not reach an agreement due to pending key issues including fishing and government subsidies

▪

COVID-19 UK Industry Impact

The no-deal Brexit is the most likely outcome

Public Admin., Defence Real Estate Finance and Insurance Logistics Agriculture, Forestry and Fishing Utilities Extraction

Professional and Technical Services Information and Telecoms Manufacturing All Industries

UK GDP Recovery Scenarios

Retail and Wholesale Health and Social Care Admin and Support Services Construction Education Leisure and Arts Food Services Transport Hotels -70%

-50%

Contained Spread

-30%

-10%

Further Outbreak Scenario

Source: BBC, PwC

© Oskar Morgenstern Capital

Page 21

Appendix Performance Fund Allocation

Source: OMC calculation

Š Oskar Morgenstern Capital

Page 22

Appendix Monte Carlo Simulation Simulation of Total Fund Value

Performance Simulation vs. Benchmark Monte Carlo (Portfolio Performance) 350

300

250

200

150

100

50

0 2021

2022

2023

2024

2025

2026

▪

Total fund value incl. simulations of performance

▪

Target rate of 4.8%, expected volatility of 8.2%

▪

Three funding phases (contributions): 2021 (£20bn), 2023 (£20bn) and

▪

25% percentile still slightly above target rate

2027

2028

2029

2030

2025 (£10bn)

Source: OMC simulation

© Oskar Morgenstern Capital

Source: OMC simulation

Page 23

Appendix Decision Hexagon Create national champions with high Venture Risk

Invest in foreign firms that contribute to the UK economy

Support declining industries

Become an impact investor

Consolidate local businesses

Help renationalize infrastructure

Š Oskar Morgenstern Capital

Page 24