Profits with principles in the ethical spending boom

With more consumers going green, investors can prosper, says David Prosser.

Ethical consumerism is no longer a niche interest for idealistic hippies who wait with bated breath each week for the arrival of their boxes of organic vegetables. Britons spent almost £30bn on ethical products in 2005 according to a report published this week by Co-operative Bank.

To put that figure into context, the amount that households spent on ethical goods last year - from organic food to specialist financial services - increased by 11 per cent compared to 2004. Household spending as a whole rose by just 1.4 per cent over the same period.

The providers of many of these products and services are clearly in a lucrative business. And the good news for them - and their shareholders - is there is plenty of room for growth. Ethical spending may have outstripped spending on beer and cigarettes last year for the first time in the UK, but it still represents just 5 per cent of the total value of the average household's shopping basket.

For investors keen to capitalise on the potential of ethical consumerism, there are two possible routes. The first option, which will appeal to investors attracted as much to the ethical part of the equation as the potential profits, is the pure play. That is, those companies which only provide ethical goods and services.

The alternative is to focus on established companies that are embracing the ethical consumerist boom. Sainsbury's organic vegetable sales, for example, beat the total combined sales of all those vegetable box companies by some distance.

Harriet Parker, a socially responsible investment analyst on Norwich Union's range of Sustainable Future funds, says both approaches are valid. "Ethical should be an important investment theme for everyone," she argues. "It's not just that climate change has moved up the agenda, education has improved too and improving wealth means that many people have more money to spend on ethical products."

Joe Walters, manager of CIS Investments' UK Growth Trust, adds: "Regardless of your views on ethical issues, these companies are experiencing strong revenue growth, strong profits growthand for that reason alone they should be attractive."

For Parker, companies that are capitalising on ethical consumerism will have many of the attractions that all investors look for. They are often able to charge a premium for their product or service, for example. They are also less likely to suffer from brand damage, crucial in a commercial world where increasing numbers of customers say that they make purchasing decisions with companies' reputations in mind.

There are also gains to be made when the specialist players meet the mass market. Mergers and acquisitions activity is an increasingly important theme for ethical fund managers, as long-established large companies try to buy into the growth story. L'Oreal's purchase of The Body Shop earlier this year, for instance, is unlikely to be the last attempt by a multi-national to buy ethical credibility.

Sometimes, the opportunities may be less obvious. Parker points out that the beneficiaries of ethical consumerism may be some way back down the supply chain. She currently likes the shares of specialty chemicals business Croda International, for instance, because it is a major supplier of "natural" ingredients (see story below).

Some sectors are likely to be more useful hunting grounds than others. Audrey Ryan, who manages the Aegon UK Ethical Fund, says many of her largest holdings come from areas such as support services and health. Financial services can also be important - one of the fund's largest holdings is in Impax Environmental, a specialist in green investment.

The transport sector is also of interest, according to Bozena Jankowska, head of the sustainability research team at investment manager RCM. She says that as in other areas, both specialist green players and traditional companies stand to benefit.

"The mid-term elections in the US have been very positive for ethanol companies, given that the Democrats are already starting to talk about the need to take action over climate change," she says. "Car companies will also be forced to start looking at producing a greater number of flex fuel vehicles and hybrid vehicles."

Walters believes there are at least three types of opportunity to explore. In addition to examples of companies that have been quick to develop green or ethical technologies or practices, there is also "the reverse proposition".

By this he means companies capable of managing potentially negative factors - the cost of carbon emissions trading, say. Finally, there are secondary opportunities, typically the suppliers of services to consumer-facing companies. This is the category into which Croda, say, falls.

Five pure ways to back ethical consumerism and four less specialist plays

Graham Spooner, an analyst at The Share Centre, suggests Porvair, a small company that is profiting from R&D on carbon dioxide and emissions. "Provair's metal filtration business is performing particularly well right now."

He also recommends environmental consultancy RPS. "It has an excellent track record advising larger companies on planning, engineering, occupational health and other issues," he says. "It will also benefit on further environmental rules coming through from the European Commission."

Norwich Union's Harriet Parker tips Intertek, which specialises in verifying companies' claims about their ethical and environmental practices. Intertek spends its time certifying companies' standards, so customers can be told that all claims have been independently verified.

Joe Walters, who manages CIS Investments' UK Growth Trust, suggests Cranswick, a small food producer that provides organic pork to Sainsbury's. "The high quality of the meat means that it can be sold at a premium," Walter says. "Demand for organic produce keeps on rising."

Spooner points out that investments in many of the smaller environmental and ethical specialists have proved volatile. He suggests the Merrill Lynch New Energy Technology as a fund offering diversified exposure to the sector. The fund is an investment trust, and its shares are quoted on the London Stock Exchange.

Parker suggests speciality chemicals company Croda International as a potentially lucrative play on ethical consumerism. "We've seen increasing demand for natural household cleaning products and personal items," she says. "Croda supplies ingredients for these products"

Robert Wiseman Dairies, which has the licences to sell Rachel's Organic Milk is Parker's second suggestion. "Sales are increasing at around 40 per cent a year and the product sells at a 10p-a-litre premium to normal milk," Parker says.

Walters highlights Scottish Power's renewable energy business. "The company is more advanced than many rivals on the development of renewables, so it should be less hard hit as tighter emissions caps bite. And its wind turbine services are in huge demand."

Among the retailers, Marks & Spencer is Parker's pick, because it has done more to differentiate itself from rivals. Like others, M&S has invested heavily in organic produce, but it is also reporting strong sales of its range of organic cotton.