Tag Archive for: investors

The rapid falls in equity markets earlier in the year spurred numerous reports about the outperformance of ESG funds through this weaker period. To me this reflected the durability and attraction of well governed businesses, as well as the continuing share of responsible investment within overall capital flows. Undoubtedly the data was helped by the disastrous performance of the traditional Energy complex as the oil price fell, a segment avoided by funds with even the faintest tinge of green. Yet even excluding this impact the trend of outperformance by companies with a strong, responsible culture should not have been a surprise.

A recent report from Grant Thornton showed the very strong positive correlation between performance and good governance. The research covered the constituents of the FTSE 350 ex-investment trusts over a 10 year period, and the results are compelling. One of the most notable elements was the exceedingly high correlation between a strong corporate governance score and cash flow generation. Again, to my thinking this was unsurprising, and explains why most long term investors take so much notice of the character and behaviour of management teams. The correlation is high because the former is an important driver of the latter. Management teams not only set the procedural policies of a firm but also set the tenor of the organisation. Culture truly does begin at the top and permeates throughout the business.

While all of this is, I believe, widely accepted it does nevertheless clash slightly with another observation. As an investor I have long been drawn to companies with significant family ownership. My experiences here have generally been very positive with my longer term approach typically aligning well with that of the majority owner. Many of these companies score highly in terms of strategy, internal investment in both plant and people, as well as flexibility and creativity. However, it is not uncommon to find less than best practice in some areas of corporate governance. For example, in my experience it is not uncommon to find a weaker than average showing in important elements such as the ratio of women on boards, and the true independence and influence of non-execs. In addition, family led companies may also be less inclined to consider wider societal issues if they impact their own bottom line. The academic literature is somewhat mixed here but in 2015  Rees & Rodionova concluded that “when it comes to investments that foster social good but do not guarantee financial returns, families tend to act as financial wealth maximizers and tend to hinder such expenditures.”

If this is right, how do we square this particular circle? If strong and demonstrable corporate governance is a key factor in longer term performance and family run businesses do not necessarily excel here, why do they still outperform? I think the answer is simply that they have the best interests of the company at heart. In order for a business to go on delivering over many years it needs investment and guidance. Family owners know this all too well, but they care less about proving it to the outside world. The capital market’s focus on good governance is to prevent poor behaviour which is ultimately costly for shareholders. A career CEO joining a new business could be more concerned about feathering his or her own nest for the next few years than steering the company into the next decade. External scrutiny is therefore a powerful force to limit this behaviour. Non-execs have a crucial role to play here by holding management’s focus across all stakeholders and steering an alignment of interests.

What to do? Ultimately if a family remains in control of a firm it is very difficult for minority shareholders to force change in these areas, but they can apply pressure. Obviously as more and more equity capital resides in the hands of ESG savvy investors the companies which score poorly in these areas will likely face declining investor interest and their share prices will suffer. This passive trend is certainly helpful but is also slow moving. This is where dialogue is so important. Even minority shareholders can bring about change if their views are clear and backed by evidence. Sometimes the best performing family companies sometimes need a nudge in the right direction. Bringing together the benefits of robust governance with the typical family focus on longevity of future cash flows is a powerful combination for the longer term investor.

It is clear from the numerous surveys carried out around the world that the importance of ESG to professional investors and individuals continues to grow each year. This sentiment comes from a good place, and aims to right the inequalities and inefficiencies inherent in our society today. Frequent headlines about climate change, poor working practices and the gender pay gap serve to reinforce these views in the minds of consumers, and harden their resolve to act. This rising ground-swell of popular opinion has been progressively pushing a somewhat reluctant financial services industry further down the ESG path every year for at least the last decade. What started as a fringe activity has now become very much mainstream. In the UK in particular wealth advisors and investment managers already see a clear ESG commitment as being a minimum entry point for attracting new assets. Yet despite the demand and the huge resources now focused on addressing it, there remains no clear rule book to follow.

Vast marketing dollars are spent demonstrating individual firm’s commitments to ESG and yet it remains remarkably difficult to accurately compare one fund from another without recourse to simple exclusion lists (no defence or tobacco etc) or even simpler returns performance. Other comparisons are rarely truly like for like. Cynics would argue that this is simply the industry using obfuscation to its advantage while making very few real changes to the way investment is done – and a few years ago I would have agreed. However, this view now seems outdated as there are genuine indications of change across many firms, not least from the rising internal importance of sustainability roles. Senior management have got the memo and they are driving real change. The intention is clearly there, but the picture remains just as confused.

Having been several times involved in incorporating ESG standards into fundamental equity investment processes I am acutely aware of the vast landscape of options that need to be considered. Much of the problem stems from the name. ESG is a catchall term that encompasses so many elements from board composition and gender pay, to biodiversity and carbon emissions. This is matched by a bewildering array of organisations offering different standards, goals and frameworks for reporting and analysing behaviour right across the spectrum. As a result It is easy to become overwhelmed by the complexity and end up achieving very little of tangible benefit. I believe this is a significant contributor to the accusations of ‘green washing’ across the financial services industry. In an effort to avoid this label investors have increasingly moved towards a box ticking approach to at least show something tangible to clients and prospects. After all, in order to achieve real change we must have real targets. The intention here may be the right one, but it is also the source of my concern. This approach can lead to an overly narrow review of the target company, and may lead to analysts simply going through the motions. Less scrupulous companies can provide shallow responses in order to tick the box and move on. This helps no-one.

Ultimately a positive ESG approach must begin with culture and intent. As investors we have not only a fiduciary duty to clients, but also a wider societal and environmental responsibility. In order to fulfil these roles we must understand the true attitudes and objectives of the companies we research, and they must understand ours. ESG is a dialogue in which management teams must understand that entrenched attitudes and behaviours are no longer acceptable. In order to achieve the environmental and societal aims that are increasingly pressing, change must happen. Each company faces a different set of challenges and can contribute in their own way. Heavy users of energy or raw materials will clearly have a different focus to asset-light service companies, and it is the analyst’s role to ensure that the right targets are being set and achieved. Tools such as the SDG Compass and the SASB materiality maps can help with this process. The key is to engage so that execs know that their feet are held close to the fire, and investors feel the same pressure from clients and the public. In the longer run this should be beneficial for profits and all concerned as change for the good will pay dividends in terms of improved energy efficiency, more transparent supply chains, better customer retention and reduced staff turnover. These tangible improvements can then be related to shareholders and their clients.

ESG is rapidly becoming a standard part of the investment world and no longer the differentiator it once was. Now the industry needs to talk less and achieve more, and the actions will speak louder than the words. Corporate responsibility is the responsibility of all stakeholders, and it begins with asking the question ‘what are you doing today to make tomorrow a better place?’