Would you buy shares in a company that managed its business responsibly over one that was focused purely on profit? It rather depends, I hear you say, on the share price performance of the two companies, because after all, your objective is to make money.
Listed companies have many stakeholders. In no particular order of importance, their business relies on their relationship with their customers, suppliers, employees, the regulator, the governments in the jurisdictions in which operate, their lenders and their shareholders. Equity shareholders are often the most fickle, with the ability to buy and sell stock at the click of the mouse and yet they wield disproportionate power. When the chips are down and no one else will lend the company money, it is the equity investor who is often the funder of last resort. Under such a risk-reward scenario, it is not surprising that shareholders will be focused on making a decent return on their investment.
The board of directors of a company have a fiduciary duty towards its shareholders who have appointed them. But it is a mistake to assume that other stakeholders are somehow less important. It hardly take a rocket scientist to work out that without customer loyalty, its suppliers’ willingness to supply reliably, its employees’ input into turning a promise to customers into a reality and the support of its government and regulators, the company cannot survive, let alone be profitable.
We live in a globally interconnected world. It is a world that is weary of a few profiting at the expense of so many. It is an age when social media and real time information can sink reputations in seconds. Regulators in the world of finance were found to be asleep at the wheel during the worst financial crises of our lifetime and are now coming back with a vengeance. According an article in the International Business Times in May 2015, twenty global banks have paid $235bn in fines since 2008 with more to come. Hell hath no fury like a regulator scorned.
In certain jurisdictions, punishment for corporate crime is in direct proportion to the alleged perpetrator’s ability to pay rather than the impact of the crime itself. UK listed oil giant BP is still paying for its part in the Gulf of Mexico disaster in April 2010 having already spent $54bn in clean up costs, legal expenses and fines for polluting the environment. Since the accident, BP’s shares have lost more than half their market value and continue to languish at a deep discount to its peer group and where it should be trading were it not for the unquantifiable US judicial risk that still hangs over the company like a cloud.
Almost every example of corporate misdemeanour has the relentless quest for profit or market share gain at the heart of it, with a complicit group of shareholders, potential investors and market commentators behind it. Although irresponsible behaviour and its aftermath have no nationality, the rule of law does. Woe-betide the investor who holds shares in a company that is caught breaking the law in the US.
Company wrongdoing does get found out: it is only a question of when, not if. Even if local shareholders are willing to overlook bad behaviour for the sake of profit, there are plenty of other stakeholders who won’t turn a blind eye. Not least of which are hedge funds whose explicit purpose it is make money by shorting companies that have a chink in the armour.
Once a company’s reputation is tarnished, especially if as a result of wilful wrongdoing, it can get labelled as risky for many years causing it to suffer a higher overall cost of doing business and trade at a discount to its better-managed peers.
Environmental, Social and Governance (ESG) or Sustainable and Responsible Investing (SRI) go beyond the more narrow religious or ethical considerations. Screening on this basis doesn’t just help reduce company specific risk. It helps identify companies that are more likely to outperform.
In March 2015, a detailed study on how sustainability can affect financial performance was produced in partnership between Smiths School of Enterprise and Environment at Oxford University and Arabesque Partners, an Anglo-German ESG Quant Asset Manager. The widely acclaimed report entitled ‘From Stockholder to Stakeholder’ draws from over 200 different academic studies, industry reports and other existing information to examine the relationship between business practices and economic performance, both in terms of cash flows as well as share price performance. 80% of the studies found prudent sustainability practices resulted in a positive investment performance. In 88% of these it resulted in better operational performance. 90% found that it lowered their cost of capital.
Responsible investing has come a long way over the past decade. 15 countries from the G20 that make up 78% of global GDP have implemented regulation or guidelines on sustainability reporting. India’s BSE and NSE have voluntary and mandatory (for the top 100 companies) guidelines on social, environmental and economic responsibilities of business. 86% (by market capitalisation) of global stock exchanges offer sustainable indices. Global Sustainable AUM at the start of 2014 was $21.4 trillion making up 30.2% of global AUM, outpacing the growth of overall assets. 79% of CEOs surveyed by Accenture and UNGC see sustainability as a route to competitive advantage.
ESG, SRI, ethical investing and other such labels often mean different things to different people, leaving too much to human judgement. A quantitative approach that removes subjectivity has the advantage of making alpha generation a repeatable process. Arabesque is one of the few quant houses that use ESG research as their starting point and then successively refine the screening process for financial, momentum and market behavioural criteria to produce a portfolio of companies that has a proven track record of significantly outperforming its benchmark. Investing responsibly is no longer the remit of just those with a social conscience. It makes economic sense to do so.
Rohini is a retired partner and former fund manager at London based asset manager Sarasin & Partners and is due to start work as Consultant to Arabesque & Partners. She is an alumnus of IIM-Bangalore.
Click here to read Rohini’s blog.
The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.