Barbara Gray, CFA – March 6, 2013 – I don’t usually attend presentations hosted by the Chartered Financial Analyst) Society as quite honestly I find them boring and too academic. However, when I received the invitation a month ago to attend a CFA breakfast co-sponsored by SHARE talking about the UN Principles for Responsible Investment (PRI), I eagerly registered in the hopes that it might advance my thinking about my social capital investment thesis. When I started looking into the concept of stakeholder equity two years ago, I started to go down the Social Responsible path and did a lot of due diligence in this growing area. However, as my passion lies in researching companies with heart and soul, I was disappointed to discover that most of the research was focused on how investors can incorporate (environmental, social, governance) factors into their analysis from a fiduciary perspective to reduce exposure to companies that generate . There seemed to be too much emphasis on the E and the G factors in the equation and the S was focused more on human rights and supply chain issues. Given consumer spending drives nearly three-quarters of and the importance of human and intellectual capital, I was mystified as to where was the research on the C (consumer) and E (employee)…CFA (
Dr. Wolfgang Engshuber, the Chair of the PRI (Principles for Responsible Investing) spoke about how the PRI was launched in April 2006 as a partnership between the UN and investors to promote responsible investment. In the past 7 years, the PRI has grown its membership base to 1,150 signatories representing US$32 trillion in assets under management, equal to 15% of the world’s investable assets. The list of signatories includes 300 pension funds, 600 investment managers, with the remainder being service providers. When I spoke with Dr. Engshuber after his talk, he shared with me how he retired early from his 25-year career at Munich Re Insurance so he could try to make a positive difference in the world of investing.
The Six Principles of the PRI are voluntary and aspirational and they call for signatories to incorporate ESG issues into their investment analysis and decision-making process and to proactively seek disclosure from the companies they invest in. As Dr. Engshuber pointed out, markets are not efficient as most investors do not take into consideration the potential impact on a company’s future cash flow from non-financial components (e.g. ESG factors) and they naively assume that risk follows a normal distribution which isn’t the case as we know from recent history by the occurrence of fat tails and black swans. This reminded me of Taleb’s latest thinking which he shared in his recent book “Antifragile: Things that Gain from Disorder” that unlike black swan events, which are unpredictable by nature, “you can state with a lot more confidence that an object or a structure is more fragile than another should a certain event happen.” As risk management is one of the fiduciary duties of investment managers, it seems like one of the best ways to assess the fragility of the economies, industries, or companies is by looking at ESG risk factors.
Dr. Engshuber spoke to how value creation is changing in the 21st century bringing new sources of financial risk and opportunity due to the increasing importance of environmental issues such as climate change, the increasing complexity of technology and industrial safety, and the rising reputational risk stemming from global supply chain risks. If anything, though, I found his presentation a bit too understated. Maybe I’m a bit too radical in my thinking but not once did he mention the role that social media is playing in making the world more transparent and connected. I strongly believe that as the truth about how companies treat their various stakeholders (whether it be their employees, customers, business partners, communities, or the environment) is exposed, this will create a high level of fragility for companies who derive their competitive advantage through exploiting their stakeholders as for the first time ever, the exploited have a voice and are empowered to join together and fight back.
One of the biggest obstacles facing PRI is the prevailing short-term mindset of investors. As most investors are narrowly focused on companies’ next quarterly earnings and value companies based on next year’s P/E or EV/EBITDA ratios, they miss the bigger picture and do not consider how the externalities created by a company will impact its future cash flows and risk/growth profile. The other challenge is the lackluster historical performance (according to a recentstudy, 88% of SRI (Social Responsible Investing) funds showed neutral or mixed results) achieved by SRI funds which has spawned investor indifference and cynicism towards the concept of sustainable or responsible investing.
To generate alpha (i.e. excess return) within the Sustainable/Responsible Investing framework, I believe investors need to move beyond their fiduciary mindset of exclusionary screening and proactively seek companies that are actually creating positive externalities. And they also need to expand their focus to the two key stakeholder groups that are largely ignored by the ESG framework: Consumers and Employees. As we enter the Social Era, an age characterized by increasing levels of connectedness and individual empowerment, I strongly believe the companies that will outperform are those with the greatest sense of humanity that display a high level of transparency, authenticity, and engagement in terms of their greater purpose, core values, culture, and community.