Obscuring the true cost of management
By Robert Swift & Robert Medd
Environmental, Social and Governance (ESG) themes are becoming more visible and popular in money management. Delft Partners uses ESG considerations explicitly in the way we research companies and build portfolios. It is very likely that a company or investment will be considered less attractive by us based upon ESG shortcomings.
As active managers we all believe that we benefit our clients by taking a view of what is not discounted or understood by other market practitioners, and own less, or more, or none of a particular company or industry. Some of the reasons for liking or disliking a particular investment can be ESG related.
Indeed, part of the mosaic of active management research has always been interaction with company management and to better understand its approach to governance of the business in the broadest sense; to verify with them what we believe to be the current state of the business; the risks in the business, and to explore management's future plans. Typically, judgements have always been made by active managers on a company's management; its ethics, its diversity and skills, and its approach to shareholders, the law, and regulators. Bad governance and risky businesses deserve lower ratings or higher risk premiums, and always have.
This use of an ESG perspective in active management then is not new, but the clarity provided by the ESG research lens and the positive benefits of beneficial change as a result of investor pressure, are now more of a focus and we embrace that.
Failures of governance can and do result in bankruptcy, unfair and overly aggressive management of employees, and anti-social effects such as bribery and corruption. It is increasingly evident that while government, and government agency, regulation provides sufficient firepower to deal with transgressions, it is often not deployed or subject to, and diluted by, powerful corporate lobbying. Shareholders and providers of capital to governments can, and should, step in to lend additional weight for necessary change. The consequences of bad capital stewardship for the company, employees, shareholders and wider society are increasingly the responsibility of the providers and owners of the capital and not government or regulators alone.
In our work we have found some typical ESG attributes to be random in their impact on stock performance and some of them to be highly correlated with standard analyses of valuation we already perform on the capital structure or leverage. For example, good governance typically results in sensible leverage and prudent accounting policies as well as long term planning perspectives.
Consequently there is no single universal truth for ESG factors. Simple scoring or box ticking ignores the nuances present in all situations and the absence of any binary 'good vs evil' values system.
The many ESG providers of boxes to tick are also inconsistent in the boxes they choose. We believe it is our judgement that matters on what is relevant and do not favour one data provider or another.
Additionally, excluding companies from consideration for investment solely on ESG principles ignores the potential for positive change which can drive a reduction in risk premiums. Simply put a company may be worth investing in as it gets better in ESG rather than after it has gotten better. Exclusion of companies also removes the right to participate in shareholder resolutions and AGMs. Not engaging is not managing but abdicating responsibility.
This ESG responsibility extends to all parts of the capital structure and even to funding government debt issuance. Governments can and do raise money for the wrong reasons and implement bad policy by spending this capital. It is not enough then to solely focus on equities with an ESG perspective.
Our belief is that G is the most important dimension of the three. G is relevant to all companies in so far as all companies are managed by executives who choose accounting policies, external service providers, provide incentives to themselves and employees, and build a culture. Governance is everywhere and in everything.
It is possible, and useful, as a portfolio manager to make valid comparisons of management skill, attitudes to shareholders, and company risk, based on G, across the full universe of opportunities. This is less true of S and E where some companies may have minimal impact on E whereas others are engaged in activities which are directly impacting E and S.
In this respect we are helped by subscribing to, and applying, the research of Robert Medd at Bucephalus in Hong Kong (www.buceph.com). Rob applies a variety of accounting analyses to arrive at a conclusion about management's honesty regarding the true state of their profits, cash flow, remuneration and the true state of their business as told to shareholders. He has identified many miscreants and helped us avoid some nasty situations. As an independent research house Rob is not compromised by other corporate relationships and this makes his work even more relevant and valuable.
Rob's latest research piece is attached because we think it is newsworthy and noteworthy. Management at some companies are paying themselves quite a bit more than many realise!
A great TV interview that Rob did with CNBC on Carlos Ghosn and the Nissan scandal is linked below.
Don't hesitate to contact us or Rob directly if you wish to learn more about Bucephalus and Rob's capabilities.