01 February 2013 - Karl Leinberger
An issue that is becoming increasingly important in our industry is that of responsible investing (RI). In 2006, the United Nations released the Principles for Responsible Investment (UNPRI), to which Coronation was an early signatory. In 2011, revisions to Regulation 28 of the Pension Funds Act included an explicit requirement that institutional investors consider environmental, social and governance (ESG) issues in their investment process.
When I joined this industry 13 years ago, the primary concern of institutional investors was short-term financial return. If they didn’t like what they saw in the companies in which they were invested, they ‘voted with their feet’ and sold out. These days, much has changed and mostly it is for the better. Management teams are more transparent and accountable to their shareholders. Institutional investors, in turn, increasingly challenge the way in which management is remunerated, allocates capital and defines corporate strategic objectives. This has undeniably resulted in a culture of better governance.
Genuine progress has been made in bridging the gap between management and shareholders – one of the eternal dilemmas of management finance, taught to first-year commerce students around the world.
But this wave of institutional activism is a double-edged sword. As the old proverb goes, ‘The road to hell is paved with good intentions’. Much of the ESG language is emotive, loosely defined and therefore at risk of being interpreted in a manner that is convenient to the reader. We are also seeing worrying signs of unintended consequences, which if left unchecked will undermine much of what has already been achieved.
Be careful of box-ticking and marketing
Institutional investors are increasingly hiring RI experts, voting against resolutions at shareholder meetings and engaging management teams on the ESG issues of the day. Fund managers’ marketing brochures increasingly market the value being added in ESG issues. It all looks very good. And yet a lot of it amounts to little more than ‘playing for the crowds’.
In my opinion, there is an enormous amount of box-ticking that is taking place. The resolutions that are voted down at shareholder meetings are, more often than not, argued on very technical grounds.
And then, strangely enough, when the big issues that fundamentally threaten stakeholder value need to be dealt with, we are constantly amazed by the absence of other institutional investors. These are the issues that require the ‘broad shoulders’ to meaningfully challenge senior management and boards of directors. They are the kinds of issues that could well find their way into the media, damage corporate relationships and put client relationships (and investment mandates) at risk. Examples might be:
- Are boards handling a takeover attempt appropriately?
- Is senior management good enough to do the job?
- Is capital being allocated in shareholders’ best interests?
- Are empowerment deals sufficiently broad-based?
- Are there any conflicts of interest that put stakeholder value at risk?
- Are remuneration schemes appropriately sized and structured
These are debates that take an enormous amount of time. Engagement on these issues is always uncomfortable. And yet this is where institutional investors can add the most value. These are issues that lie within our circle of competence, unlike many of the environmental and social issues that also fall within the ambit of ESG investing. In my mind, acting appropriately on one of these issues is worth a hundred non-material resolutions voted down at annual shareholder meetings.
This is where we spend most of our time and energy. In 2012 we had 65 interactions with management teams on governance issues. This, in my opinion, is where the ‘heavy lifting’ takes place, and it almost always doesn’t make it into the public domain. It isn’t something we would include in our marketing documents but it is the area where we have the most expertise and where we have added the most value for our clients over the years.
Don’t allow corporate governance to undermine good common sense
We are finding that a growing number of retiring chief executives are asking not to be put forward for non-executive board appointments. This is a worrying trend. People are living longer and someone retiring at 65 may have ten productive years ahead of them. Skills are short in South Africa and individuals with three or four decades of business experience are hard to come by. Why are these individuals opting out of corporate life?
I believe that the answer lies in the law of unintended consequences. In the past, governance was nonexistent and executives were beholden to no-one. Today, the pendulum has swung to the other extreme. In many boardrooms today the tail is wagging the dog and the focus is increasingly on form over substance. None of us wants this, yet it is slowly happening. Over time, boards are losing their commercially-minded people. The business people are being chased away as boards spend most of their time discussing the technical minutiae of governance and too little time discussing the performance of the underlying business, the merits of expansion strategies, the allocation of capital and the performance of key executives.
Non-executives are increasingly avoiding owning stock in the companies on whose boards they sit for fear it will make them conflicted. We find this odd. We prefer a non-executive who has ‘skin in the game’ – someone who isn’t just going through the motions of board meeting after board meeting.
Boards are so afraid of making mistakes that they are being ‘frozen out’ by corporate governance concerns. This is a very difficult issue to get one’s mind around. How does one ensure that a board is filled with independent and commercially-minded business people who will challenge executive management in a healthy and productive way? How does one ensure that the boardroom includes enough governance and process to ensure that the business is being run for its stakeholders? And how does one make sure that the latter doesn’t crowd out the former?
There is no template. In my experience, good commercially minded people find a way of making it happen within a broader culture of good governance and custodianship. The concern is that there are fewer and fewer of these people around. And they are being spread among more and more companies. The investing public need to make sure that we don’t blindly follow dogma and, in so doing, undermine good common sense.
How does one balance financial return and social good, and are these mutually exclusive?
This issue is carefully sidestepped in most debate. In practice we all, either explicitly or implicitly, have to reach a conclusion on our own. This is not necessarily a bad thing (I believe in free choice after all).
But it does mean that there is a risk that some end-investors don’t know what they’re getting, and that many intermediaries haven’t fully thought through the implications of what they are asking for. Most advocates for RI argue that one doesn’t have to forego financial return. They argue that incorporating sustainability into the investment process makes common sense. But is that correct? Might it not be a bit convenient?
- How much weight should one give to foregone return in the quest for responsible investing? For some, the challenge of providing for retirement is far more pressing a priority than for others. How does one cater for the contrasting needs of different investors?
- Are companies that score poorly on ESG issues investable or uninvestable? How poorly does a company have to score before it becomes uninvestable?
- If companies score poorly, should they be simply ‘engaged’ with, rather than excluded from the investable universe? Does such an engagement process actually achieve anything? What is the risk that this becomes a box-ticking process that achieves nothing?
- If an institutional investor penalises the valuation of a company that scores poorly on an ESG issue, does the client then understand that stocks will be sold at lower prices than they otherwise would have, in the process possibly foregoing return?
Don’t allow the wave of good governance to undermine stakeholder value
A good example of this is the increased disclosure companies are being forced into. It is not easy to argue against more disclosure: the more transparency the better, surely?
Once again it is a question of judgement. We are increasingly finding companies complain that invasive disclosure requirements in new integrated reporting standards are forcing disclosure of sensitive business information that risks undermining their organisations (and, in so doing, stakeholder interests).
Another example of unintended consequences, perhaps?
The environmental and social pillars have not been properly thought through
Corporate governance lies squarely within the circle of competence of any institutional investor. As custodians of our clients’ retirement capital, this is where we need to be doing the ‘heavy lifting’ on their behalf. But the environmental and social pillars are a lot trickier in my view.
The more one thinks through environmental and social issues, the more one realises how imponderable many of them are:
- Is the globe warming? If it is, is it being caused by man or is it part of a natural cycle?
- If it is being caused by man, then how life-threatening is it? Could the massive resources being allocated to climate change around the world not be better spent on poverty alleviation or eliminating diseases like malaria?
- If enough of the questions above are in the affirmative, then is carbon dioxide (CO2) the cause of climate change? Isn’t CO2 an inert gas? Aren’t there better ways to mitigate man’s impact on the planet than focusing almost exclusively on carbon emission?
- Are companies that make money out of alcohol, tobacco or gambling poor corporate citizens? Or do you believe in free choice? Don’t all of these industries contribute disproportionately to the fiscus?
- From whose perspective do we view the debate? This is quite material because social objectives vary significantly around the world. As an example, in Africa tobacco and beer companies have contributed significantly to local economies through infrastructure development, clean water, upliftment of local agriculture etc.
- Should platinum miners provide housing and education and also meet other basic needs of their employees? Or do they already pay their staff more than other industries? Do they not pay a higher effective tax rate (after normal income tax and mining royalties) than other industries and should government not be providing these basic services?
- Should empowerment deals be broad based? Should they include or exclude wealthy and established black business people?
These are enormously difficult issues that even the experts can’t agree on. As institutional investors, we certainly can’t claim any special competence in these fields. One of the outcomes I fear most is that of fund managers ‘over-reaching’ in their own personal crusades to make the world a better place. At Coronation, some of us have grave concerns about the environment while others passionately believe that the money being spent on the environmental issues of the day could be better spent on poverty and disease alleviation. And yet the ESG codes require us to engage management on these issues and take action where we feel that companies are failing their stakeholders.
I fully subscribe to the noble ideals of the UNPRI. But I find that, ironically, not enough is being done where we as an industry have expertise and too much is being taken on where we have none. As an industry we need to take our time about this. If we don’t, we will be left with an egg we need to unscramble.
What does ESG or RI mean to Coronation?
Coronation’s primary focus is to ensure that we manage money on behalf of our clients in accordance with the investment mandates given to us. We incorporate ESG issues into our investment decision-making process in a way that is fully consistent with our long-term investment horizon. We believe that companies cannot achieve sustainable economic success while neglecting their social and environmental responsibilities. Corporate social responsibility has the potential to increase the quality of a company’s earnings stream and consequently its long-term investment potential.
In our view, ESG issues form an intrinsic part of the mosaic for any investment case. Poor ESG performance may not necessarily exclude investing in a company, but it does force us to carefully consider the issues and engage management on those issues.
Furthermore, we feel it is very important that we focus our attention and time on those ESG issues that have the most meaningful impact and where our expertise lies, rather than on issues that are intrinsically fraught with ambiguity.
We do not exclude companies from our investment universe. As a manager of third-party client assets, we believe that this decision (and its consequent return implications) lies with the clients themselves.
KARL LEINBERGER is CIO and a member of the executive committee. He joined Coronation in 2000 as an equity analyst, was made head of research in 2005 and appointed CIO in May 2008. Karl co-manages the Coronation Houseview portfolios.