Importance of a socially-aware investing approach

Q. You have said that the market meltdown of 2008-09 serves as “a multi-trillion dollar advertorial for  sustainability-enhanced investing approaches.” How so?
For anyone who was paying attention, it was a pretty spectacular demonstration that the traditional balance sheet-driven approach to financial analysis does not provide an adequate picture of the risks that exist.  My colleagues and I have been working to increase awareness of sustainability factors within the financial community for nearly 25 years. In the early days, the mainstream response was typically, “These concerns you are raising around environmental and social issues are frankly, extraneous; the financial system is working just fine.” Well, we now know that it is not.

We did an in-depth study of Bear Stearns in early 2008, and concluded that it was not an investment-grade company. By looking at it through a non-traditional risk perspective, we found that there was a complete lack of awareness of any of the big-picture contextual issues that the company was facing.  We said to our clients, “In terms of any awareness of environmental, social or governance risks—either their own or those of the companies they’re investing in—we cannot find a trace of it, which gives us serious concerns about this company.”  

Ironically, that very same day, a number of the leading Wall Street firms published ‘buy’ recommendations for Bear Sterns; they thought it was the best thing since sliced bread.  I don’t think this was just a lucky call on our part: it was indicative of the extra informational advantage you can get from taking a 360° look at a company.  

I used to think that if anything could shake Wall Street, Bay Street and the City of London out of its status quo approach to investment analysis, it would be the near-death experience of the entire global economy; but it certainly has not had the accelerating impact that my colleagues and I had hoped for.  

Q. The crisis also provided a strong stimulus for investors to re-examine what the phrase ‘risky asset’ means.  How do you define the term?
The leader in this space is actually one of my heroes: NYU business school Professor Baruch Lev.  He was one of the first to credibly point out the limitations of traditional accounting-based financial analysis in capturing a) the true risk profile of company and b) value creation possibilities. He believes that traditional financial analysis captures maybe 15 to 20 per cent of the reality—and I agree.  I often use the metaphor of an ‘iceberg’ balance sheet, which shows only the tip of the iceberg above water; of course, what is more important is what is going on below the water line.

My colleagues and I have developed a five-factor model to assess companies, and it’s all driven by this notion of iceberg balance sheets.  The ‘under-water’ factors we look at are: environmental sustainability, human capital, organizational capital, adaptability and innovation capacity.  These five elements don’t explain the entirety of the 80 per cent of the hidden iceberg, but they cover a good deal of it.  

Q. What is your company’s mission?
The fundamental logic underpinning our work is deceptively simple:

• Major multinational companies arguably have greater environmental and social impacts than any other institutions in contemporary society;
• Those corporations’ priorities and behaviour are heavily influenced by the expectations and requirements of their institutional investors—the providers of their financial ‘oxygen supply’; and
• If you change the priorities of those investors, you will inevitably change the priorities—and behaviour—of the companies themselves.

In short, if sustainability factors can be systematically and credibly injected into investment analysis, major corporations will be forced to improve their performance on environmental, social, and strategic governance issues dramatically.

Q. Does your approach fall under the socially-responsible investing (SRI) umbrella?
There is an alphabet soup of acronyms out there: SRI, CSR, ESG, etc. We believe what is required is SAI: strategically-aware investing.  The basic thesis is that the environment in which global companies are competing is changing at warp speed. It is basically unrecognizable from five years ago—and it will be unrecognizable again, five years hence.  One key aspect of the current environment is radical transparency. Stakeholders have an unprecedented level of access to information about companies’ performance on some non-traditional environmental, social and other risks, and once they use that information to form a view of a company, they can literally broadcast their views instantaneously—and globally—cost-free via social media.  As a result, old corporate dogs sorely need to learn some new tricks.
 
What we’re trying to do with strategically-aware investing is to say, let’s acknowledge that the competitive context has changed, and that it demands a whole new set of skills and capabilities—none of which can be adequately captured by traditional financial analysis.  As indicated, the traditional view of these issues is that they’re either irrelevant or extraneous to financial performance, and therefore, analysts and portfolio managers can’t justify spending their time looking at them. An even more conventional view is that they actually hurt returns. But in fact, if you look at the evidence, it’s actually running massively in the other direction.  

There is a huge degree of mythology and inertia in the investment world that is blinding many investors, consultants and asset managers. If you asked 100 investors whether they use the same analytical models and research sources they used ten years ago, most of them will say, “Um, yes.” Our point is, that is just not good enough.

Q. Some of the areas you focus on are intangible in nature.  How can data-driven individuals be expected to embrace them?
The strange part is, if you ask any Wall Street or Bay Street analyst whether these five attributes are critical for a particular company going forward, they will say, “Absolutely!”  So my question is, why aren’t they looking at them?  Yes, what we are talking about is intangible and difficult to analyze, but that does not make it responsible to leave out 80 per cent of the picture when you’re trying to build a portfolio for your clients.  

A couple of years ago, the Wall Street Journal approached the top 15 or 20 investment banks in the U.S., with a very simple question:   One year from today, will the stock of Company A be up or will it be  down?  Do you know what the top-performing Wall Street investment bank scored that year? Something in the order of .270, which means they were wrong seven-plus times out of 10.  In the world of asset management, pick a year, any year, and six or seven out of ten managers of active stock-picking strategies will underperform the benchmark. Yet it’s this same group of people who are largely resistant to new approaches .

Your critique of conventional financial analysis includes qualms about investing in Africa, which you call the “strategic investment opportunity of the 21st century”.  Please discuss.

A while ago I heard Sir Bob Geldof speak on this quite eloquently at a conference.  He basically said, “You’re all avoiding Africa like the plague because you think it’s ‘risky’; clearly, you prefer to put your money into completely riskless assets like mortgage-backed securities and derivatives!” Enough said.  

If you look at Africa from a strategic perspective, you must understand that it is 54 countries—not one homogeneous continent filled with corruption and bloodshed and conflict. Yet it is perceived as a homogeneously risky place to try to invest and do business.  By contrast, if you look at some of the drivers that exist there, they auger extraordinarily well for the future. For instance, Africa has 60 per cent of the uncultivated arable land left in the world, in a world that is going to have produce a lot more food by 2030.  Also, it has a young demographic going for it. If you look beneath the surface, you see massive value potential.

We really think that the opportunities have been underappreciated and the risks have been overstated.  Yes, the Democratic Republic of Congo is a very difficult environment at the moment, but that is not the entirety of the African story.  The fundamental mega-trends indicate that Africa offers some of the most exciting investment opportunities that exist.  Even if you use conventional measures like GDP—which we think is a severely flawed measure in the first place   —Africa is a continent that’s going to be growing three-four times as fast as Canada, the U.S. or Europe over the next five-plus years.  There’s a great growth story there—and a great investment story.  

Q. Do you see your approach to investing gaining momentum?
Not nearly as rapidly as we would like ! Unfortunately, even “ ESG investing” [environmental, social and governance]—is still a kind of niche.  Depending on who you talk to, it’s either one per cent of the investment world or maybe—on a fabulous day—five per cent.  And our particular approach here at Inflection Point , “strategically aware investing” or SAI, is rarer still. And yet we devoutly believe that  this is the way of the future.  Frankly, it’s just glorified common sense: it’s investing paying conscious , systematic  attention to the secular global megatrends which are rapidly re-writing the rules of global competition for the companies in which we invest. With same-sector variances of thirty times or more in the company-specific impacts of those megatrends, we believe that to fail to research them carefully is to do a serious disservice to one’s clients. We firmly believe that any sentient investor will be investing this way 10 or 15 years from now.  I can see no intellectual counter-argument to it, and recent history suggests that there is plenty of upside and opportunity for value creation.

Dr. Matthew Kiernan is the founder and CEO of Inflection Point Capital Management, and played the same roles at IPCM’s predecessor company, Innovest Strategic Value Advisors. He is the author of Investing in a Sustainable World: Why Green Is the New Colour of Money on Wall Street (Amacom, 2009), and The 11 Commandments of 21st Century Management (Prentice-Hall, 1995). He was the first Director of the World Business Council for Sustainable Development in Geneva, the primary private sector advisor to the Secretary General of the Earth Summit. He is also a former senior partner with KPMG.

[This article has been reprinted, with permission, from Rotman Management, the magazine of the University of Toronto's Rotman School of Management]