My father’s table: We get the CEO we deserve
Recent high profile corporate failures, particularly those that have resulted in the demise of a once strong global brand name, shed some light on corporate leadership, ethics and board efficacy. Gordon Gekko’s motto – “greed is good” – has morphed from a line in a Hollywood movie to a corporate mantra; anything for a profit.
But what if this quest for next year’s profit destroys not only corporate brand name but challenges the sustainability of the company’s sales and profit beyond next years? If and when consumers finally lose confidence and trust, will anyone really surprised when they take their business elsewhere?
Those of us employed within the financial services industry know this all too well. The most valuable intangible asset we own is our brand name; the employees are the most valuable tangible assets. But what about as investors? How does one assess the value of these assets, let alone study how the board and management protect them? Enter ESG, or Environmental, Social, and Governance.
While there are multiple descriptions as to how ESG is employed within investment analysis and portfolio construction, I’d dare to suggest that nearly 90 per cent of these are nothing more than marketing fluff. That’s not to say that ESG isn’t employed – just that how it’s actually employed can often be the difference between what we tell others and what we actually do. As a former colleague with strong ESG leanings once described it, ESG analysis is about sustainability – assessing how well corporates and their boards manage towards the next economic cycle, not just next year.
So given how common ESG principles are in the world of institutional investment, why the confusion? Much of it has occurred due to managing towards near term share price over something more sustainable like long term profit measures.
The fact that ESG advocates haven’t been more vocal in their opposition to remunerating management using share options astounds me. The market price is not a functional indicator of sustainable business practice. The market (and media) can easily be distracted by what’s in front of them rather than what’s beyond the horizon.
Take share buybacks as one example. As a young analyst I was taught investment metrics which helped assess if management should retain earnings, pay out dividends, or implement a share buyback. If a company maintained a competitive advantage, had high operational efficiency, or was in a growth phase, retaining earnings ultimately yielded higher returns for shareholders than market beta or dividend yield alone.
But using share buybacks to reduce free float, thereby momentarily pushing-up share price, does little to nothing to improve medium to long term profit as its objective is usually tied to coincide with an option expiry. In fact, there’s academic journals which show how increasing the float via share splits is actually advantageous to short term pricing as lower absolute share price allows easier access for the retail investors.
To quote the late great management doyen, Tom Peters, that which gets measured gets managed. And if one measures success off strike price targets, then is it really that surprising that management will turn its attention towards such short term measures over those which are more sustainable? The incentives behind share options given to management are often misguided.
Less an aspiration than a responsibility
Under classical economic theory an economy is said to be thriving when there is unity between management, employees, and capitalists. Each of these capital owners are often advisories against each other; if one alone benefits, it’s usually at a cost to the other. As another example, take the choice between paying/increasing dividends, retained earnings, or share buy backs. Who do these benefit?
As any real estate investor knows, A grade buildings require a larger portion of retained earnings to sustain the A grade relative to a B or C grade. The same is true with brand name, where cutting expenses can often cost brand reputation. Choosing between these three capital distribution strategies must benefit the three capital owners so as to drive a more sustainable and equitable profit cycle.
As challenging as it may be to manage on behalf of these three capital owners, the fiduciary responsibility ultimately falls back on shareholders, albeit through their appointment of the board and chair. Responsibility around corporate direction falls on management, which is overseen by boards (and shareholders who appoint the board).
If we look back on the high profile corporate failures over last two decades, the start of a failure can often be traced back to a lack of fiduciary oversight. All too often boards forget that while they share business cards with those they’re meant to be monitoring, the buck ultimately stops with them. How someone can think that being on more than three boards is prudent is beyond me. To properly carry out their responsibilities requires proper time management.
So while corporate failures do make for interesting media stories, as investors, managing towards proper ESG is less an aspiration than it is a fiduciary responsibility. Our responsibility extends beyond just analysing past achievements as spelled out in an annual report, or even any accolade expressed via current share price.
As part owners of a business, our responsibility is to both appoint and monitor those who represent our long term aspirations. Not that long ago, the institutional investment community stood up against corporate abuse and mismanagement. Investors once ousted non-compliant CEOs and chairs rather than voting with their feet. It’s interesting that overall portfolio turnover has increased on previous decades as more funds have signed on to ESG principals.
Contrary to what some suggest, employing ESG is less about generating alpha (excess returns) than it is about minimising the risk of investing in companies with failed long term and sustainable business model. Fiduciary oversight employed through traditional accounting and ESG metrics is the minimum requirement. As shareholders, we get the CEO we deserve.
My Father’s Table is a recurring column penned by Rob Prugue. The previous instalment can be found here.