Environmental, social and governance issues – known as ‘ESG’ for short – are becoming an ever greater focus for governments, companies and investors alike. In that last context, here on The Value Perspective, we have always viewed the ideas it embodies as integral to a proper analysis of any business.
We do not, however, obsess about what each letter represents but instead have always focused on a business’s governance and stakeholders and how these areas could impact risk or future profits.
It should go without saying, for example, that the quality of a company’s management and board, how they are remunerated and the degree to which their interests are aligned with those of shareholders are very important considerations for us. If we do not believe a company is acting in the interests of long-term shareholders, we will do all we can as investors to try and bring about a change.
Similarly, the way a business treats its stakeholders – not just its investors, but its employees, its suppliers and the governments and regulators with which it deals – helps us determine the sustainability of margins for that company.
After all, if a business is paying too low a tax rate or underpaying its staff or squeezing its suppliers, fundamental economics would indicate the associated risks increase. For us, then, here on The Value Perspective, being satisfied a company is behaving itself both inwardly and outwardly makes a huge amount of sense as a risk-reduction technique and to help determine our view of sustainable margins.
To start with a relatively straightforward example, one financial business in which we are interested and about which we have written in the past, pays a 10% tax rate, which is well below that of the jurisdiction in which it operates. As we do not believe this is a particularly sustainable course of action for too many businesses, we have adjusted our numbers – reaching a judgement on the company’s valuation as if it were paying a more appropriate 20% tax rate.
Another business we have been looking at recently is, let us say, rarely held out as a shining example of how to treat employees. Among other things, it does not appear to be paying all of its staff in a sustainable manner and it has been earning a higher margin than similar businesses. Taken all together, this suggests the margin it makes across the next cycle may be lower than the last. In our valuation of the business therefore, we have taken an extra 200 basis points off the historic margin to reflect that particular stakeholder risk.
Better business, better investment
We can be less coy with our next example because Tesco has been working hard to address the widespread view a few years back that it was not offering the greatest deals to its customers, its employees or its suppliers.
The main components of CEO Dave Lewis’s turnaround strategy for the business he joined in July 2014 have been to reduce prices, re-engage colleagues and reset the group’s relationships with its suppliers. Evidence from customer and employee satisfaction surveys and supplier rankings suggests the strategy is working on these fronts and this is feeding through into a better business – and a better investment for our clients.
This is why we pay such close attention to whether a company’s governance is appropriately aligned and why we are so attuned to potential stakeholder risks – and it is why, if we find an ‘ESG-related’ issue we think is unsustainable, we will make an appropriate adjustment based on a business’s normalised numbers. We would never claim to get it right every time but the important point is that we can and do make these adjustments at all.
Equally, when we do so, we have a huge advantage because we are able to take a much longer-term and more independent view than many of our peers. While most professional investors are obsessed with trying to forecast what will happen to earnings over the next year or two (or sometimes even quarters) – and thus find themselves constrained by having to compare themselves with consensus on tax rates, employee costs and so forth – we say what we think a business can earn over a cycle and so end up with a much purer number.
What is more, when we make an adjustment, we do not have to specify a precise reason. If, for example, a company’s margin is artificially high because it is underpaying its staff, then we know there is a risk that margin could fall. It could be because the staff turnover rate is too high or employee costs go up or the customer is seen to be valued less highly or any of a number of other reasons.
Unlike most analysts, however, we do not have to pick one – to forecast (for which read ‘guess’) what might happen. In this example, we may not know the exact mechanics of the margin decline; it is simply enough to understand that some stakeholders have been under pressure, and so the past may not be a good guide to the future. All we then have to do is acknowledge that fact in our valuation by introducing a figure based on normalised profits, say, or in some circumstances enterprise value.
Here on The Value Perspective, we do not do ESG because it is in ‘vogue’ but because, in helping us to identify governance and stakeholder risks, we believe it improves investment performance for clients. At its core, value investing is about buying cheap stocks with an asymmetric risk-reward balance. In analysing the risk part of that equation, we will take into account anything that helps us make the best analysis – including ‘ethical’ and ‘socially responsible’ considerations in the past, ‘ESG’ today and whatever it may be called in years to come.