Quarterly capitalism is manifest when far too many CEOs, directors, investors, and analysts focus on short-term earnings to the detriment of long-term value generation.
Pressured Whole Foods Sale Exposes Conflicting Motivations under Sustainability Tent
Many investors now look to ESG (Environmental, Social, and Governance) factors for insight into more sustainable investing strategies. ESG scores are generated by internationally recognized ratings agencies to compare one company’s performance on material non-financial factors to that of its peers. However, of course, ESG means different things to different people.
When news broke that Amazon planned to purchase Whole Foods Market, many SRI (Sustainable, Responsible, Impact) investors, myself included, shared in a collective sigh with the acknowledgement that one of the shining stars of a more conscious capitalism was being swallowed up by the e-commerce giant.
It may surprise SRI investors to learn that Whole Foods’ high ESG scores actually exposed the company to pressure from activist investors, who charismatic Whole Foods CEO John Mackey compared to Ringwraiths in Lord of the Rings. About them, he said, “And their mantra is basically shareholder value. They don’t care about the stakeholders or long-term value. It’s just, ‘How do we make as much money as we can as quickly as possible?’ ”
Before the merger with Amazon, Thomson Reuters ESG research gave Whole Foods a perfect A+ score for it shareholder governance score. This impeccable score suggested that Whole Foods put very little restriction on shareholders ability to make changes to the Board of Directors and executive management. In the world of great ideals, this shareholder power would enable investors to hold the CEO and the Board accountable for poor performance and excessive pay. In reality, most asset managers simply ignore shareholder powers because they are either too small or too conflicted to get involved. It the real world, “shareholder friendly” means that you’re vulnerable to takeovers from activist investors.
And that’s exactly what happened to Whole Foods. Jana Partners, an activist hedge fund, disclosed in early July that it had quietly amassed enough stock and options to become the second-largest Whole Foods shareholder in a filing with the SEC (Securities and Exchange Commission). In partnership with Neuberger Berman, Jana Partners threatened a proxy fight and board takeover if the company didn’t put itself up for sale. Within a couple of months, John Mackey was standing before his employees to offer insights into the transition by saying, “When this deal closes, we’re all Amazon people. We’re not Whole Foods people and Amazon people. We’re all Amazon people.”
Clearly, not all companies aim for perfect shareholder governance scores. In contrast, Tesla scores a C in on shareholder governance because Elon Musk has retained an additional four anti-takeover devices to defend his company from activists including a staggered board strategy and additional limitations on replacing board members. For the sake of comparison, Google and Facebook both score a D-.
My point is not to suggest that all companies should have protective governance practices but to suggest that in every case, governance practices are distinct and sometimes opposed to the environmental and social strategies (ES) around sustainability. In LinkedIn conversation here, Mike Tyrell, Editor at SRI-CONNECT, shared, “Sustainable investing starts to get interesting when you disaggregate the E, S & G factors (or better still do away with the term altogether) and consider the investment effects of companies’ responses to specific exposures to individual factors at particular times.”
The impact of flexible shareholder governance practices on long-term sustainability initiatives is one that deserves further study. Conflating ESG into one unified score obscures some very different motivations, and this is why SRI investors need to understand these nuances. It’ll be interesting to watch the Whole Foods-Amazon merger and observe whether this union serves the long-term interests of both sets of investors. One thing is certain, though: Jana Partners struck it rich on this deal.
We believe it’s important to read articles that challenge our thinking. In this recent article by Cliff Asness on the potential costs involved with social investing Cliff asserts that we need to “embrace the suck.” While we agree with Cliff’s assessment in theory (“good company” stocks should underperform bad actors) we aren’t seeing this in practice and the reasons are worthy of attention.
As I shared in my last post, while tobacco companies have historically outperformed – by a fractional measure, we see companies that are engaged corporate citizens perform just as well relative to the stock market as a whole.
So why does the practice diverge from the theory? Cliff’s theory holds true in in an equilibrium environment. However, the current moment is nowhere close to equilibrium on the topic of Sustainable, Responsible, Impact (SRI) investing. A growing number of investors are updating their portfolio investments to incorporate ESG data. The US Sustainable Investment Forum suggests that we are likely at the early stages of a growth curve which is why we don’t see evidence of underperformance in practice.
Not only are we at the early stages of investor perceptions of SRI and ESG investing, we are also at the early stages of quantifying sustainable brand value in the marketplace. We find that marketing analysts (here and here) are far ahead of financial analysts in measuring the financial consequences of social impact and brand reputation and these findings suggest to us that this blind spot will continue for a long time to come.
That said, Cliff’s contribution is ancillary. The first question is how should a person or institution invest their wealth? This question, like all the big questions, begins not with finance but with values, ethics and theology.
Photo used as featured image under Unsplash Creative Commons Zero.
Opposition to personal profit from tobacco is as old as Virginia’s founding plantations. Many leading endowments and pensions took a stand to divest from this addictive leaf several decades ago but the movement failed to catch on a small and mid-sized institutional asset managers. However, a growing interest in impact investing suggests that more and more investors may be expected to kick the tobacco habit in the years to come.
This resolve to divest picked up speed in 1990 in response to new research on tobacco’s devastating health effects. Harvard University and the City University of New York (CUNY) were the first University endowments to divest, and John Hopkins University followed closely behind them.
In 1996, the American Medical Association’s House of Delegates made the claim that “all physicians, health professionals, medical schools, hospitals, public health advocates and citizens…divest of any tobacco holdings” and even called on all life and health insurance companies and HMOs to divest, as well. This clarion call took the divestment campaign beyond academic institutions and into the centers of commerce and public life. Since smoking affects societal health costs and worker productivity, insurers and public pensions could no longer ignore the divestment issue.
Since that early flurry of activity a few decades ago, the drive to divest from tobacco has moved forward at much slower pace. With this backdrop, all eyes were recently focused on America’s largest state pension, the California Public Employees Retirement System (CalPERS). After making the decision to divest from tobacco investments in 2000, some of the CalPERS trustees and staff were still feeling what we can call the “pangs of withdrawal.” The question emerged: Was it still prudent to blacklist this historically profitable industry? To help answer this question, the trustees ordered an historical analysis to better understand the true costs of divestment.
The divestment report, completed by Wilshire Associates, revealed that the decision to divest from tobacco had cost CalPERS 1.94% of its total global equity portfolio over 14 years from 2000-2014. On an annual basis, the cost was 0.14% of growth per year. Despite this relatively small impact, these losses still reduced the portfolio by over $3 billion dollars due to the immense size of CalPERS equity portfolio—a number that cannot be ignored.
After hearing arguments from both sides, CalPERS recently voted in December 2016 to not only maintain their current tobacco stock blacklist, but also order complete divestment from all funds with tobacco holdings. Selling individual stocks in a portfolio is a relatively easy task. Eliminating these same positions from every fund balance requires much more intentionality as more rigid fund managers need to be fired and replaced. Could this moment be the fuel that reignites the tobacco divestment movement?
Whether new investors pick up the tobacco divestment mantle remains to be seen. However, what is absolutely certain is that today’s investors are becoming much more focused on aligning their portfolios with their mission and values. The US Forum for Sustainable and Responsible Investment (US SIF) reports that allocation to strategies that either use exclusionary screens to avoid unpalatable business practices or best-in-class screens to reward corporate citizenship have increased 33% in the last two years. Many investors are deciding that the well-being of their community and beyond is not worth sacrificing for mere tenths of a percent.
“We need red blood cells to live – the same way a business needs profits to live, but the purpose of life is more than to make red blood cells – the same way the purpose of business is more than simply to generate profits.”
-R. Edward Freeman
Since 2003, I’ve lived my life in two worlds. Years ago, my wife and I committed with close friends to move into the inner-city of Richmond, Virginia in a faith-inspired effort to invest in our local community. During this time, we’ve spent countless hours at our local elementary school, welcomed an after-school tutoring effort into our home, and helped start an affordable housing non-profit. While it hasn’t been an easy path, the journey has rewarded us with relationships and experiences that I wouldn’t trade for anything.
At the same time, I’ve worked in what I now look back on as an emotionally unsettled career as an investment advisor for high net worth families and institutions.
It has taken me many years to identify that my vocational angst lies not at the edges of the complex global financial system, but with its central assumptions. These central assumptions require that I ignore many of the first principles that led our family to put down roots in an economically distressed neighborhood.
I now reject the assumption that the sole purpose of a corporation is to maximize profits for the owners. In 1970, the most influential economist of his day, Milton Friedman, wrote in the New York Times Magazine that a corporation has only one purpose: to increase profits within any legal means necessary. At the time, Friedman had valid reasons to be skeptical of calls for social responsibility. He was combating many ill-conceived arguments that were contrived to pressure corporations to lower their prices to solve a monetary inflation crisis. In the process of clearing some of the dirty water, Friedman also dumped the proverbial baby. Thus, the inspirational leader and his so called Chicago School acolytes struck an academic wedge between business and personal values. The longer this wedge remains in place, the more we risk confusing future generations.
With three young boys, my challenge is to model for them the behaviors and beliefs that lead to maturity—and there’s no better place to work at this than on the soccer field. Winning is fun. I don’t need to teach them this. But if they don’t learn to carry themselves honorably on the field, they will soon find that their victories carry no enduring satisfaction.
On the “field” of finance, the desire to win never goes away, but the game gets much more complex and stretches as far as the international markets allow. Here, profit-seeking is forever running into ethical questions about ecological impact, human dignity, and property rights. Here, guiding principles become even more important. These moral and ethical principles remind us that there is more at stake in business enterprise than can be illustrated on an income statement.
In investment management, Friedman’s ideas about the purpose of a corporation directly influenced how we think about the optimal/efficient portfolio. Upon this cornerstone, all of modern portfolio theory has been built. Put simply, the optimal/efficient portfolio assumes that an investor’s only concerns are financial returns and risk of loss. In the process, morals and ethics get reduced to whatever you can legally get away with to turn a profit.
Not only does this wedge between personal and business values distort our definition of the optimal/efficient portfolio, it also perpetuates derivative concepts that have won the day in the capital markets. The most powerful child of modern portfolio theory is the now fully developed juggernaut that we know as passive (index) investing. This movement has stressed the importance of low costs and attention to broad diversification over individual stock selection. Passive investing strategies flourished by accurately noting that most highly paid active managers fail to beat an index fund that holds every stock in the target universe (e.g., S&P 500). To illustrate this, Burton Malkiel preferred the punchy image of monkeys throwing darts who regularly outperformed the expensively clothed professionals.
While the movement helped investors shed unnecessary fees, it also enabled them to believe that it is possible to make money without any oversight at all. “Set it, and forget it” became standard advice. In the process, all of the responsibilities of ownership lost their meaning. If you don’t believe me, try attending a typical shareholder meeting where turnout is often just a handful of investors. The very structure that was created to offer shareholders the opportunity to engage with executives is now little more than a compliance annoyance. When you consider that only 30% of shares owned by retail investors get voted, you see that similar disinterest in yet another fundamental right of ownership. Concern over these trends have been noted for years but the focus on the return of an optimal portfolio leaves little energy to address issues of responsible ownership.
The emphasis on passive investing also led investors to believe there are no limits to the benefits of diversification. Most recommended investment strategies push investors to own virtually every public company in the global economy. The end result is absurd diversification and a disengaged investor.
In some cases, these companies are operating in ways that directly conflict with personal and societal values. As one personal example of the many I could cite, my own portfolio once owned an oil and gas company with a terrible track record of spills and controversial exploration practices. Without basic oversight, companies have come to believe they have our de facto blessing to maximize returns by any legal means necessary—no matter the externalities born by other parties.
At this point in my story, I think it’s worth sharing that I count Jack Bogle—the man largely considered to be the great prophet of this passive investing movement—as a personal hero. While the passive investing tsunami is fostering all kinds of irresponsible investing behavior, I believe this movement was necessary to break through to a new investor consciousness. Thomas Jefferson argued that revolutions are necessary every few decades to preserve liberty by breaking the up the establishment. Before Jack Bogle, most investors had little option other than to entrust their life savings to overconfident and overpaid money managers. The passive investing movement ushered in a creative disruption that upended the traditional investing power structures. Now it’s time to tame the dragon.
Finally, it’s time to reject the traditionally held view that a fiduciary standard is the highest form of service that the financial management industry has to offer. The fiduciary standard (which includes both a duty of loyalty and a duty of care) is a legal standard focused on financial interests. Legal standards are essential in that they ensure that our most basic rights are protected but at their best, they are also limited.
Applying fiduciary service should represent the bare minimum expectation in the financial planning profession. Fiduciary service simply ensures that a financial advisor’s recommendations are legally defensible. But I also don’t want to suggest that the step beyond fiduciary service is an easy one. Moving beyond fiduciary is a move into a universe of goals and aspirations more focused on the complexities of human and social capital than the clarity of financial capital. Moving beyond fiduciary allows investment managers to begin customizing investment advice to reflect the values of their clients. Moving beyond fiduciary recognizes that investors can get to the end of their life with only a limited balance sheet remaining and yet still have died wealthy.
Today, many have come to accept the wedge that lies between personal values and business/investment values as normative. It’s a schizophrenic mindset of honorable values on the one hand and “anything legal goes” on the other. Yet, we suffer no such confusion when we train our children. The power of living out our values never gets old—even on the soccer field.
It’s time to begin a process of aligning our principles and our business beliefs in earnest. It’s time to stop investing like passive bystanders. It’s time to figure out how to reclaim our first principles as we pursue the optimal portfolio. And it’s time to start looking for investment advisors who are willing to offer advice that moves beyond fiduciary.