Investing Lessons from America’s First Stock Company

Investing in America began with bankruptcy. In the early 17th century, the hottest stock in England was the Virginia Company of London. Instead of adding to their fame and fortune, wealthy investors gained several hard insights from this first company to go bust on American soil.

Fame Is Not To Be Confused With Fortune

Sir Thomas Smythe.jpg

Sir Thomas Smythe (1558 – 1625) was Treasurer for the Virginia Company and a prominent citizen of London

By 1609, the Company was two years into the Jamestown settlement and despite many setbacks from rugged conditions and native attacks, Virginia Company trustees captured enough public interest to issue a second stock offering. This wasn’t quite tulip bulb euphoria but it is safe to assume that any new information on this overseas enterprise was a hot topic in every pub from London to Liverpool.

To publicize the glory of joining ranks with the Virginia Company, investors were given the moniker “adventurers” which sounds better than “people who are willing to take huge risks with their life savings while sitting on their 17th century couches.” Name tags are no substitute for a return on investment. Any time an investment is motivated by having a good story to tell at a social event, there’s a strong chance your financial returns will suffer.

Exclusivity Is A Poor Predictor of Performance

A single share of Virginia Company stock cost 12 pounds 10 shillings, the equivalent of over six month’s wages for an ordinary working man. As you can imagine, the high cost of ownership culled shareholders into a who’s who of English society.

Today’s investors continue to be wooed by the allure of elite hedge funds only available to those with enough wealth or income to meet the “accredited investor” standards of the Securities and Exchange Commission. Despite our efforts to expose the unjustifiable costs and underperformance of hedge funds, their greatest attraction seems to be the fact that average investors are barred from accessing them.

Doing Good Is Not A Business Plan

The marketing campaign for the Virginia Company relied heavily on a stream of ministers in support of their effort. Printing sermons may sound like a strange marketing strategy in modern times, but if there was one idea that bound England’s established Anglicans and upstart Puritans together, it was the idea that the Native Americans must be ushered from savage paganism and shielded from the Catholics. Royal Chaplin, Daniel Price, called the Virginia Company’s colonization effort “the most worthy Voyage that ever was effected by any Christian, in descrying any country of the world.”

The modern divorce between moral responsibility and wealth management swings to the other end of the spectrum. Faith-based zeal is good complement but poor substitute for a prudent business plan.

The pursuit of survival in the New World left little space for pursing the religiously inspired motivations of investors. After failing to identify a plentiful source of valuable natural resources, colonists found a profit source that many considered a detestable vice in the home country: tobacco.

In fact, King James so despised tobacco he wrote a treatise enumerating its many health dangers and described the odor as “hateful to the nose.” Tobacco would grow to become Virginia’s most valuable export, but not quickly enough to offer much benefit to investors.

As the financial stability of the Virginia Company crumbled, the top officers resorted what should have been a final warning to savvy investors. From 1612 onward, the Virginia Company offered a series of lotteries to provide most of its revenue. As morally dubious then as it is today, lottery revenue helped keep the colony afloat for a dozen more years.

Instead of saving native souls, the Virginia Company brought tobacco products and lottery tickets to their fellow Englishmen. Dark irony should be expected when doing good is a substitute for a solid business plan.

Frontier Investing Is High Risk

The trustees of the Virginia Company should be commended for retaining their investors’ patience for approximately fifteen years, but the King of England was not so easily soothed.

After grave reports of mismanagement at the Virginia Company and staggering loss of life filtered back to England, the Crown’s patience was finally exhausted and the company’s charter was revoked on May 24th, 1624. Other than a few hundred acres of generally worthless land that was awarded to shareholders in absence of any monetary returns, shareholders lost their entire investment.

Despite the financial failure of the Virginia Company, surviving colonists persevered and planted the first seeds in what would become the wealthiest nation the world had ever seen. Americans celebrate their birth, but wealthy English investors learned the hard way that speculative investments can fail spectacularly.

What Gets Measured Gets Managed

CDP (formally the Carbon Disclosure Project) is a not-for-profit organization with headquarters in London that is one of the more important advocates for the SRI investors concerned about climate change. For over ten years, CDP has been leveraging market forces to encourage companies to disclose data related to their environmental stewardship.

Despite offering guided support, companies like Pioneer Natural Resources Co (PXD) still do not disclose their carbon footprint along with other pollutants (NOx emmissions, SOx emissions, hazardous spills). Failing to disclose these environmental impacts suggests that either Pioneer Natural Resources Co has something to hide or they don’t care.

Some have come to believe that the only companies that fare well in these ranking systems are companies like Tesla Motors but this isn’t the case at all. Spectra Energy Corp (SE), a natural gas distributor, receives CDP’s highest ratings for disclosure and for their environmental stewardship.

A failure to communicate on material issues leaves investors with unknown environmental risks which all too often have economic consequences. I would like to see the day when the majority of investors refuse to buy stock in companies that fail to disclose material non-financial data.

Principle Numero Uno: Remain Vigilant on Fees

The biggest challenge for the Sustainable, Responsible, Impact (SRI) investor is avoiding excessive fees. High fees have plagued the entire SRI industry and have, unfortunately, left many to forgo the pursuit of any values alignment in one’s portfolio.

Most investors don’t know that they pay excessive fees because they don’t even know what to look for. If you’re buying a fund, start by making sure that it’s a no-load fund. The markets are too volatile to have a commissioned sales person get 5% before you’ve even put your money to work in the markets.

The next thing you need to understand is the expense ratio. The expense ratio is the ongoing fees charged by the fund and, while it comes out daily, it’s measured as an annual percentage fee (e.g., 0.5%).

If you plan to invest in a US Stock fund, there’s no reason to pay more than 0.65% in fees. If you’re investing the assets in a large family foundation or a university endowment, you won’t have any problem finding funds that charge less than this benchmark. But if you don’t have access to institutional pricing, fees can take a big bite out of your returns.

If you go to the US Sustainable Investment Forum (USSIF) mutual fund member list, you’ll only find a small number for funds that achieve this reasonable cost threshold. One example is the TIAA-CREF Social Choice Equity fund which has a 0.44% fee for the retail share class and only requires a $2,500.00 minimum investment. By keeping its fees competitive, this TIAA-CREF fund has only slightly underperformed the cost-less benchmark over its ten-year history.

All of the other funds on this list that meet the 0.65% criteria are institutional funds and require a much larger starting investment, often as high as $1 million. The remainder of the US Stock funds available on this list to retail investors have an average expense of 1.06% and even go as high as the 1.68% for the Praxis Small Company A fund. As I alluded to earlier, there’s a lot of expensive garbage in SRI investing and the stink has contaminated the general perception of the industry as financially irresponsible.

Another US stock fund with reasonable fees is the Vanguard FTSE Social Index fund (VFTSX), which charges 0.25% for its entry level “investor shares.” Two Exchange Traded Funds (ETFs) that meet the fee benchmark are the iShares MSCI USA ESG Select ETF (KLD) and the iShares MSCI KLD Social 400 (DSI), both of which charge 0.5%. New lost cost ETFs that seek sustainable profits will be added every year.

Until recently, investors needed very large nest eggs to access low cost ESG options in the foreign markets. Now, BlackRock offers the iShares MSCI EAFE ESG Select ETF (ESGD) which covers developed markets and offers a very reasonable 0.4% expense ratio. The iShares MSCI EM ESG Select ETF (ESGE) which covers emerging markets is priced at 0.45%.

Some in the industry will argue that high fees are necessary to offer a high level of shareholder advocacy. By this, they believe that their efforts petitioning the board and executive team to make improvements mean needing to spend your retirement dollars. Most of these organizations don’t have the scale to be anything but an annoying fly. (In Part 2 of this series, I’ll share some ways to csider joining the efforts of others that don’t require excessive fees.)

Jack Bogle, founder of Vanguard Funds, illustrates the importance of watching fees with his Relentless Rules of Humble Arithmetic. Here’s the equation he offers:

Total Stock Market Returns − Total Fees from Finance Industry = Average Investor Return

If the total market of stocks for and bonds are expected to yield 7% on average (from a balanced portfolio) and total fees from the finance industry equals 2%, this leaves 5% as the average net return. This humble arithmetic concludes that the more extracted in fees, the less remains as a reward for the risk undertaken by investors.

Simply reducing your fees by 1% over a 35-year career can add an additional 20% to your total retirement savings. This means that if your goal is to accumulate $1 million, an extra 1% in fees can cause you to fall $200,000 short.

In conclusion, keep your US stock fees at or below 0.65% and you’ll have a found a solution that passes the first principle of SRI investing. International fund fees may be a bit higher and fixed income fees should be a bit lower. Your portfolio seeking a more sustainable future should also have fees that are sustainable to your own nest egg.

Shareholders Need New Advocates

In his 1914 collection of essays called Other People’s Money and How the Bankers Use It, Louis Brandeis argued that powerful men such as J.P. Morgan leveraged unbalanced control of the public’s assets to their own benefit. Over one hundred years later, not much has changed. If Brandeis were alive today, you can be sure that he would be advocating for new systems of financial accountability for those on top of the financial hierarchy.

The world now has more stock owners than ever before. Increased ownership is a triumph for the free markets, but it also diminishes the influence of individual investors. While John Pierpont “J.P.” Morgan can use his influence to stuff the board of directors of Standard Oil with “Morgan Men,” John the UPS driver might not even realize that he owns a small piece of Exxon stock in his 401(k) plan. In fact, if John the UPS driver owns Exxon stock through a mutual fund, he lacks a single vote to determine the board of directors.

The very funds that make it possible for average investors to access the capital markets also carry the responsibility to vote their shares. But many question whether institutional fund companies take this responsibility seriously. Institutional ownership has grown by leaps and bounds, from 6.8 percent in 1945 to more than 60 percent today. The fund company has become the so-called “legal owner,” and the role of folks like John the UPS driver is relegated to that of “beneficial owner.” This means that the fund company retains the power and influence of ownership, but it is still considered an agent of the beneficial owner.

Delegating investment management offers many potential benefits to the majority of investors who lack the time and expertise to understand and respond to corporate matters. As aggregators of many investors, some fund companies are very powerful. For example, Vanguard, Black Rock, Fidelity, and State Street are the largest shareholders of Apple Inc., the world’s biggest company by market value.

However, fund companies have generally been accused of being more content to quietly side with corporate management than to stick up for their investors. This has not stopped the founder of The Vanguard Group, John C. “Jack” Bogle from becoming an outspoken critic of his own industry for failing to live up to their responsibilities as stewards of other people’s property.

Bogle points to spiraling executive compensation as a symptom of a larger problem. As Bogle explains in The Clash of the Cultures, since 1980 executive compensation has risen twice as fast as the earnings growth rate at America’s large corporations. During that time, CEO compensation relative to average worker pay started at a ratio of 42-to-1 and now stands at 320-to-1. Fund companies have been largely silent about this trend until recently forced to make their opinion public on so-called “say-on-pay” votes.

Fund Companies Have Conflicts of Interest

Investors have every right to question whether a fund company like Fidelity can cast an impartial vote on an executive compensation package while those same corporate executives are deciding whether to invest their 401(k) and pension plan assets with Fidelity. Recent studies suggest that the largest fund companies exhibit the most corporate-friendly voting patterns. Neither group has much incentive to criticize the other, and Bogle calls this moral hazard a “happy conspiracy.”

If all corporate management teams were always looking out for the best interests of their shareholders, you would expect more common outcry when their close friends and family members were offered positions on the board of directors. Or when executives award themselves the promise of an overly generous golden parachute in the event of acquisition. But executive elites have little reason to follow best practices in corporate governance if the shareholders fail to demand it.

Without significant outside pressure, I don’t expect fund companies to respond to Jack Bogle’s calls for increased fiduciary support of shareholders.

Investment Advisors Lack Motivation

Registered investment advisors (RIAs) have a fiduciary duty to serve the best interests of their clients, but most of them are largely silent on issues of corporate governance. Fund companies are required by the SEC to vote proxies on behalf of those who entrust their investments to them, but RIAs are under no such obligation. Most state explicitly on their ADV disclosure that they do not vote proxies and leave the responsibility with their investors. These firms have determined that the benefit of voting individual share proxies is not worth the effort and liability.

My attempts to inspire RIAs to work together in pursuit of a more robust shareholder advocacy effort suggests that this group is not ready. In 2014, I wrote the headline article for our association journal titled RIAs and Corporate Governance: Ready to Take the Lead? and the editor was very excited but I am still waiting for the first comment from a practitioner. This was followed up by a shareholder advocacy seminar given to our 2015 NAPFA national conference which received a similar response.

Like the fund companies, I don’t expect to see much movement on corporate governance issues until investors start demanding it. This begins by developing awareness and asking some penetrating questions of your investment managers. One preliminary question is simple: “Please share with me what you are doing to manage my shareholder voting rights.”

A Mission Statement Worth Reading

Responsible investment is an approach to investment that explicitly acknowledges the relevance to the investor of environmental, social and governance factors, and of the long-term health and stability of the market

The PRI, the world’s leading proponent of responsible investment, has 1500 signatories and this represents $63 trillion dollars of assets under management as of April, 2016. If your investment manager isn’t aware or engaged in this initiative, it’s time to start asking some questions. It won’t be long before investment manager’s who ignore the SRI movement will be in the minority.