Companies do not exist in isolation: they use resources from the commons, employ labour and attract customers from towns and cities, and are required to operate under the laws of the land. They influence the lives of far more people than shareholders alone, but unfortunately plenty of businesses act to the detriment of many – including, in the long run, themselves and their investors. To help ensure that companies exert a positive impact on the world, including the bottom line, we believe that investors need to do more than assess environmental, social and governance (ESG) risks. They must engage.
To understand the need for engagement and the imperative for businesses to act responsibly, some historical context is useful. For most of the 20th century in the West, governments oversaw national economies. In the US, Theodore Roosevelt reined in the robber barons before his distant cousin Franklin occupied the commanding heights of the nation by mobilising resources to counter the Great Depression and then to fight World War Two.
But this economic playbook had a weak chapter on the globalisation of finance. In the 1970s, the burgeoning Eurodollar market enabled US banks to trade instruments without answering to the rules of their home market, and the Nixon Shock initiated the current era of fiat money and floating exchange rates. Add high inflation and industrial strikes, and it became apparent that the model was outdated. Thus in the latter half of 1970s, with the growth of the post-war decades petering out, people sought an answer to the uncertainty.
In response, Margaret Thatcher and Ronald Reagan captured the zeitgeist, and Western economic orthodoxy consequently took a dramatic turn. Their conservative message invoked Adam Smith’s invisible hand to push aside policies of income redistribution and promised upward mobility through hard work in a market economy. The Civil Rights Movement and rise of counterculture throughout the 1960s and into the early 1970s, epitomised by anti-Vietnam War protests and social and psychoactive experimentation, took a back seat. Spurred on by low interest rates and the rhetoric of a dynamic, deregulated economy in which the market would allocate capital more efficiently than the government ever could, more people pursued wealth.
While Thatcher and Reagan were the political advocates of this change, its ideological proponents were two radical thinkers, economist Milton Friedman and philosopher Ayn Rand, who respectively championed a government retreat from business affairs and prized the individual pursuit of satisfaction above all else. Given the expense of regulation, the new light-touch politics coming into play was a relief for businesses. But Friedman was just getting started.
The social responsibility of business
In 1970, the New York Times Magazine published Milton Friedman’s essay, “The Social Responsibility of Business is to Increase its Profits”. In it, the Nobel Prize-winning economist challenged General Motors to neglect its “social responsibilities” – which were, specifically, to build safer and more fuel-efficient cars – and focus on maximising returns to shareholders by continuing to produce unreliable gas-guzzlers. He effectively said: ignore the environment, ignore safety and just go and make money.
Instead of becoming more profitable, as Friedman expected, General Motors alienated baby-boomers seeking safer and more environmentally friendly vehicles. This growing part of the market turned to Honda and Subaru – companies which understood that protecting the lives of road users and environmental preservation are ultimately connected to the bottom line.
Japanese companies have not been the only ones to dismiss Friedman’s definition of responsibility as bunk. Closer to home, Jack Welch, CEO and Chairman of GE from 1982 to 2001, called it “the dumbest idea in the world”. Jack Ma, Founder and CEO of Alibaba, says that “customers are number one, employees are number two and shareholders are number three”. Google’s founding motto, “Don’t be evil”, was later dropped because it was not challenging enough. And Tim Cook, CEO of Apple, says the company’s ultimate aim is “to leave the world a better place than we found it”. Even Paul Tudor Jones, the Connecticut-based hedge fund manager, believes that Friedman’s logic is flawed. “Shareholders have benefited at the expense of labour and that has had a huge social impact on this country,” he says, speaking of the growing wealth disparity in the US.
If these leading capitalists understand that businesses should have a higher aim than to turn a profit – and if they are big enough, improve the world at large – isn’t a redefinition of the social responsibility of business long overdue?
Objectivism: losing hearts and minds
US President Donald Trump is not known for being a great reader, which may help explain why he considers Ayn Rand to be his favourite writer. Rand’s philosophy has significantly influenced American society in recent decades by shaping the thoughts of prominent Conservatives, Freedom Caucusers and assorted Libertarians. In a 1991 opinion poll by the United States Library of Congress, her major work – Atlas Shrugged, the 1957 fiction novel depicting a dystopian US in which private businesses struggle under burdensome laws and regulations – was cited as the most influential book after the Bible. It should not come as a surprise that Trump has prestigious company: Reagan, ex-Federal Reserve Chairman Alan Greenspan, and Senator Paul Ryan are among many other Republican politicians who have shown public admiration for Rand’s arguments.
Her philosophy, at its core, is simple: we should be selfish in order to pursue our own happiness. Called Objectivism, it argues that personal contentment is the moral purpose of life, productive achievement is the noblest activity and that an individual’s sense of reason is the only absolute. There is no place for social mores, altruism, empathy or compassion: by caring for others, we neglect our own happiness and become "sacrificial animals". We should be driven by the primary virtue of selfishness, because nothing is more important than our own happiness.
Sadly, Rand practiced what she preached. She was described by those close to her as haughty, narcissistic, devoid of empathy and, ironically, unhappy. These relationships were defined by animosity and vindictiveness. She despised the vast majority of human beings, calling them “mediocre, stupid, and irrational”, and saw personal gain as the primary motivation for any relationship. So she argues in The Virtue of Selfishness:
“The principle of trade is the only rational ethical principle for all human relationships […] Love, friendship, respect and admiration are the payment given in exchange for the personal, selfish pleasure which one man derives from the virtues of another man's character.”
Objectivism laid the foundation for the doctrine, not widely adopted today, that governments should not ask people to take an interest in the welfare of the poor, sick and elderly – let alone use taxpayer money to support them. Sure, people can help the needy if it creates personal satisfaction, but they should know that charitable giving or wealth redistribution is purely optional rather than a social duty.
It follows that Objectivism has been key in justifying the individualism (and narcissism) that has spread in the US since the Reagan Era. European philosophers, and the majority of their US peers, have largely dismissed Rand as, at best, a minor philosopher and an individual who lacked empathy. Yet it would be a mistake to underestimate the influence she continues to exert on many sectors of life, politics and business in the US – and by extension, the West. Like a physician fighting a virus that has unexpectedly transformed into a disease, society needs to find a cure. Investors can play a role in this.
As investors, how can we play a part?
To confront the crises of our time – inequality, conflict and the exploitation of people and the environment, among many other injustices – we need to be considerate of others and not act purely for personal gain. In a previous issue of Gemologist, we argued that the act of investing for a financial return cannot – and should not – be separated from the environmental and social impacts of allocating capital to a company or asset. Indeed, financial gain and sustainability are connected: there is a wealth of evidence demonstrating that long-term investment in companies with positive ESG practices results in stronger performance. So in our view the rationale for being unselfish in an investment sense is logical: stronger holistic returns benefit the investor and the innocent bystander, too.
Figure 1. EM v DM: Rule of law
We all know that sustainability, as a global movement, is gaining momentum. In September 2015, 193 countries adopted a set of United Nations-sponsored goals to end poverty, protect the planet, and ensure prosperity for all. For these objectives, the UN Sustainable Development Goals (SDGs), to be achieved, governments, citizens, companies and their investors need to act.
Figure 2. EM v DM: Regulatory quality
Emerging market (EM) companies are typically perceived as laggards in sustainable practices, with corporate interest in ESG considerations generally lower than in developed markets (DMs). This is true at the institutional as well as the corporate level; the World Bank views emerging market corporate governance as substantially weaker than that of the developed world (see figures 1-3).
Figure 3. EM v DM: Controlling corruption
Source: World Bank as at 22 September 2017.
The stronger governance among DM companies may simply be due to the fact that information about their ESG characteristics is more easily accessible than in EMs, where coverage is patchy. Indeed, we know first-hand of many positive ESG stories among EM companies that much of the investment world underestimates or is not aware of (though also some that are not so positive).
As an investment team, we analyse ESG risk as part of our fundamental research of companies, but we do not stop there. We leverage the expertise of the engagement specialists within Hermes EOS, which is one of the largest corporate stewardship teams in the world and has $424.9bn in assets under advice. The team engages with companies – including holdings in our portfolio – that have both the willingness and potential to improve their ESG policies and practices. Our investment in China Mengniu Dairy, which has doubled since the company dramatically improved its food-safety checks and processes, is proof of the benefit of engagement. The academic evidence is also supportive, with a joint study between London Business School, Boston University and Temple University finding that engagements typically lead to a 1.8% additional return in the subsequent year, with successful engagements generating 4.4% more in cumulative returns (see figure 4).
Figure 4. Corporate engagement: evidence of its effectiveness
Source: “Active ownership” by Dimson, E., Karakas, O., and Li, X. Published in 2013 by London Business School, Boston College and Temple University.
Engagement case studies
Engagement is a feature of our investment strategy: Hermes EOS, Hermes’ engagement arm, often in tandem with the emerging markets investment team, is in continual dialogue with targeted companies in our portfolio on strategic and ESG considerations. Here we discuss several recent engagements and our role in contributing to the first-ever stewardship code in a major EM:
- Banorte: Managing conflicts of interest at the board level
- Sberbank: Strengthening anti-money-laundering and whistle-blower policies and procedures; integrating ESG in risk in loan approvals and strengthening anti-corruption policies
- Alibaba: Combating counterfeits and bolstering cyber security
- Brazil Stewardship Code: Working with regulators and investors to introduce robust governance standards
- South Africa: Responding to the state capture scandal
Banorte: All above board
Hermes opposed the re-election of Banorte Chairman Carlos Hank González at the Mexican bank’s 2016 AGM. Our reason was the potential conflict of interest arising from his family’s major shareholding in Grupo Financiero Interacciones, a competing bank run by Gonzalez’s father, Carlos Hank Rhon.
Afterwards, Banorte failed to convince us (among other shareholders) that the safeguards it had put in place were adequate to mitigate the risk of it acquiring Interacciones at a valuation that would harm the interests of minority shareholders. The only evidence that the management produced was a copy of the company’s code of conduct, signed by the Chairman. We made it clear that this was insufficient and started engaging to obtain a clear, formal and robust policy to manage this potential conflict of interest.
Gonzalez was nevertheless re-elected as Chairman in 2016, but perhaps felt the embarrassment of receiving 75% of votes in favour compared to the approval given to other board nominees, who garnered more than 95%. Banorte did take the concern felt by us and other investors on board, however, and subsequently took action to mitigate this governance risk.
Figure 5. Banorte stock price, January 2016 – September 2017
Source: Bloomberg as at 30 September 2017.
It embedded a risk control designed to prevent acquisitions of large assets that were seen by shareholders to be against their interest. Indeed, the lender called an extraordinary general meeting of shareholders to propose that any acquisition amounting to more than 5% of its assets be referred to a shareholder meeting. Thus, any acquisition worth more than $3.5bn would need to be referred to a shareholder meeting. The previous level of 20% meant that acquisitions of $14bn could proceed without recourse to shareholders.
Until a 10% slide in the share price of Interacciones in late October 2017, the new level put any purchase of the bank without shareholder consent out of reach, thus preventing the Chairman from selling his stake in Interacciones to Banorte. Although we did not suggest this specific solution, we judged it to be an effective risk control that was aligned with the aim of our engagement, and voted in favour of it.
In a call with Banorte’s head of investor relations in April 2017, we expressed our support for the corporate governance improvements described above, and we were further encouraged by the restructuring of the board nomination committee, which is now majority independent. We voted in favour of the re-election of the chairman at the April 2017 AGM.
In October, the bank announced that it would acquire Interacciones for $716m plus 110m Banorte shares, amounting to $1.4bn in total. Even though this sum is below the $3.5bn requiring a shareholder meeting on the purchase, the deal is nonetheless subject to shareholder and regulatory approval.
Sberbank: shedding light on black money and environmental risk
Given the frequency of bribery, corruption and money laundering in Russia, we made sure we addressed these risks in detail during our engagement with Sberbank, which began in 2016. The nation’s largest bank recently published a comprehensive anti-corruption policy, and we have seen the steps it is taking to deliver on this while identifying room for improvement.
In our discussions, the lender’s Head of Compliance described the preventative measures being taken: investment in systems to monitor and intercept suspicious transactions; extensive anti-corruption training for all employees; embedding performance indicators linked to conduct; and promoting a whistle-blower hotline.
Sberbank has carried out money-laundering checks for some time, but lacked a centralised approach, which we have encouraged it to implement in order to limit human error and ensure consistency across all branches. The company implemented this suggestion, creating a new central compliance centre based in St Petersburg, operating on a unified IT system focused on detecting suspicious transactions. This replaced a number of legacy systems, which as a group lacked cohesion, but there is still plenty of work to be done.
To us, it seemed that the company’s internally run whistle-blower line could be improved – a view reinforced by the fact that it had not received many calls thus far. Our work with other businesses has shown that for these channels to be most effective, they should be operated by a specialist third party. The bank recognised the limitations of the internal model and promised to consider outsourcing the function when it next comes under review.
Figure 6. Sberbank stock price, January 2016 – September 2017
Source: Bloomberg as at 30 September 2017.
The credit underwriting process was another key area of our engagement. Sberbank had not committed to the Equator Principles – a framework enabling financial institutions to manage environmental and social risks – nor did it have a clear policy to mitigate the impacts of the projects that it financed, including coal mines and oil fields. Since the bank funds many domestic mining and drilling projects, which can have high environmental and social impact, this was a concern.
We met with Sberbank’s Senior Independent Director, who confirmed that although the bank’s loan officers are instructed to consider the environment when assessing a business-loan application, there is no company-wide policy, set of detailed guidelines or reporting methodology for modelling environmental and social risk that they could follow. Given that inconsistent ESG risk assessments in underwriting could not only lead to controversies but also result in regulatory fines and damage the bank’s reputation, this has become an area of emphasis for the engagement.
Progress is being made. We have not yet seen a draft policy but are encouraged by some positive developments, such as:
- A sustainability committee has been established to focus on embedding analysis of sustainability risks in the underwriting process
- A senior executive responsible for sustainability policies will be appointed by January 2018
- Sberbank agreed to our offer of initiating a dialogue with Banco Bradesco in Brazil, which is willing to share its experiences of developing a framework for social and environmental risk management in 2016. The two banks are now in contact.
The engagement continues. Our overall view is that Sberbank’s steps to prevent money laundering and, in time, reduce environmental and social risk in the projects that it finances, are taking the bank in the right direction.
Alibaba: Vetting vendors, fighting fakes
We are enthusiastic about the Alibaba’s potential for further growth and impressed by its new ventures and outstanding ability to capture and process data. However the scale and complexity of its business means that it must work hard to remain vigilant towards ESG risks, which has been a focus of our engagement with the company.
Last June, we informed Alibaba’s Senior Vice President that non-government organisation China Labor Watch had reported on the death of a 14-year-old labourer at Zhiya Undergarment Company. The company is a vendor on 1688.com, an Alibaba platform. China Labor Watch stated that Zhiya had been approved as a “quality supplier” for Alibaba since 2012, and accused the e-commerce business of paying little attention to the human rights of factory workers and for not applying workplace health and safety standards, focusing instead on product quality.
We encouraged Alibaba to respond openly. Within a week it investigated the matter, issued a public response condemning child labour and worker abuse in general. It committed to collaborate further with stakeholders – including international auditing bodies and Chinese government and law enforcement authorities – to combat the problem.
In addition to workers’ wellbeing, Alibaba also has a responsibility to protect consumers. For a number of years consumers (and the market) have been concerned about Alibaba’s quality control and stewardship of its customers’ purchasing rights, as some Chinese buyers have been wrong-footed by merchants of counterfeit products operating on Alibaba’s platforms.
Alibaba’s problems are not unique: according to MarkMonitor, 23% of consumers across the globe have unknowingly bought a counterfeit product online. We initiated our engagement programme soon after the group’s September 2014 IPO, with the aim of helping the company to protect not only consumers but also its brand and future cash flows.
Alibaba’s monitoring of vendors has steadily improved as it seeks to further protect customers and strengthen its business. In doing so, the company recognises that proactively working with brands to promote and assess the integrity of vendors is a vital step, and in the past year has taken significant strides towards protecting both customers and the intellectual property of brands. This is definitely in Alibaba's interests, given that 75% of the world's most valuable consumer brands – such as Apple, Disney and GE – are now available on the company's platforms.
Using an online ‘takedown tool’, it now helps to defend brands by monitoring its sales platforms for counterfeit products by initially screening merchandise and then carrying out test purchases to check if the products marketed to the public are authentic. The programme is both efficient and effective: from June 2016 to the end of August 2017, 97% of all takedown requests made during business days were handled within 24 hours, of which 83% resulted in takedowns. And this response rate is complemented by Alibaba's efforts to shut down counterfeiters before they reach customers' screens. From September 2016 to August 2017, the company removed 28-times more listings proactively than in response to requests from rights holders. And almost all of those takedowns – 98% – were removed before a single sale.
Alibaba is also collaborating with other companies to fight fakes. After suing two merchants for selling false designer watches on its platforms, it launched the big data anti-counterfeiting alliance (BDAA) with international brands such as Louis Vuitton, Samsung, Swarovski, Mars (yes, fake chocolate bars!) and Huawei. The BDAA aims to stop the production and sales of bogus goods by enabling members to formally share data and analysis to curb the production and sales of counterfeit products. We have encouraged Alibaba to invite more brands to join.
Figure 7. Alibaba stock price, September 2014 – September 2017
Source: Bloomberg as at 30 September 2017.
In our engagement, we discussed its efforts to combat counterfeiters. We learned that Alibaba now has an unconditional, seven-day refund policy and a dedicated fund to reimburse customers who have been burned by fakes; and guilty merchants are subject to a penalty-point system that can ultimately see them blacklisted from the company’s platforms. In the course of our engagement, we discussed technology that can identify counterfeit goods that, having been spotted on one retailer’s portal, are relisted by another.
Alibaba’s big-data analytics capability, based at its headquarters in Hangzhou, is also being used to catch counterfeiters. The company can trace funds through its global payment network which helps to pinpoint illegal business activities. The company has helped authorities in China and overseas stop cross-border criminal operations, with 1,009 arrests being made from the 1,573 leads it has provided to the police. It has also established a scheme, called ‘Made in China’, to educate small businesses about developing their own brands and businesses. Further measures to prevent luxury-item rip-offs entering the market have been introduced: sellers are required to show proof that their goods are authentic, such as an invoice or letter of authorisation from the brand.
In our engagement, we discussed the alleged attempted hacking of 20m customer accounts on Taobao, the company’s online marketplace, as reported in the media. Data security is a global issue, and we sought insight into the robustness of Alibaba's security systems. We were reassured that Alibaba’s data analysts have developed a methodology for spotting the accounts of potential hackers and freezing them. Aware that strong cyber security is critical to Alibaba’s success, we encourage the company to keep striving to improve its protection of consumers.
Another dimension of our engagement is Alibaba's corporate governance, and shareholder democracy in particular. We have asked the company to discuss, with shareholders, how the current governance structure can be improved and what potential changes could be made in the future to meet investors' expectations of best-practice governance.
Engaging on public policy: Stewardship in Brazil
Many ESG concerns are not company specific thus need to be addressed through engagement with policymakers and industry bodies. This is particularly true in EMs, where corporate disclosure, pollution, workers’ safety and other standards are often behind those in the West. Our role as active owners is to help close this gap.
Hermes is a key player in ESG-focused public-policy initiatives worldwide, and a member of various stakeholder and investor groups aiming to improve corporate standards at domestic and international levels. Hermes has played a fundamental role in developing policies supporting responsible investment, such as the UN Principles for Responsible Development and stewardship codes in the UK, Japan, Malaysia and, most recently Brazil.
In 2016 the Brazilian Stewardship Code was created by a working group of members of the Association of Capital Market Investors (AMEC), of which Hermes was the only non-Brazilian member. The process included the benchmarking of stewardship codes, interviews with the International Corporate Governance Network (ICGN), the Financial Reporting Council, local and international asset managers and owners, as well as a public consultation. We expect that the new code will be instrumental in developing a stewardship culture in Brazil, especially as a number of major local asset managers attended the launch. The aim is to help investors better accomplish their fiduciary duty by undertaking to:
- Implement a stewardship programme
- Establish mechanisms to manage conflicts of interest
- Consider ESG matters in their investment processes
- Monitor the companies they invest in
- Exercise voting rights with diligence
- Establish collective engagement criteria
- Disclose activities related to stewardship