In certain parts of the world fishermen use a destructive shortcut to increase the size of their catch. Instead of using nets, they drop a stick of dynamite on top of a reef to kill the fish, which then float to the surface and can be easily taken onboard. The problem, of course, is that the dynamite destroys the reef the fish needed to survive, removing a source of future catches and making the fisherman’s job more difficult. The story illustrates a principle called “short-termism”, which is a mindset that targets short-term results at the expense of strategies that produce long-term, sustainable profits.
Fishing with Dynamite
As a portfolio manager, I look to invest in profitable companies that are operating on principles that will last for the long-haul. If we buy firms that are “fishing with dynamite” in a figurative sense (like operating illegal sweatshops overseas to save on labor costs), we might make money in the short-run, but could ultimately lose when the company is sued or fined for bad behavior. We also “lose” in a non-financial way because we supported a company that was exploiting workers.
In the past it has been difficult to get accurate information on the full range of activities of publicly-traded companies. Asking the company to self-report on its own bad behavior is like asking the fox to tell us how things are going in the henhouse. Thankfully, we now live in the age of “big data” with an abundance of information available at our fingertips. Sifting through that information is a daunting task but some research and investment firms now have whole divisions that specialize in helping us look past the numbers to find companies that have made a commitment to long-term sustainable business strategies.
How to gauge a firm's sustainable practices?
There are three main categories analysts use to gauge the strengths and weaknesses of a firm’s sustainable practices, labeled “ESG” (environmental, social and governance factors). The individual importance of those three factors will vary by industry, so we can start with “governance”, since that is a crucial factor for any company. I’ll discuss the other factors in future blog posts.
For publicly-traded companies, governance rests on the shoulders of the Board of Directors, who oversee the management team. The board members have what’s called a legal “fiduciary duty” to ensure the firm is operating according to internal policies and within the bounds of the legal system. Board members are typically executives that are currently working at (or retired from) other publicly-traded companies; the majority (77%) are compensated with both cash and stock. The average total compensation for a board member for S&P 500 companies was $288,909 in 2017 (1).
As investors, what would we look for to identify companies that have strong, sustainable governance practices?
One place to start is to look for any embedded conflicts of interest.
Examples:
- Does the CEO also have the role of Chairman of the Board?
- If so, it is possible that the dual role could create conflicts of interest.
- Has the CEO stacked the board with friends who may not be willing to hold him or her accountable for questionable behavior?
- The technical term for this is “BIG problem”.
- Is the compensation structured to reward board members for fishing with dynamite?
There is a long list of questions that should be asked on the topic of governance before deciding we’d like to invest in a company. Since I don’t have time to personally ask all those questions I rely on specialist ESG research firms to summarize the key factors and provide me with an opinion. Each year the opinions are backed by more data as the ESG research industry evolves and matures.
At Archetype Wealth Partners, our ESG portfolio is constructed using our “three dials” approach, with the additional overlay of seeking strong environmental, social and governance factors.
If you would like to learn more about our approach, please contact me.
Sources:
(1) https://www.spencerstuart.com/research-and-insight/ssbi-2017-director-compensation
(2) https://archetypewealth.com/2018/08/24/three-dials-deep-dive-part-i-valuation/
