Intangible Assets: Understanding the Link Between Ethics and Returns
By Guest Contributor
By Sarah Reice
With the onset of 2017, we find ourselves in an extremely turbulent economic, cultural, and political environment. Despite efforts to create a global unified rule of law by organizations such as the United Nations and the International Monetary Fund, no global regulatory consensus exists. In a world of unprecedented globalization, no single government can unilaterally address today's global challenges.
Given its status as a global economic and political leader, the United States has been tremendously impacted by the tumultuous global regulatory environment. In a 2014 survey of 400 U.S. CEOs by Forbes Insights and KPMG, respondents revealed that the regulatory environment has a decisive influence on company operations and business decision-making. However, many sectors of the economy remain unregulated or unevenly regulated.
Many investors are noting regulatory inaction, and as a result are directing their investments towards funds that mandate social responsibility. This is because they believe it is good not just for the world, but for business as well.
Social Responsibility is Intangible
Tim Erblich, CEO of Ethisphere, articulated the link between ethics and performance at the 2016 SRI Conference, stating that previously "market value was made from 83% tangible assets", this number has now dwindled to 16%. These assets reflect standard investing methods, focusing on measures such as profit or sales. Nonetheless, these practices are relatively easy to understand, and thus are already reflected into pricing.
As a result of market value representing a smaller percentage of tangible assets, Erblich states, "Intangibles have become the most important factor in valuation". These include features such as retaining the right people, acting as a force for good, and generally doing more than just making a profit. To date, measurement for these intangible factors is difficult with no clear methodology or universal set of standards. Because of this uncertainty, intangibles tend to be disregarded by traditional investors, despite mounting evidence that intangible components are highly impactful to returns on investment and should not be ignored.
Have Integrity, Do Better
Though hard to measure, integrity has proven to lead to outperformance. According to Ethisphere, "good ethics is good business," as companies with robust ethical standards continue to outperform their competitors. Companies like Dell Inc., Cisco and Ford Motor Company have promoted effective internal ethics standards. This demonstrates the power that investors have to drive business as a force for good.
This idea of using investing as an agency for ethics was a hot topic at The SRI Conference. In fact, Mark Ohringer, Executive Vice President and General Counsel from JLL, says that from a company perspective, having an ethics policy is the best thing you can do for risk mitigation. This goes for internal and external risks, ultimately with the idea of maximizing shareholder wealth in mind.
"Sustainability to me is literally how do you sustain the organization, and one of the most important things you can do is keep bad things from happening" Ohringer advises. Though the stock market cannot be controlled- losses due to fraud, employee carelessness and supplier misbehavior can certainly be minimized. Ethical codes allow for the prevention of judgment lapses and negligence alike, by providing training and in the end holding people accountable.
Times are Changing
As shareholders become more values driven, companies have been forced to act in response. Instead of just paying lip service to sustainability standards, corporations are now choosing to disclose them. Though not mandatory, these disclosures provide good indicators of both integrity and quality assurance; thus alleviating much of the difficulty that previously arose from measurement of intangibles.
Attitudes towards reporting are also changing from a company perspective. More executives view environmental social and governance (ESG) disclosure as a way to mitigate risk and better understand the drivers of financial impacts . Upon analyzing CEO's agenda's, PwC reveals that "74% of CEO's told us that measuring and reporting their total (non-financial) impact contributes to their long-term success".
This is because reporting has allowed companies to better analyze their operations. As a result, businesses are able to reduce costs by minimizing inputs and increase revenues from introducing superior products. Previously viewed as a reputation booster, reporting has now enabled corporations to foster innovation and identify efficiencies by taking a closer look at the entirety of operations and better understanding material issues.
Reporting requires time, resources and, in most cases, a huge shift in corporate attitude. However, when non-financial performance is embraced as a part of business practice, reporting can be used as a resource for anticipating uncertainty associated with decision making and recognize areas for improvement. This is something that both investors and executives should see value in.
The Bottom Line
The movement behind integrating non-financial criteria into investment decisions has been around for decades, but has recently experienced a huge upswing. Concerns about climate change, environmental regulations, and poor governance are driving demands for more information.
Intangibles are undoubtedly hard to measure and translate, but evidence is skyrocketing that shows companies who pay attention to non-financials perform better in the long run than those who do not. This is because these corporations predominantly experience less fraud, have built a strong reputation, have confidence of investors, attract customers and hold suppliers to higher standards. All of this leads to risk mitigation that in the end generally translates to higher profit.
Creating an investment strategy that encompasses intangible assets is not easy, but it is getting easier. More companies are reporting on their non-financial activities, while independent information and indexes are becoming more prominent for investors willing to dig through to find what they are looking for. And those that take the time and resources to back socially responsible strategy find the same results, that ethical investing works.
First Affirmative understands that the ways we save, spend, and invest can dramatically influence both the fabric and consciousness of society. We believe that in addition to the benefits of ownership, investors bear responsibility for the impact our money has in the world. Are you making conscious decisions about the impact of your consumer purchase and investment decisions?
NOTE: Mention of specific companies or securities should not be considered an endorsement or a recommendation to buy or sell that security. For information on the suitability of any investment for your portfolio, please contact your financial advisor. Past performance is no guarantee of future results.
Posted: March 13, 2017