Why We Are Impatient for More Patient Capital
By Mel Miller
At First Affirmative we've built a business that helps our clients invest in companies that operate sustainably and responsibly. The investments strategies we offer own companies that contribute to a clean and healthy environment, treat people fairly, embrace equal opportunity, produce safe and useful products, and support efforts to promote a more peaceful world, all while earning competitive long-term returns on those companies' stocks.
The ideals of Sustainable, Responsible, Impact (SRI) investing increasingly underpin the investment decisions of investors big and small – from millennials just beginning to build an investment portfolio, to large pension funds like CalPERS. As a result, public companies are being held to higher and higher environmental, social, and governance (ESG) standards that are increasingly important in institutional money managers' investment processes.
Still, change rarely happens overnight. Companies committing to high ideals are committing to efforts that require sustained focus and innovation predicated on financial investment. While we may disagree on how to define long-term, we likely agree that three months is definitely not long-term.
Unfortunately, however, this is the time period during which the management of publicly traded companies are generally expected to produce results that meet or exceed analyst expectations. Missing targets-or not producing exciting enough results-can lead to a decline in a company's market value and a mauling by a media that loves to gorge on tales of failure. More insidiously, management attempts at producing instant gratification can lead to decisions that sacrifice long-term value.
I had some personal experience of this short-term phenomenon as Executive Vice President/Chief Investment Officer at Heartland Financial, USA where I was employed twenty-eight years prior to joining First Affirmative Financial Network. Heartland started out as a privately held one-bank organization in Dubuque, Iowa, owned by a few families and executives.
To expand outside Dubuque, it was necessary to form a holding company structure and raise money from outside investors-thus the birth of Heartland Financial. Long-term strategies were emphasized; five-year strategic plans were developed, implemented, and monitored. Even though a large percentage of the stock was still held by insiders, the pressure to produce on a quarterly basis grew as additional stock was issued to support expansion. While then CEO, Lynn B. Fuller, did an excellent job of making sure the management team remained focused on long-term goals, the market pressure remained.
Generally speaking, institutional investor money is not "patient" money. Based on the continuous burden of managing to quarterly targets in order to appease investors, almost 80% of 400 CFOs of large U.S. public companies "said that they would sacrifice economic value for the firm in order to meet that quarter's earnings expectations." Alongside chasing profits by reducing headcount and other cost-cutting measures, companies influence key metrics such as earnings per share (EPS) targets by employing share buybacks. This practice uses company cash to reduce the amount of stock outstanding even when the long-term impact may be less than positive for the company. Per a recent Financial Times article, companies often "buy high and sell low." In essence, they engage in long-term value destruction which, ironically, can end up negatively impacting the more fickle shareholders whose loyalty they chase.
It's not hard to extrapolate why this behavior is problematic. Essentially, companies are limiting their ability to invest in innovation that will support their long-term success. Competition in today's markets is fierce and stories of large firms being outclassed by peers, or even being "Netflixed" by more nimble upstarts, are easy to find. Such is the pressure that even the most valuable and innovative companies on the planet-for example, Apple-must constantly run on the hamster wheel of product development to retain their leading status (Nokia, anyone?).
Notably, Apple's own share buyback program saw it purchase $11 billion of shares between January and June, 2015 "on buybacks at $127 on average" compared to its current price of $105 (as of April 22, 2016). Not only does this constitute a significant cost to shareholders, it also adds to concerns over the company's long-term success: "… buybacks send a message of fatigue, that management doesn't have any good ideas for using the cash, other than giving it back to shareholders."
However, there are examples of public behemoths finding ways to create a corporate culture of innovation, sustainability, and patience. And, this culture can filter through to their capital structure, as evidenced by their level of participation in quarterly earnings fervor, or lack thereof.
Unilever, for example, has taken the bold stance to "abolish quarterly profits" and stop providing guidance on quarterly reporting as it continues to make sustainability and environmental concerns a critical element of its overall business.
Unilever CEO, Paul Polman, says, "It's very easy to show more profits… by cutting investments in training and development of your people or your IT systems… I need to create this environment for the company to make the right longer-term decisions. So we stopped giving guidance. We stopped doing quarterly reporting. We changed the compensation for the long term." Despite an 8% share price drop at the time of the announcement, the company is proof that sustainability is good business. In 2014, 50% of Unilever's growth came from its sustainable brands, growing at twice the rate of other parts of the business.
Furthermore, Polman has explicitly stated that "certain kinds of shareholders" (i.e. short-term speculators) are not the kinds of shareholders Unilever seeks. They're not aligned to key company values such as those embedded in Unilever's Sustainable Living Plan. Polman says "that you need to attract a shareholder base that supports your strategy, not the other way around."
Similarly, the leading hybrid car manufacturer, Toyota, has made efforts to attract aligned shareholders. In 2015 Toyota issued 50 million "Model AA" shares of stock raising approximately $4.2 billion (named after the automaker's first passenger car). The stock, only sold to Japanese, carries voting rights unlike preferred shares, equal to the common stock rights, but not listed on any exchange. At maturity, after five years, holders can sell the AA stock back to the company at the issue price. The shares can also be converted to common stock.
During the five year lock-up period, Toyota will pay a guaranteed dividend starting at 0.5% increasing 0.5% per year to the maximum of 2.5% in year five. At issuance, the Toyota Model AA stock carried a 20% premium to the company's common stock. The reason cited for the issuance was to generate "patient" capital to finance the development of the "next generation" car. Mr. Toyoda (Toyota President) said "This shows how the management wants to build corporate value over 5 years together with shareholders."
Toyota's unique structure is not without its critics. Institutional Shareholder Services, Inc. a foreign proxy advisor (U.S.-based) said such a move would lead to more docile and silent shareholders. And, in a twist of criticism, CalSTRS, the large California public teachers' pension fund, is critical of the fact that potential investors outside of Japan cannot purchase the stock.
Still, it's encouraging to see more companies finding ways to re-orient their businesses toward long-term goals in a current market reality that does not ensure long-term innovation. Large public companies have the power to create incredible, positive change-but they also need the courage to use their power, and they need shareholders who act as partners in supporting their visions for sustainable success. They need shareholders who act as true owners.
Marjorie Kelly, Senior Fellow and Executive Vice President of Democracy Collaborative, states that our current economic system is one of "Extractive Ownership" and calls for "Generative Ownership." She says, "the generative economy is built on a foundation of stakeholder ownership designed to generate and preserve real wealth-resources held and shared by our communities and the ecosystems we live in. These enterprises don't have absentee ownership shares trading in a casino economy, but ownership held in human hands."
With current corporate ownership dominated by absentee membership, short-term profit maximization, and its associated impacts, is the unfortunate result. Economist John Maynard Keynes warned in 1933: "Experience is accumulating that remoteness between ownership and operation is evil in the relations among men, likely or certain in the long run to set up strains and enmities which will bring to naught the financial calculation."
Responsible investors are a step closer to meeting the conditions of Generative Ownership. Factors other than short-term profits play a role in the decision-making ownership process, longer-term holding periods are more common, and shareowner advocacy, which encourages even higher levels of corporate citizenship, is often integral to the investment strategy. But, while SRI investors and courageous companies are still in the minority, publically traded firms remain subjected to quarterly earnings pressure.
CEOs like Paul Pohlman of Unilever are looking for another alternative, as are investors and investment managers like First Affirmative Financial Network.
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. Past performance is no guarantee of future results.
Posted: May 10, 2016