A quarter of firemen fatalities are due to traffic accidents. Why is that? When firemen are rushing to a fire they are extremely focused on reaching and analysing the fire. This tunnel vision helps firemen do their job well, but it comes at a high price: due to their focus, firemen do not pay sufficient attention to other important issues, like fastening their seat belts.
The same can happen to investors who invest against a benchmark. Because they are so preoccupied with trying to beat the benchmark, they might overlook important factors. They elaborately analyse in which stocks, in which sectors and with what strategies they recently performed well or poorly. In jargon: where did they win and lose performance? This means investors focus too much on the past and neglect important matters like the long term value creation of a firm. That should not be the intention. What is ultimately the purpose of an investment? It may look good to beat the benchmark, but if the absolute return is negative it still isn’t good. In the end, it is about enabling customers, people like you and me, to secure their financial futures. But of course, that requires there to be a liveable future in the first place.
“Finance does have an important social function, namely to steer means to their most productive ends.”
How liveable that future will be, partly depends on current investment decisions. Many investors think that finance is socially neutral; that they only need to focus on the expected risk-return for all to turn out well. But that is a misperception. Finance does have an important social function, namely to steer means to their most productive ends. It is easily forgotten that these are productive ends in a social sense too, which can turn out quite differently from financial reporting returns. After all, the firm’s activities can yield social gains and losses that do not benefit or burden the firm. These unpriced social gains and losses are called externalities.
For centuries, firms have been able to get away with negative externalities – think of manufacturers who dumps waste materials in rivers or do not recover lands to their original condition. But society is becoming increasingly less tolerant of such behaviour. The costs of matters like CO2, waste and tobacco are being internalized more and more by regulations, taxes or consumer actions. This often comes at the expense of the profitability of producers of negative externalities. The opposite applies to producers of solutions (like catalysts, enzymes, windmills etc.).
Unfortunately, financial-economic models do not take a changing world into account. Investors who only focus on the statistically measurable risks of models, are in fact focused on past patterns and do not take into account changing distributions, new business models, etc. For instance, they might keep investing in manufacturers of cigarettes because they achieved historically high returns in combination with a low variance. Indeed superficially, manufacturers of cigarettes have been good investments, but socially they have destroyed a lot of value due to very negative health effects. These effects are accepted less and less, and tobacco business models might very well collapse. In my opinion, these are not sustainable firms.
But what firms are sustainable then? To answer this question one needs to assess the sustainability of their business models. A good sustainability score is not enough. For several reasons, such scores are flawed. For example, they mainly focus on the firm’s operations (how do they treat suppliers, employees and other stakeholders?), but barely take the sustainability of products into account. Consequently, manufacturers of cigarettes and oil companies can achieve high scores. Moreover, the scores are based on reporting, which is an advantage for larger companies with big reporting departments, and a disadvantage for smaller companies with fewer resources. In addition, scores often look at the wrong issues or weigh them incorrectly. So please, do look beyond these scores and judge firms on both their products and their behaviour. How do they really contribute to society?
“It is attractive for asset managers to invest in companies that invest in the SDGs. Moreover, it is a way to show the added value of active asset management in a world that is shifting to passive investing.”
A good measure for firms’ social contributions can be found in the UN Sustainable Development Goals (SDGs). These are 17 ambitious goals set by the United Nations in September 2015 in order to improve the world. Goals include eradicating poverty (SDG 1), achieving clean and affordable energy (SDG 7) and reducing inequalities (SDG 10). National governments have committed themselves to achieving these goals, but they need help from companies to deliver. This applies especially for the goals of innovation (SDG 9) and sustainable products and services (SDG 12). Fine, you might think, but in what way is this important for investors?
SDGs matter because companies benefit from contributing to the SDGs in various ways. Firstly, they help making the world a better place – which is rewarding in itself but also raises their own chances of survival. Secondly, they are likely to achieve higher financial returns. After all, they create social value by offering solutions for the SDGs, which can often be translated into shareholder value, provided that people are willing to pay for the offered solutions. It is therefore attractive for asset managers to invest in companies that invest in the SDGs. Moreover, it is a way to show the added value of active asset management in a world that is shifting to passive investing.
But the SDGs are not the only criterion on which to assess companies. That would be tunnel vision too. Other criteria include financial returns (i.e., based on valuation and value creation) and decent ESG (Environmental, Social & Governance) factors: is the company well managed? Does the company have a healthy culture? Is it well prepared for the future?
Back to the firemen: they too can benefit from companies that make a positive impact. Innovative companies are developing self-driving cars, which will reduce the number of traffic fatalities – also among firemen. As a result, many more firemen will enjoy their retirement in a better future. Get rid of tunnel vision, embrace a long term vision!
