My ESG Takeaways from "Grow the Pie" by Alex Edmans

I recently read Grow the Pie, by Alex Edmans, and though this is not an "ESG book" per se, as someone who works in ESG I couldn't imagine something more relevant to what we sustainable financiers are trying to achieve.

Alex explains patiently that a lot of what ESGers take for granted as received wisdom and settled knowledge is in fact myth, and will also point you to the tools and practices that really 'work'. And if some of Alex's ideas are counterintuitive to you - the notes in the back set out the evidence and facts that his thinking is based on. The end-of-chapter "in a nutshell" notes and the Action Items section at the end of the book also make it a practical and indispensible 'how-to' guide for the ESG practitioner.

I took copious notes in reading the book and wanted to share them here but want to emphasize here that I feel that for anyone who is interested in, or works in, responsible investment and ESG there's really no excuse for NOT having read this book. And please note that this is not a summary of the book - I've only noted here the messages that are central to my own work and interests.

So I hope these notes are an encouragement to get your own copy. It may be the most 'responsible' investment you ever make...

Grow the Pie – Alex Edmans

Conclusion

303

We started this book by acknowledging the severe crisis that capitalism faces. In the eyes of millions of citizens, it’s a rigged game. Corporations exist to line the pockets of executives and investors, paying scant attention to worker wages, customer welfare or climate change. … That’s why we have a crisis. Citizens and politicians can’t just hope for the system to reform itself – many believe it is inherently broken. They argue we need a new system, and so there are serious proposals to overthrow capitalism as we know it by breaking up or nationalizing large companies, regulating executive pay and share buybacks, and wresting the control of businesses away from shareholders. But such reforms risk stifling the many positive contributions that enterprises make to society. … So what we need is a solution that works for, and involves, both business and society.

3 / 4

Profits & shareholders

Crucially, the pie represents social value, not profits – profits are only one slice of the pie. Thus, under the pie-growing mentality, a company’s primary objective is social value rather than profits. Surprisingly this approach typically ends up more profitable than if profits were the end goal. That’s because it enables many investments to be made that end up delivering substantial long-term pay-offs. But since these pay-offs couldn’t have been forecast from the outset, the projects would never have been approved under a traditional shareholder value framework.

Without profits, shareholders wouldn’t finance companies, companies wouldn’t finance investments and investments couldn’t finance shareholders’ needs (citizen’s retirements, insurance companies’ claims or pension funds’ liabilities). Thus, ideas to reform business that ignore profits’ crucial role in society are unlikely to be implemented – enterprises aren’t charities.

Profits are often the by-product of taking some things and making them better, the root of human progress across the ages. Investors shouldn’t always be suppressed; they’re allies in reforming capitalism to a more purposeful and more sustainable form.

27/28

Pieconomics vs CSR

Pieconomics in turn leads to a shift in thinking about what leaders’ and enterprises’ responsibilities are, and how both should be held accountable by citizens. Its views differ from the traditional term Corporate Social Responsibility (CSR) in two fundamental ways. First, CSR typically refers to activities that are siloed in a CSR department, often to offset the harm created by a company’s core business, such as charitable contributions. Pieconomics is embedded into the core business and ensures that its primary mission is to serve society. We’ll thus frequently refer to an enterprise’s social performance or purpose rather than its CSR. Second, a common dictum of CSR is ‘do no harm’?- not to take from other stakeholders. But Pieconomics stresses that it’s even more important for a company to positively do good by creating value. Being a responsible business isn’t so much about sacrificing profits to reduce carbon emissions (splitting the pie differently), but innovating and being excellent at its core business (growing the pie) – like Merck developing ivermectin for human use. Conversely, the main way that enterprises fail to serve society is not by errors of commission (giving too large a slice to leaders or investors), but by errors of omission (failing to grow the pie by coasting and sticking to the status quo).

39

Profit maximization

The second, and more powerful, defence of profit maximization is that the only way an enterprise can make profits – at least in the long term – is if it serves society.

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Pieconomics vs Enlightened Shareholder Value

Friedman’s second argument is the foundation for a broader approach to profit maximization called enlightened shareholder value (ESV). Enlightened shareholder value agrees with the pie-splitting mentality that an enterprise’s goal is to maximize profits. But it’s enlightened because it recognizes that doing so in the long run requires it to grow the pie and thus serve stakeholders. (…) But there is a key difference. ESV argues that an enterprises’ ultimate goal is to increase long-term profits – and by doing so, it will create value for society as a by-product. Pieconomics argues that an enterprise’s ultimate goal is to create value for society – and by doing so, it will increase profits as a by-product. Profits are an outcome, not a goal. (…)

ESV’s single objective then leads, at least in theory, to two overlapping advantages. First, ESV is concrete. Because there’s a single, clear objective, there’s a single clear way to take a decision – will it increase long-term profit? (…)

Second, ESV is focused. A company practicing ESV has a single goal – increasing long-term profits.

(…) I’d argue that the same two reasons are why the pie-growing mentality is fundamentally superior – not only for society as a whole, but also, perhaps surprisingly, for investors themselves. I’d turn both reasons on their head. The pie-growing mentality may be less concrete, but it’s intrinsic rather than instrumental. The pie-growing mentality may be less focused, but it considers externalities rather than just profits.

45

Instrumental vs Intrinsic

When decisions are instrumental – driven by the desire to achieve outcomes – they’ll be made only on the basis of outcomes that can be quantified with some degree of accuracy. But most important outcomes can’t be quantified. (…) Profits can only be measured looking backwards; it’s very hard to estimate them looking forwards.

most important outcomes can’t be quantified

(…) That’s where Pieconomics comes in. A pie-growing enterprise makes decisions for intrinsic reasons – to create value for society – rather than to instrumentally increase profits. Stakeholders are the end itself, rather than a means to an end. (…) Apple never set out to be worth 1 trillion, but to push the boundaries in innovation and design – and doing so led to its substantial value. While some executives draw a distinction between financial and non-financial value, Pieconomics argues that, in the long run, almost all value becomes financial value.

49

ESV believes an enterprise should be instrumentally motivated to create profits, whereas Pieconomics believes it should be intrinsically motivated to create social value.

63 / 64

Growing the pie does not mean growing the enterprise; buybacks; M&A

Senator Warren’s full argument was that ‘stock buybacks create a sugar high for the corporations. It boosts prices in the short run, but the real way to boost the value of a corporation is to invest in the future, and they are not doing that’. (…) We note that, by choosing not to grow and instead paying out funds to investors, an enterprise can allow another company to be financed and grow. Importantly, leaders have self-interested reasons to invest, even in projects that don’t benefit society. This is known as empire-building. Bosses of larger firms earn significantly more and also enjoy prestige and status – the CEO of the market leader is most likely to keynote at industry conferences or speak at the WEF in Davos. (…) A leader may thus grow the firm to preserve her legacy. (…) A study by Sara Moeller, Frederik Schlingemann and René Stulz found that over just four years – between 1998 and 2001 – US firms lost their investors $240 billion through acquisitions. Buying those companies allowed CEOs to build their empires, but the opportunity cost was the substantial value that the purchased businesses were generating on their own beforehand.

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Multiplication / comparative advantage / materiality

The rest of this chapter provides three interrelated principles to guide a leader’s judgment in these complex situations (tradeoffs on which projects to undertake or turn down). The principle of multiplication ensures that the social benefits of an activity exceed its private costs, so that the activity delivers value to society. The principle of comparative advantage, combined with the principle of multiplication ensures that the social benefits of an activity exceed its social costs, so that the activity creates value for society. The principle of materiality, combined with the first two principles, makes it likely that the social value created will ultimately increase profit. Then, the activity creates profits through creating value for society – the definition of Pieconomics.

The principle of multiplication: if I spend $1 on a stakeholder, does it generate more than $1 of benefit to the stakeholder? (…If not) the enterprise could instead pay the dollar to the stakeholder (e.g. higher wages to colleagues or lower prices to customers) who can then use it more effectively.

The principle of comparative advantage asks the following: Does my enterprise deliver more value through this activity than other enterprises? (…) There are two broad cases in which the principle is usually satisfied. First, a company typically has a comparative advantage in any activity it controls directly. While charities can fund cancer research and feed the homeless, only Apple affects the plastic packaging it uses for its products. (…) Second, a company may have a comparative advantage due to its expertise. Many charities are successful in getting medicines to the airports of developing countries, but the final challenge of transporting them to families or doctors in rural areas is much harder. That’s where Coca-Cola steps in.

The principle of materiality asks the following: are the stakeholders the activity benefits material to the enterprise? Materiality stems from two sources. The first, which we’ll call business materiality, is how material a stakeholder is to the enterprise’s business. (Note that business materiality is subtly different from calculation. It doesn’t require the firm to calculate how much investment will boost profits by, or even identify the channels through which it will do so – only to recognize that, if a stakeholder is material, creating value for that stakeholder is likely to flow back to profits.

Combining these principles, creating profits through creating value for society requires a firm to undertake an activity that benefits stakeholders if and only if these benefits exceed the costs to the firm, it has a comparative advantage in that activity and these stakeholders have high business materiality. All three principles should be satisfied, because none of them automatically implies another.

The second dimension of materiality is intrinsic materiality. Stakeholders could be material to an enterprise simply because it cares for them, even if they don’t contribute to its profits. (…) Given its different role, intrinsic materiality may sometimes be used in isolation, rather than combined with multiplication and comparative advantage.

86/87

Materiality

Recall the principle of materiality, that only delivering value to stakeholders with business materiality will ultimately benefit investors. The authors used the SASB materiality map … to stratify the fifty-one issues into material and immaterial ones, given each company’s industry. Firms that score high on material issues and low on immaterial issues beat the market by a statistically significant 4.83%. So companies that do well on only a few items, and show restraint on others, actually perform better than those that do well across the board. Indiscriminately investing in stakeholders doesn’t deliver long-run value to investors, but targeted investment in material stakeholders does.

Eccles, Ioannou and Serafeim investigated whether companies had genuinely adopted these (stakeholder-oriented) policies (rather than simply announcing intentions), by scrutinizing their annual reports and sustainability reports, and interviewing over 200 executives. They found that enterprises which had adopted a high number of these policies beat those which had adopted few by 2.2% to 4.5% over 1993 to 2010. (…) The above studies show how social value creation improves investor returns. … To reach the land of profit, follow the road of purpose.

88/89

What does the stock market value

I found that the Best Companies systematically beat analyst expectations (known as a positive earnings’ surprise), causing their prices to rise significantly. This suggests that employee satisfaction improved productivity, but the market didn’t previously take this into account and so underpredicted their earnings. This result shines a light on what the stock market does and doesn’t value. For some intangible assets, the market values them not directly, but only when they later show up in tangible outcomes such as profits. So a pie-growing mentality requires long horizons – treating other stakeholders well does benefit investors, but only in the long term. That’s also true for other measures of social performance. Customer satisfaction, eco-efficiency and stakeholder-oriented policies are all public information but take a long time to affect the stock price.

90

Linking social performance to future stock returns, rather than market share, revenues or profits, takes us closer to causality. But it doesn’t fully prove it. … Since the Best Companies beat these forecasts, it must be something over and above management quality that’s driving their profitability. But that’s still an assumption, and there’s no way to directly test it.

91 – 94

Does ESG outperform?

So why hasn’t Pieconomics been more widely adopted? Because it’s important to acknowledge the evidence isn’t all one way. … One of the most challenging pieces of counterevidence is that SRI funds in general don’t beat the market. … “Impact funds” are those with social as well as financial objectives. Barber, Morse and Yasuda studied 159 such funds over twenty years and found that they underperformed traditional venture capital funds by 3.4% per year.

One of the most challenging pieces of counterevidence is that SRI funds in general don’t beat the market

Some SRI advocates sweep these findings under the carpet. One claimed in the Financial Times that ‘The outperformance of ESG strategies is beyond doubt.’ Such a claim is unfortunately not true, but often accepted uncritically given confirmation bias. …

Many funds use screens to assess whether a company creates value for society. They screen out a stock if it fails to tick a box (e.g. has insufficient board diversity) or ticks the wrong box (e.g. is in the oil and gas industry). This approach has three shortcomings…

First, box-ticking measures are superficial, and thus incomplete at best or prone to manipulation at worst. …

Second, box-ticking is one size fits all. It assumes that better social performance is always beneficial to investors, but this ignores the principle of materiality that’s central to Pieconomics. …

Perhaps the most important drawback is that box-ticking is piecemeal rather than holistic. Most firms perform well on some dimensions but not on others. …

The complexity of evaluating employee satisfaction means that it can’t be whittled down to a single box that can be ticked, such as a measure of wages. … Funds labelled as ‘socially responsible’ might underperform, not because social performance harms financial performance, but because they don’t properly evaluate social performance. The performance of socially responsible investors tells us little about the performance of socially responsible investing.

95

Discerning

What’s the conclusion from all this research? Pieconomics isn’t a too-good-to-be-true pipe dream – serving stakeholders does in fact deliver higher long-term returns to investors. But it doesn’t in every single situation. So while a company’s primary goal should be to create value for society, it’s important that it does so in a discerning way.

105

Executive pay

Pay structures can either encourage or hinder value creation, so the second concern – that pay packages can distort CEO behavior – is entirely valid. As Jensen and Murphy title their influential 1990 HBR article, ‘it’s not how much you pay, but how’. So our bottom line is this: The goal of pay reform should be to incentivize leaders to create long-run value for society, rather than reduce the level of pay.

115 / 116

Incentives / alignment

This seems to suggest that incentives work – perhaps unsurprisingly, performance targets encourage leaders to hit performance targets. But they don’t encourage them to create value. To paraphrase Steven Kerr, they reward A, but society and long-term-oriented investors want B. The researchers studied what actions CEOs took to hit the targets. They found that leaders that just hit the target undertake significantly less R&D than those who just missed it, suggesting that they reached their goal by cutting R&D. They also have more discretionary accruals, a way of using accounting policies to increase reported earnings. So ‘long-term’ incentive plans actually lead to short-termism as the end of the evaluation period approaches. This highlights a fundamental problem with any target-based approach – non-targeted dimensions get deprioritized. ?

What’s the solution? It’s simplicity – to replace formula-driven bonuses with standard shares that the CEO can’t sell for several years (known as ‘restricted shares’). The value of these shares is automatically sensitive to performance. It depends on the stock price in several years’ time, so there’s no need to lay on complex performance conditions or choose particular measures, weightings or thresholds.

127

Studying over 2,000 firms, we found that the more equity is vesting in a quarter, the more slowly investment grows. … One interpretation is that the CEO inefficiently cuts good projects to inflate short-term earnings. But a second is that she efficiently cuts bad projects. It takes effort to identify wasteful projects and shut them down, and doing so may make the CEO unpopular. When she’s about to sell her shares, she’s willing to take tough decisions. If true, then short-term pressures are motivating, rather than distracting – a bit like how an impending essay deadline forces students to stop procrastinating.

If vesting causes the CEO to get her act together, you’d expect her to improve performance not just by cutting bad investment, but also by cutting other expenses or increasing sales growth. We found no evidence of this, suggesting that the investment declines are myopic, rather than part of an overall efficiency program. Also supporting the myopia interpretation, the leader reduces investment more when she’s more likely to get away with it – for example if she’s closer to retirement and so is less concerned with the reputational damage from scrapping good investments.

129

ratio of CEO pay to average worker pay

We close this chapter by examining a frequently proposed reform to pay which, while well-intentioned, may backfire because it’s based on pie-splitting. This remedy concerns the pay ratio: the ratio of CEO pay to average worker pay. …

In a reward context, fairness is pay that’s proportionate to the leader’s contribution – pay should reward value creation. … The correct benchmark isn’t how much a CEO’s colleagues are being paid, but how much she’s grown the pie.

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Stewardship / hedge funds

As Peter Georgescu argued in the Introduction, ‘Shareholder activists … are more like terrorists who manage through fear and strip the company of its underlying crucial assets…. These concerns are very serious, and if true, should be urgently addressed.

But are they actually true? Let’s look at the evidence. Finance professors Brav and Jiang have spent over a decade studying the effects of hedge fund activism, in a series of papers with various co-authors. This research is particularly striking even though activists hedge funds are only a small part of the investment industry, and thus far from the only focus of this chapter, because they’re viewed as the epitome of a pie-splitting investors. But the evidence shows they often grow the pie. …

As Paul Singer, founder of the activist investor Elliott, argues: ‘The benefits of fixing a broken strategy, getting rid of a bad acquisition, redeploying an underperforming asset, or replacing an ineffective management team or board may show up right away in a company’s stock price, but that immediate result doesn’t diminish the long-term benefits.’

143/144

Activist interventions / R&D

What happens to investment (after an activist intervention)? Inconsistent with concerns of short-termism, IT spending increases, which might be a reason for the productivity gains. But even more important for society is innovation because of its spillover effects. Alon, Wi, Song ma and Xuan Tian found that, when a firm is targeted by a hedge fund, R&D falls by an average of 20% compared to non-targeted firms. This appears to be a smoking gun ….

Yet here again there’s a twist. Even though R&D expenditure falls, firms file 15% more patents, and each patent that it does file generates 155 more citations (a measure of patent quality). The firm produces more output for less input. ..

This is an important point. Commentators often use the level of investment to measure short-termism. But investment only measures how much you spend (the input), not what you do with what you spend (the output). …

145

We need more hedge funds

But CEOs and their advisors often view hedge funds as enemies who attack the firm. Lawyer Mary Lipton, a prominent opponent of hedge funds, wrote a blueprint on how to deal with them, which uses the word ‘attack’ and its variants twenty times. Yet engagement improves long-run stock returns, profitability, productivity and innovation – exactly what leaders (and society) want to happen.

147

Stewardship: Portfolio concentration / financial incentives / substantial resources

So, just as socially responsible investing doesn’t always pay off … engagement doesn’t always pay off. The reasons are similar. SRI can be implemented in a box-ticking fashion – for example, choosing stocks based on pay ratios without considering pay horizons. Similarly, engagement can also be implemented through box-ticking – pushing for quick wins on ratios rather than deeper issues such as horizons. What matters is engagement quality, rather than simply engagement activity.

What matters is engagement quality, rather than simply engagement activity.

What strengthens engagement?

There are three reasons why activist hedge funds are particularly effective. ..

1.??????Portfolio concentration

2.??????Financial incentives

3.??????Substantial resources

The silver lining is that none of these three features is unique to hedge funds. Other investors can adopt the same practices – and many of the best do. … Investors should pay their fund managers according to long-term performance and devote significant resources to engagement. Active funds should hold concentrated stakes rather than hugging the index. There’s nothing special about hedge funds; they’re just one example of a concentrated, incentivized and resourced investor.

152

Protection mechanisms / investor rights / short termism

Companies with the fewest protection mechanisms and thus the strongest investor rights beat those with the opposite by 8.5% per year. They also had greater sales growth, suggesting they fulfill customers’ needs, and higher profitability. …

Dual-class shares are associated with higher CEO pay, worse acquisitions and poorer investment decisions – suggesting that they entrench management and allow them to empire-build.

These findings are important and go against current thinking. There are many calls to restrict investor rights, based on the claim that shareholders extract value from stakeholders or interfere with the CEO’s vision, particularly if she founded the enterprise, by pushing for short-term profit. This narrative is popular given the differing public perceptions of entrepreneurs and investors. Entrepreneurs create ideas; investors make money on the back of someone else’s idea.

154 / 155

Investor rights / regulation

So the optimal design of investor rights isn’t one-size-fits-all, which explains the variety across firms and countries that we see. It may also vary over time for a particular firm, with defenses preserving stakeholder relationships for a newly public enterprise, but leading to entrenchment when it matures. The challenge for regulators is to ensure that protections from investors, which might be justified in certain circumstances, aren’t abused by underperforming leaders to entrench themselves at society’s expense.

Monitoring

Engagement is a form of stewardship. The Merriam Dictionary definition of stewardship is ‘the careful and responsible management of something entrusted to one’s care’. An investor is entrusted with a savers’ money. Managing this money responsibly typically involves improving the long-term performance of the firms he invests in. We’ll thus move from a stewardship definition that looks backwards at savers to one that looks forward at companies,… Stewardship is an approach to investment that improves the value an enterprise creates for society. It seeks to grow the pie and enhance a company’s performance, rather than taking the pie as given and profiting from finding undervalued pies.

Stewardship is an approach to investment that improves the value an enterprise creates for society.

157 / 158 / 159

That’s why monitoring is crucial. By taking the time to ask questions first – understand whether low earnings are due to mismanagement or investment – investors shield a leader from short-term pressures. …

The above discussion (incl. about Unilever shareholders with the Kraft acquisition bid) might suggest that the ideal investor is one who holds his shares for the long term and never sells. Such investors are known as ‘patient capital’ – loaded language, as patience is seen as a virtue, and so policies aim to encourage it. …

But patience isn’t always desirable. The praise of patient investors is fundamentally flawed because it confuses the holding period of an investor with his orientation. The former is how long an investor holds shares before he sells. The latter is the basis – long-term value or short-term profits – that triggers an investor to sell.?… An active investor who holds onto his shares for the long term, regardless of how the enterprise is performing …. Shouldn’t be called a patient investor. He’s an irresponsible investor who’s failing to monitor the firm. Similarly, an investor shouldn’t automatically ‘hold your stock when you hit your quarterly earnings target’. It should investigate how the company hit the target, and take action if it did so by scrapping good investments.

160/161

Divesting / long termism / policymakers

Selling shares might thus not be an act of short-termism, but an act of discipline. Economists call this ‘governance through exit’ (while they label engagement ‘government through voice’). For exit to be effective, what matters is the information it’s based on, which is what we mean by the investor’s orientation. If he sells based on short-term earnings, this is indeed damaging, because the leader then prioritizes short-term earnings. But if he sells based on long-term value, the CEO knows she’ll be held to account for long-term value. …

So the crucial question isn’t whether investors hold for the long term, but whether they trade on long-term information. How can we ensure the latter? Through the same way as we promote engagement: investors taking large stakes. …. While stake size encourages monitoring, loyalty dividends and taxes on selling discourage it, by making it expensive for the investor to divest if he learns something negative.

So the crucial question isn’t whether investors hold for the long term, but whether they trade on long-term information.

Relatedly , we do want investors to be loyal. But unconditional loyalty – staying with the firm, regardless of whether it’s creating long-term value – simply entrenches management…. It’s the combination of loyalty if the firm invests for the future, and exit if it doesn’t, that represents good stewardship. …

Policymakers should promote engagement by all investors, just as enterprises should encourage engagement by all employees. … Similarly requiring investors to wait several years before they have full voting rights will both hinder them from improving a company they already own and deter them from owning it in the first place. And monitoring and engagement aren’t separate stewardship mechanisms, but complimentary ones.

163

Short termism / high turnover

Sterling Yan and Zhe Zhang show that high turn-over investors trade on their own information and are actually better informed than low-turnover investors. While contrary to the common critique of high-turnover (or ‘short-term’) shareholders, these results make sense. High turnover could arise because a shareholder has many insights not captured by the market and is acting on them. …

Sterling Yan and Zhe Zhang show that high turn-over investors trade on their own information and are actually better informed than low-turnover investors.

164

Blockholders / taking stewardship roles seriously

A final strand of research investigates how companies act differently when they have blockholders. They manipulate earnings less and need to restate earnings less often, likely because leaders know that blockholders will see through earnings inflation. They also invest more in R&D and produce more patents. Blockholders deter firms from cutting R&D to meet analyst earnings forecasts, while fragmented investors encourage such behavior. …

First, while advocates of shareholder value claim that investors are unambiguously good, and opponents claim that they’re unambiguously bad, you can’t lump all investors together. … While investors are often seen as the enemy of stakeholders, the evidence suggests that large, long-term oriented investors grow the pie for the benefit of all. Rather than heralding patient investors, who may just passively hold shares, society should promote investors who take their stewardship roles seriously. By doing so, they help build the great enterprises of the future.

168

Repurchases

I’ll acknowledge that buybacks can indeed be a pie-splitting device that fails to create or actively destroys value. And I’ll argue that pie-growing enterprises should engage in far fewer buybacks than those that practice ESV. But I’ll also stress that, properly executed, buybacks can grow the pie.

Of course the critical words are ‘properly executed’ and ‘can’. So we’ll use large-scale evidence to show that, in most – but not all – cases, buybacks do create value.

178

This observation addresses a concern beyond buybacks – that the financial industry creates little value for society. … But looking at net financing flows is incorrect. The stock market’s role is to allocate scarce funds to companies where they’ll benefit society the most. This involves firms with poorer opportunities paying out their excess cash, allowing those with better opportunities to invest more.

The stock market’s role is to allocate scarce funds to companies where they’ll benefit society the most.

Enterprises

189 / 190 / 191

The success of M-Pesa highlights the main way in which enterprises can grow the pie – excellence. Companies can create even more value by having an uncompromising commitment to excellence in their core business than by pursuing ancillary activities with an explicitly social mission. The biggest way that Vodafone serves society isn’t through reducing its carbon footprint, even though doing so is still important, but by being excellent in delivering its existing mobile services and constantly innovating new ones.?

Recognizing the importance of excellence is critical for many reasons. First, it stresses that ‘serving’ society goes far beyond making financial sacrifices, such as Merck giving ivermectin away for free or Apple building the gym without a calculation. … But, often, excellence is the best form of service. … While many companies undertake significant philanthropic efforts, their most important contributions to society are often through excellence in their core activities. …

This observation highlights the difference between Pieconomics and CSR which we introduced in Chapter 1. Pieconomics is about creating value for society through your core business. CSR is sometimes about a non-core CSR department undertaking activities to compensate for a pie-splitting core business. …

Second, not every company has as clear an effect on society as Merck or Turing – but that doesn’t mean it’s any less important. Instead of moving into pharmaceuticals, it should focus on fulfilling its role in the world in an excellent manner. …

While it might seem obvious that an enterprise should strive to be excellent, this goal is sometimes underweighted by firms who (correctly) recognize their need to serve society and (incorrectly) think this means they should focus on explicit ‘serving’ activities. In contrast, one of the biggest ways in which a company can destroy value is to tolerate mediocrity over excellence – an error of omission. …

What does ‘growing the pie’ entail for a particular company’s unique circumstances? It means fulfilling its purpose.

197 / 198

Defining Purpose

But the trade-offs companies face are uncomfortable. A broad purpose statement ignores the reality of trade-offs, but an uncomfortable statement provides guidance in three important dilemmas. The first is whether to take actions that help some stakeholders and hurt others. … The second is where to allocate an enterprise’s limited time and resources. What a company leaves out in its purpose can be as important as what it includes because omission helps guide trade-offs. To paraphrase leadership expert Craig Groeschel, ‘to do things no-one else is doing, you have to not do things everyone else is doing’. …

To paraphrase leadership expert Craig Groeschel, ‘to do things no-one else is doing, you have to not do things everyone else is doing’

The third is which business opportunities to turn down. …

We saw in Part I how pie-growing firms make decisions with judgment rather than calculation. The clearer the purpose, the easier it is to judge whether an action furthers it – such as whether selling cigarettes helps people on the path to better health. …

While the first guideline highlights that a purpose statement should be focused, the second helps leaders decide this focus. The why should be based on the principle of comparative advantage and the who on the principle of materiality.

200 / 201

The third guideline is that a purpose is both deliberate and emergent. Leaders should set the tone from the top, but also recognize that they don’t have a monopoly in defining the enterprise’s purpose. Purpose may bubble up from colleagues, and a purpose that emerges in this manner may be more likely to be embedded throughout the organization than remaining in the C-suite. When workers have helped shape purpose, they feel ownership of it and are more likely to embed it. This requires viewing employees as a source of ideas rather than just a way to execute them. …

Purpose can also be shaped by input from an enterprise’s key external stakeholders, so that outside perspectives are incorporated. …

Once a purpose has been decided upon, it must go beyond a statement and live in the enterprise. Living purpose means two things – communicating purpose externally and embedding purpose internally.

204 / 205 / 206 / 207

Integrated reporting / quarterly reporting

Arguably, the greatest role of integrated reporting is to spark integrated thinking. … This reduction was sparked by Walkers adopting carbon labelling, which made its carbon footprint visible and motivated Walkers to reduce it. The Economist noted: ‘It’s not so much the label that matters… but the process that must be gone through to create it’. …

The Economist noted: ‘It’s not so much the label that matters… but the process that must be gone through to create it’.

As discussed in chapter 6, 80% of CFOs would cut investment to meet an earnings benchmark. While that’s a survey of what CFOs say they’ll do, two studies of what they actually do confirm that quarterly reporting reduces investment. Yet even though the EU has scrapped the requirement for firms to issue quarterly reports, many still choose to do so. …

Demanding predominantly comparable metrics may backfire for investors, as it makes them ripe for replacement by computers… To prevent them from being replaced by artificial intelligence, investors should ask companies for non-comparable, narrative information that can only be understood within the context of the enterprise’s purpose – an assessment that can only be done by humans. …

investors should ask companies for non-comparable, narrative information that can only be understood within the context of the enterprise’s purpose

FCLT, a global consortium of companies and investors, provides a roadmap of ten topics that such conversations can be centered around, to maximize their effectiveness. … Companies pay consultants high fees for advice on issues such as strategy and capital allocation, but investors and stakeholders are happy to share their ideas and act as a sounding board for free. They’re allies of enterprises in growing the pie, but too often are an untapped resource. Similarly, meeting investors on a routine basis is one of the best ways to pre-empt confrontational shareholder activism. Doing so allows leaders to notice simmering investor concerns and address them before they boil over.

The value of moving from reporting to communication can be substantial. When a company receives an unwanted takeover bid, it typically has to go on the defensive and argue why the bid undervalues the enterprise. But when Kraft bid for Unilever, it was Unilever’s shareholders who led the defense and quickly rebuffed the bid… This is because Unilever had made substantial investment into ensuring that its shares were held by investors that looked beyond short-term measures and wouldn’t be tempted by Kraft’s 18% premium…

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The attitude of empowerment, in contrast, argues that you don’t need close supervision to avoid errors commission. Colleagues are intrinsically motivated to work hard due to their ‘seeking systems’ – a term social psychologist Dan Cable uses to describe their innate desire to explore and create. They also have specialist expertise and ground-level information to come up with the best way of achieving a goal. The challenge for leaders is to activate and channel those seeking systems. Micromanagement and hierarchy suppress them, risking errors of omission by failing to tap into employees’ skills and knowledge.

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The attitude of reward…

Just like investment, rewarding employees doesn’t just involve money. Due to their seeking systems, colleagues are also motivated by the desire to contribute. The attitude of reward thus involves sharing the intrinsic as well as financial benefits of pie growth by giving them task ownership ?- responsibility for a task, sometimes unconditionally. One benefit of task ownership is empowerment, as discussed earlier. But another is the fulfilment the colleague enjoys when he completes the task. Sometimes a senior might wish to rewrite part of a document that a junior has written. The changes might lead to a genuine improvement, but a minor one. The small cost of sticking with the original is outweighed by the reward the employee enjoys from having had full responsibility for the final product.

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Turning stewardship from a policy into a practice

Before we start, I’ll stress two points. The first is the urgency of improving stewardship. Just as purpose isn’t an optional extra for companies to confine to a CSR department, stewardship isn’t an optional extra for investors to confine to a stewardship department. Most obviously, stewardship typically serves savers – investors’ clients – by improving long-term returns and achieving their non-financial goals. More broadly, stewardship is important for the legitimacy of the investment management industry. Society views investors as having stewardship responsibilities and has blamed corporate collapses, such as the 2007 financial crisis, on investors failing in these responsibilities. Regulators look to investors to implement public policy objectives, by pushing companies to increase diversity or take action on climate change. …

stewardship isn’t an optional extra for investors to confine to a stewardship department

Given the importance of stewardship for society, several countries have introduced Stewardship Codes. While a good first step, there are widespread concerns that codes encourage statements of policy rather than actual practice. If investors don’t improve stewardship by themselves, they may be faced with tougher codes or regulation. Arguments to decrease investor rights … are based on the concern that investors aren’t using these rights responsibly.

Stewardship codes often assume a one-size-fits-all approach, for example that engagement is always more effective than monitoring and that more stewardship is always better than less. But this ignores the principle of comparative advantage. A fund may choose not to engage in stewardship. If stewardship isn’t its expertise, the best way it serves society might be to provide savers with low-cost access to equity markets, so that they can share the fruits of economic growth. A clear definition of stewardship is therefore important. What matters isn’t so much that a fund engages in extensive stewardship, but that it does what it says it will. This should avoid the problem of ‘closet indexers’ … who charge high fees for active management without actually practicing it.

The starting point for stewardship is a fund’s purpose. This purpose should explain how it aspires to serve savers and society. Its stewardship policy then follows, by outlining how it aims to use stewardship to achieve its purpose. The policy should cover not only engagement, but also monitoring – in particular, investors should have a policy for what will cause them to sell. This helps ensure that selling isn’t a knee-jerk reaction to short-term earnings, and recognizes that selling can be an effective stewardship mechanism.

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Hedge fund features: portfolio concentration, financial incentives, resources

Recall that chapter 6 highlighted three features of hedge funds that make them particularly effective at engagement – their portfolio concentration, financial incentives and resources. These same features also enhance monitoring. We stressed that these dimensions aren’t unique to hedge funds, so the first step to embedding stewardship is to adopt these features. Starting with portfolio concentration, an investor that claims to be active should truly be active, holding only a small number of companies. Its default position should be not to own a stock, rather than to own it because it’s part of the benchmark. Then, every company is a conviction holding, whose long-term story the investor either believes in or believes that it can turn around.

Some investors argue that a concentrated portfolio exposes their clients to too much risk. But if a client has chosen an active fund, it believes in the manager’s stock selection ability and is paying for him to use it. A client that wants more diversification than what the active fund provides can simply allocate more of its portfolio to index funds. Instead, these arguments are often out of self-interest – a fund manager doesn’t want to risk underperformance, as it may lead to client withdrawals or him being replaced.

The second feature is incentives. Just as chapter 5 stressed that leaders should be paid like owners, the same is true for fund managers. Khorana, Servaes and Wedge show that when a manager owns 1% more of his fund, risk-adjusted performance rises by 3%. …

The third characteristic is the resources an investor dedicates to stewardship. One resource is the stewardship team. This is a specialist department that doesn’t manage money, but focuses on engagement and monitoring. What’s important isn’t just the size of his team, but also its prominence. ….

Stewardship resources aren’t just confined to the stewardship department. Just like the integrated thinking ?we stressed for purpose in chapter 8, stewardship should be integrated into an asset management’s investment process. Fund managers should (and sometimes do) have explicit responsibility for stewardship and be evaluated for it, and lead voting decisions and engagement jointly with stewardship departments. One asset manager requires all graduate hires to rotate through the stewardship department so that, when they become fund managers, they’re able to direct stewardship efforts. However, there remains significant room for improvement in integration. …

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Effective monitoring / long termism

Critics of the stock market accuse it of focusing excessively on short-term financial performance. But simply observing the astronomical valuations of tech companies, such as Facebook and Amazon, suggests that reality is more nuanced than this caricature. Their prices are several orders of magnitude higher than their current earnings, so the market must be incorporating some long-term factors.

Monitoring can only improve investor returns if it’s based on long-term factors that aren’t incorporated by the market. Then, when the investor trades on this information, he’ll put it into the stock price and cause it to more closely reflect long-term value – a form of stewardship. There’s evidence that intangible assets that directly generate profits, such as a strong brand, are incorporated in the stock price.

However, chapter 4 showed that intangible assets that directly generate social value, such as employee satisfaction, are only partially valued. Effective monitoring thus requires investors to?- evaluate stocks according to how much social value they create, not how much profit – including whether companies are delivering on their stated purpose.

Intangible assets that directly generate social value, such as employee satisfaction, are only partially valued.

This requires a shift in thinking. ESG metrics should be taken seriously by all investors, even those whose only goal is financial performance. While ‘socially responsible investors’ use ESG metrics to pursue (and potentially trade-off) both social and financial returns, ‘responsible investors’ may employ such information even if they have purely financial objectives, based on the evidence of chapter 4. Indeed, even quant funds (which use statistics to maximize purely financial returns) are starting to take stakeholder capital into account. …

ESG metrics should be taken seriously by all investors, even those whose only goal is financial performance.

Most investors haven’t heard of these (ESG) measures, even though they’re rigorous and objective. So they’re unlikely to be priced by the stock market, and thus investors can gain a competitive advantage by using them. …

But monitoring must go even beyond ESG metrics. As discussed in chapter 4, some investors use them in a box-ticking manner, and screen out a company if it doesn’t tick a particular box, regardless of its other qualities. But underperformance in one dimension doesn’t reduce returns if the dimension is immaterial, and it may be outweighed by strong performance elsewhere. Traditional ESG measures don’t capture excellence, which chapter 8 argued is the main way a company grows the pie.

Blueprint for Better Business questions

Blueprint for Better Business recommends the following eight questions to help investors identify whether a company is purpose-led.

1.??????In simple terms, what is the company in business to deliver and for whom? How does that differentiate you?

2.??????What does success look like and how do you measure and review it?

3.??????How does your pay policy link to long-term success?

4.??????How are your board discussions and agenda anchored to your purpose? Can you give some examples of how your purpose has changed your decisions?

5.??????What positive and negative impacts does your company have on society? How are you maintaining your ‘license to operate’?

6.??????How are your people? Can you give examples of how you have responded to specific concerns?

7.??????Which external relationships are most important to achieving your purpose (e.g. customer, supplier, regulatory)? What key measures do you use to assess the strength of these?

8.??????[For chairs] How do you as a board know you are doing a good job?

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If responsible investing could be implemented simply by box-ticking, any investor could do it. Indeed, a computer would be most effective, removing the need for human fund managers. Similarly, there’s no clear answer to whether a stock will be a winner based on traditional factors such as strategy and management quality – which is why conventional investors use them, hoping their assessment is more accurate than the market’s.

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Engagement / voting

And engagement is far more than just voting. If an investor has voted against management, it should tell the company why, so that it can address the shortcomings. Even if the investor has voted in favor, it may not agree with every aspect of a proposal and can voice its concerns. More effective than engaging after a vote is to do so beforehand. Rather than voting against, an investor can discuss its concerns privately with management, so that it ends up making proposals that the investor is willing to support.

Engagement is far more than just voting.

Just as some companies only reach out to investors in an emergency, some investors only engage when a company is in severe difficulties. But prevention is better than cure. This involves meeting with management on a regular basis even if there are no fires to be fought, and providing positive as well as negative feedback – else a company may make changes without knowing that investors support the status quo. But while engagement should be routine, investors must be careful not to micro-manage the enterprise. Leaders have far more expertise and information about day-to-day operational decisions. Instead, investors’ main value-add is on long-term issues such as strategy, intangible investment and purpose – issues for which an outside perspective is particularly useful. For example, if a CEO has proposed a major investment, shareholders can evaluate whether the principles of multiplication, comparative advantage and materiality are satisfied. Similarly, while a company may be in certain businesses by historical default, investors can challenge management on whether it still has a comparative advantage in each one. … Selling non-core plants or patents creates value not only for the vendor, but also for society, as they’re more productive under new ownership.

In addition to frequency, the theme of engagement is also important. Policymakers or citizens may pressure investors to engage on pie-splitting issues such as excellence and purpose. How is the enterprise ensuring continued excellence? How is it investing in innovation and its workforce, and responding to long-term challenges from technology and climate change? What is the enterprise’s purpose and what has it deliberately omitted from its purpose? …

FCLT has provided a list of questions, informed by stewardship codes and external experts, that investors can ask themselves internally to ensure that they’re undertaking both monitoring and engagement effectively.

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Voting

Equally important is to report outcomes – how much the policy has been put into practice. Let’s start with voting. Most investors report the frequency of votes against management, broken down by theme. But of potentially more interest (and reported by some investors) is how often they vote against proxy advisor recommendations or house policy, to ensure that neither are used mechanically, as well as their voting rationale – just like companies in chapter 8, combining numbers with narratives can be particularly telling. Turning to engagement, an investor could report how many company meetings it held and how often it discussed each theme. Since these numbers may reflect engagement frequency rather than quality, more informative might be case studies of successful engagement.

But of potentially more interest is how often they vote against proxy advisor recommendations or house policy, to ensure that neither are used mechanically, as well as their voting rationale, combining numbers with narratives can be particularly telling.

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… We discussed the survey by Graham, Harvey and Rajgopal which learned that 80% of CFOs would cut investment to avoid missing an earnings benchmark. Benchmarks might be past earnings, yet the survey found that 73.5% of CFOs considered analyst forecast an important benchmark. A separate study by Stephen Terry documented that firms that just meet analyst earnings forecasts have 2.6% lower R&D growth than those that just miss, suggesting that CEOs cut R&D growth than those that just miss, suggesting that CEOs cut R&D to hit the forecast. …

The second step is for analysts to embed their stewardship approach internally. This involves ensuring they have adequate resources to evaluate an enterprise’s stakeholder capital. While equity research departments previously had different teams covering each industry, most now also have a specialist SRI unit. Its main clients are socially responsible investors, but we’ve stressed that societal factors matter to all shareholders. An analyst should have processes to ensure that societal impact enters all reports, not just those by the SRI team. …

Embedding stewardship involves ensuring that asset managers have large stakes, long-term financial incentives and stewardship resources.

-?????????Effective monitoring assess the value an enterprise creates for society – information that’s likely not in the current stock price.

-?????????Effective voting is informed by proxy advisor recommendations and house policy, but also considers an enterprise’s unique circumstances.

-?????????Effective engagement focuses on pie-growing (e.g. purpose and strategy) rather than pie-splitting issues (e.g. the level of pay) and may involve collective engagement with other investors and an escalation mechanism.

-?????????… The most valuable communication may be qualitative – engagement priorities, monitoring themes and case studies of successful engagements or divestments.

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The Pie-Growing Mentality

The pie-growing mentality stresses the importance of errors of omission. But regulation is most effective in punishing errors of commission – it’s very difficult to fine an enterprise for not creating value. Not only does regulation fail to reduce errors of omission, but it may make them more likely. By trying not to commit an error, a company may omit to innovate. …

Evidence over Anecdote / regulation

Evidence can guide regulation in two ways. First, it can diagnose the extent of a problem and whether it indeed requires a solution to begin with. Regulation can sometimes be a knee-jerk reaction to a few bad apples, even if the rest of the apple cart is fresh. …

It might seem that these unintended consequences resulted from this particular regulation being poorly designed. But the lessons are general. There are two major problems with regulation. First, it almost always has unintended consequences. Since it focuses on tangible metrics, it’s often prone to manipulation; since it usually sets a limit, it encourages companies to go right up to that limit. These outcomes are like the side effects of medical intervention. In medicine, diagnosis precedes treatment. A patient should only be subjected to invasive surgery, with all its side effects, if his condition is severe. Second, regulation is wide-ranging. Thus we should only impose regulation, with all its side effects, if the problem is widespread across a large number of companies.

There are two major problems with regulation. First, it almost always has unintended consequences. Second, regulation is wide-ranging.

A second role for evidence is to guide the treatment of a problem, as potential solutions may have been tried in other countries. Proposing extreme reforms often gets you lauded as a revolutionary, but is very risky in the absence of evidence that they work. Indeed, research may uncover counterintuitive results that go against what hunches might suggest. …

But the focus on tangible metrics runs two major risks. The first is quantity over quality. Since quantity is tangible, but quality isn’t, regulation may improve the former, but worsen the latter. In the US, a 2003 law made it a mutual fund’s fiduciary duty to vote – but many ended up following proxy advisor recommendations rather than doing their own research. Uninformed votes are arguably worse than not voting at all.

The second is compliance over commitment. Regulation may lead to enterprises complying with the tangible metrics highlighted in the policy, rather than committing to its spirit.

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Externalities

Pie-growing firms take externalities into account. But many investors and enterprises – even enlightened ones that pursue ESV – don’t practice Pieconomics, and thus sometimes ignore externalities. Regulation can address this.

The simplest – and often most effective – solution is to prohibit practices whose negative externalities outweigh any benefit, and mandate those whose positive externalities outweigh any cost. …

Instead, a solution is to assign property rights to goods affected by externalities, so that companies take these externalities into account and weigh them up against the benefits. (e.g. carbon emission trading rights)

Regulators can also cause companies to internalize negative externalities by taxing actions that create them. … Alternatively, they can subsidize activities that generate positive externalities. …

Firms are rarely able to create Pareto improvements by themselves. … Governments have a major role to play in creating Pareto improvements by redistributing the gains and losses from pie-growing activity. One force that grows the pie, but – without remedial action – shrinks individual slices, is technology.

Governments have a major role to play in creating Pareto improvements by redistributing the gains and losses from pie-growing activity.

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Failure / blackbox thinking

Not only is a willingness to fail valuable ex ante, but the failures themselves are valuable ex post as they allow us to learn. … Author Matthew Syed names this mindset ‘Black Box Thinking’, after the black boxes in aeroplanes that record the plane’s movements and cockpit conversations. …

Black box thinking is painful. Rather than taking ownership of failure and holding yourself accountable, it’s tempting to blame it on external circumstances – a behavior known as self-attribution bias. …

Part of the reluctance to admit mistakes and learn from them is due to the way society views failure. We often play a game of ‘gotcha’ – catch others doing wrong – and call out mistakes. As Syed argues, ‘We should praise each other for trying, for experimenting…. If we only ever praise each other for getting things right, for perfection, for flawlessness, we will insinuate, if only unintentionally, that it is possible to succeed without failing, to climb without falling.’

We should praise each other for trying, for experimenting… If we only ever praise each other for getting things right, for perfection, for flawlessness, we will insinuate, if only unintentionally, that it is possible to succeed without failing, to climb without falling.’

Deliberate practice

What matters isn’t just hours spent performing the activity, but what researchers call ‘deliberate practice’, which they define as an activity ‘rated very high on relevance for performance, high on effort, and comparatively low on inherent enjoyment’. Deliberate practice is uncomfortable as it involves going through difficult tasks where you’re like to fail, and then reviewing your missteps.

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Ensure that the enterprise serves society not only through ancillary ‘CSR’ activities, but primarily through excellence in its core business. Allocate headcount, financial resources and your time to the businesses where your company has the greatest comparative advantage and affects its most material stakeholders.

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Action items for stewardship

Define your purpose – how you aim to generate long-term returns to savers – and your approach to stewardship. Recognize that more stewardship is not necessarily better; instead, ensure that your approach to stewardship is aligned with your purpose and comparative advantage.

For engagement, clarify your key engagement priorities and how you intend to pursue them – for example, through voting, private meetings or public activism.

For monitoring, highlight the dimensions of performance that you will particularly scrutinize. Formulate a divestment policy for what will cause you to sell a holding. …

Devote substantial resources to stewardship and integrate them into the investment process. Ensure that voting and engagements are jointly led by the stewardship team and fund managers rather than outsourced to the former.

Devote substantial resources to stewardship and integrate them into the investment process.

Communicate the Delivery of Stewardship

Select metrics that are relevant to your stewardship policy (e.g. voting record, including frequency of votes against house policy and proxy advisor recommendations) and report them. Consciously choose not to report certain metrics if they may be misleading, and explain why you are not doing so.

Undertake narrative reporting – for example, how you are ensuring that stewardship is integrated into the investment process and how fund managers are incentivized. Provide case studies of engagement or divestment.

Undertake narrative reporting

Practice Informed Voting

Consider formulating a house voting policy, informed by a stakeholder roundtable or advisory committee, and publish it. Anticipate the situations in which the house policy may not be applicable, and ensure that the policy is not automatically followed in those circumstances.

Engage Routinely with Executives and Directors

Involve other investors in engagements, viewing them as partners rather than a benchmark to be beaten. Consider joining a collective engagement organization, if available. Participate in industry-wide engagements – for example, to encourage all companies in a sector to report certain metrics.

Engage in Diagnosis before Treatment