February 2021.

As we enter 2021, which feels more like 2020 Part II [1], we might wish we could have begun the year with renewed confidence. However, few would object that the path ahead looks challenging. The new viral strain of COVID-19 is likely to entrench already excessive levels of inequality in many countries, causing further dispersion of economic performance around the world. Growing rates of bankruptcies, mortgage foreclosures and the development of short-term problems into structural constraints across the global economy could extend the recovery over many years [2]. Maybe central banks can continue shielding financial markets from economic and corporate shocks, but what if this level of intervention only widens the chasm between Wall Street and Main Street? How could we restore social and economic stability on a sustainable basis and prepare for the future? We believe a solution to some, if not all of these issues, lies in a reassessment of the purpose of both corporates and investors alike: a purpose that looks at the long term, restores social mutuality and aims to benefit a broader range of stakeholders.

Finding opportunity in a crisis

While 2020 was a year of crisis, we can still draw some positive outcomes of the COVID upheaval. We learnt how swiftly we can transition entire businesses to operating digitally (only a few years ago businesses would have planned for multi-year transitions [3]); we learnt how to remain connected to colleagues and how to creatively engage online (I have looked forward to our team’s Friday catch ups). And we also learnt the importance of looking after our physical and mental health [4].

Interestingly, for some responsible investors corporate management of COVID has fallen under the governance pillar (and not the social pillar of ESG assessments). Why has management of the pandemic formed part of a company’s core corporate resiliency? Because the strategic ability of companies to tackle complex challenges sits with Boards and top management: where corporate purpose originates, evolves and can later contribute to stakeholder capitalism.

What is stakeholder capitalism?

During COVID-19, governments and central banks have routinely drawn on leading economist Milton Friedman’s work. Friedman was a 1970 Nobel Laureate who also argued that “the sole purpose of the company is to generate profits for its shareholders” provided the business “stays within the rules of the game”. Friedman argued “that the social responsibility of business is to increase profits because doing so gives individuals—investors, employees, and customers—maximum flexibility to choose which social responsibilities they wish to fulfill”. A misunderstanding of Friedman by many has resulted in an exceeding focus on shareholder primacy and a narrow definition of fiduciary responsibilities. But don’t companies have a social responsibility to contribute to the society in which they exist?

When we consider the purpose of a corporation, whether its core aim is to exclusively generate returns for shareholders, or why it should account for other stakeholders at all, the question is not really whether there is a tension between shareholder supremacy and stakeholder considerations, but rather whether a business is run for the short or long term? Considering the current pace of technological disruption and market volatility, will the current business strategy and operations be viable in 5, 10 or 20 years? Is a business resilient to sudden or chronic shocks? In short, will it be able to generate sustainable profits? Shareholders should care about these matters. Portfolio manager Barnaby Wiener [6] puts it plainly:

“ …a good durable company needs to manage itself in the interest of all stakeholders, because if it doesn’t, you can’t do it without one of these stakeholders. If you’ve got no customers, ultimately you have no business, if you can’t persuade people to come and work for you, you’ve got not business, if you squeeze your suppliers to death, you’ve got no business, if you alienate the communities you operate in, you have no business, if you alienate the regulators in which the company operates, if they say “we do not like the way you are behaving”, that’s ultimately going to jeopardise the future of the business. As a long term shareholder you are insane not to be worrying about other stakeholders: it is in your interest that the company is operating in the right way”.

Shareholder value is a long term concept, representing the present value of all future cash flows that a company generates. It turns out ‘right is good’ for shareholders and the root problem sits with short-termism: short-term stock price maximisation, short term profit maximisation, quarterly earnings guidance and reporting. In a 2005 study [7], it was found that 80% of CFOs would scrap value-creating long term projects to meet an earnings benchmark. What are value-creating projects? Projects that would ensure the very continuity of a business and, on the basis of commercial transactions’ reliance upon a broader network of social relations [8], a diversity of stakeholders.

“A company that cuts value-creating investments in stakeholders is maximizing short-term profits but harming shareholder value. Thus, the solution to short-termism is actually a greater focus on shareholder value, no less” Prof. Alex Edmans (London Business School).

At U Ethical, we believe that it is the responsibility of companies to consider the needs of a broader set of stakeholders, rather than purely focus on short term benefits for shareholders. As part of our investment process we actively seek out and actively engage with organisations that demonstrate adherence to stakeholder capitalism and believe that this will deliver long term value for investors.

[1] Gaia Ines Fasso, CAST Board Trustee
[2] https://www.afr.com/policy/eco...
[3] Jacki Johnson, Co-Chair of Australian Sustainable Finance Initiative
[4] We cannot omit the astonishing ability we demonstrated to adopt scientific evidence and deliver a vaccine beyond unexpected timelines
[6] Head of sustainability and stewardship at MFS, in Market Narratives podcast, 30th Nov 2020
[7] Graham, Harvey and Rjgopal (2005) as quoted in Alex Edmans “Response to the European Commission Study on Sustainable Corporate Governance”, November 2020
[8] David Rouch (2020). “The Social License for Financial Markets”