21 Dec 2010

Sustainability : entrepreneurs and shareholders should reconsider the very reasons they start and run a business if they want to survive

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In June 2010, Joseph F. Keefe, President and CEO of Pax World Management, a leading US investment company specialised on sustainable investing exposed with much brightness the lessons of the financial crisis and what will help the entire business community to get out of it with success.


Ready to change ?

“It seems clear to me, first of all, that over the next few decades, market capitalism will need to undergo a Sustainability Revolution equal in significance to the Industrial Revolution that ushered in the modern period. In order for this to happen, corporate behavior, market behavior and investor behavior will need to change. In each case, they will need to become more sustainable—which means, among other things, to behave in a way that focuses more on the long term”.

As a reminder of what has happened in the near past : “To be fair, prior to the crisis financial professionals were only relying on generally-accepted models of how markets and prices are supposed to behave.

The efficient market hypothesis told us that prices are always right because they reflect all known information; the capital asset pricing model told us that we could diversify away company risk and achieve optimal systematic risk; and the Black-Scholes formula told us that we could then virtually eliminate systematic risk through options or portfolio insurance – shorting the market as it falls, thereby escaping loss.
Why wouldn’t we be irrationally exuberant when the leading financial theories were telling us we couldn’t lose? Why would one expect anything but excessive leverage and risk taking ?”.

Really nothing new in the request to renovate the market capitalism, nevertheless no sign of change has been appearing on the horizon since then.

An economy harnessed to and dependent upon speculative bubbles is one where short-term investors have triumphed over long-term investors. Corporations – including, in this most recent crisis, our largest financial institutions – are transformed into vehicles whose primary purpose becomes making a small group of insiders enormously rich over extremely short periods of time.
Moreover, the excessive focus on quarterly earnings and the alignment of compensation incentives – stock options, bonuses and other get-rich-quick schemes – with short-term outcomes, places the interests of management insiders at odds with those of ordinary shareholders, and in particular retirement investors, who by their nature are long-term investors whose nest eggs truly shouldn’t be exposed to so much risk.
When the short-term interests of corporate managers conflict with the long-term interests of corporate shareholders, the idea of the publicly traded corporation itself becomes to some extent delegitimized”.

Agency and externalities : 2 critical points to overcome

Very original view, that of saying the largest companies are tending to become financial instruments as a result of a double effect : on one side, a misuse of the agency theory. This theory explains the relationship between principals, such as a shareholders and agents, such as a company’s executives. The theory argues that under conditions of incomplete information and uncertainty, which characterize most business settings, two agency problems arise: adverse selection and moral hazard. Adverse selection is the condition under which the principal cannot ascertain if the agent accurately represents his ability to do the work for which he is being paid. Moral hazard is the condition under which the principal cannot be sure if the agent has put forth maximal effort (Eisenhardt, 1989).

On the other side, an insufficient shareholders engagement resulting in a deficient control on the company’s operations.

In under-regulated markets where investors are deprived of information and influence, and where boards of directors fail to do their jobs in representing shareholders and overseeing managers, business corporations have a natural tendency to focus on short-term profit and share price, and take on undue risk, to the detriment of long-term investors and the broader economy”.

Agency theory is rarely, if ever, of direct relevance to portfolio investment decisions. But it should be, in order to invest with a positive impact ! As Joseph F. Keefe explains : “Investors could impact markets by buying the securities of more sustainable companies and selling the securities of less sustainable companies – buying the leaders and shorting the laggards. This in turn would further incentivize companies to improve their ESG [Environmental, Social and Governance criteria] or sustainability performance”.

Investor’s empowerment and engagement

Let’s summarise here the concept of sustainable investment : “Sustainable Investing, unlike other investment approaches, attempts to address two of the fundamental reasons that corporations and markets fail to produce better outcomes: the problem of agency and the problem of externalities.

The problem of agency is essentially the separation of ownership and control at the heart of the modern corporation, and increasingly at the heart of most financial institutions, where agents or fiduciaries invest and control other people’s money.
The problem of externalities is that market transactions often impose costs on others not party to the transaction, and I can think of no bigger externality than climate change, but all of the developing ecological imbalances [that] can be understood as the externalities of commerce”.

As a logical consequence : “To invest in more sustainable companies, to invest in companies with superior ESG performance, is to invest in companies that are better addressing the issues of agency and externalities”.

Joseph F. Keefe closed majestically his pregnant thought while highlighting the imperious need to turn a page in the history of the economic development :
Sustainable Investing must become the investment arm of the Sustainability Revolution just as classical conservative investing was the investment arm of the Industrial Period. While classical conservative investing – think Milton Friedman’s famous dictum that the only duty of a corporation is to make a profit – largely ignored questions of agency and externalities, Sustainable Investing posits a role for investors in addressing them”.

As a conclusion, if you run a company just for profit you will fail. Successful companies are or will be these which have a vision and share it with their investors and stakeholders.

From an inside view to an outside one – that’s the challenge of sustainability.

Dear investors … you can not say, you have not been warned : “So, go out and vote, support the non-profits of your choice, serve in your local community, eat organic food, drive a hybrid, do all the other things you think will make a difference, but for God’s sake, don’t ignore your power as investors”.

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