ESG – A Defense, A Critique, And A Way Forward (part 3 now): Evidence-Driven Pragmatic Perspective

In part 3, I focus on questions one can ask CEOs and boards centered around corporate purpose, is myopia a real problem, how does the shareholder model need to be modified, why we set the cost of natural capital to zero and how to account for the externalities, negative and positive, that businesses add.

Parts 1 and 2 of this series looked at the evidence against claims made by folks who label ESG as “woke” capitalism and by the pro-ESG advocates. In part 3 below I outline an agenda of inquiry/questioning that investors might want to pursue with the CEOs and boards of companies that they hold ownership stakes in.

3.0 Is there a constructive path forward?

To be clear, I am, what my friend and co-author, Bob Eccles, calls an ESG pragmatist. I accept climate change is an existential threat but am not convinced that abandoning the shareholder model is necessarily the way forward. I am also happy to admit that a few things with the shareholder model are broken. In that spirit, it would be useful to put the following questions to boards, CEOs and influential investors. These questions are inspired by my own research, work by Judy Samuelson of the Aspen Institute and my conversations with Bob Eccles.

Corporate purpose

· What markers should we look for to separate the companies that pay lip service to corporate purpose relative to small minority that appear to effectively employ purpose for value add?

License to operate

· Why do we grant corporations the license to operate? Can this license be measured and valued?

· Can we identify firms that do not have a real understanding of the public license to operate and/or fail to build protocols for driving that purpose?

The role of markets

· How does one reconcile the actions of those who think markets can fix everything and that the government’s role should be limited with concurrent actions by the same players to limit the ability of the market to act by opposing disclosures for political reasons that would give investors the information they want to make the markets work?

Is the shareholder model broken?

· If you believe that profit maximization and short-term thinking contribute to the most pressing problems of the day, what, if anything, is the way forward? Why is the shareholder model popular then worldwide?

· How should CEO deal with the following tradeoff if we don’t follow shareholder value maximization?

For instance, an auto manufacturer proposes to close a plant producing gas-based cars in Detroit in favor of producing electric cars in the poorer southern state of the U.S. Should the CEO close the plant and hurt workers and community in Detroit? If the CEO does not close the plant, she hurts the environment and workers and community in the South. What should the CEO do?

· Without shareholder value tenet, can the CEO claim to do anything and still assert she added value?

· If a firm does not compete in the product market, will it get competed away to a firm that values shareholder capitalism? Consider Whole Foods, an employee centric company. Even in its heyday, Whole Foods’s employee productivity (defined as revenue divided by number of employees or an estimate of employee costs) was arguably worse than that of Kroeger, a unionized shop, in the last years when Whole Foods was an independent company. Whole Foods has been sold to Amazon whereas Kroeger is still standing as a stand-alone company. Was Whole Foods too employee friendly? How high is high for say worker wage if we don’t follow the market clearing wage? $15 an hour, $50, $100, $1000? How would we know?

• Could we argue that auto companies in the 1960s and 1970s prioritized workers unions and employees as partners/stakeholders? Ultimately, these companies fell behind Japanese competition and did not invest enough to retain market share.

· Is the dichotomy between stakeholders’ and shareholder interests potentially artificial? Do good companies take care of stakeholders anyway? Is Unilever’s success a case study of the power of shareholder or stakeholder capitalism?

· I agree that the current system is associated with a series of evils: marketing unhealthy products, tax avoidance, obesity, infatuation with guns, food waste, de-forestation and pervasive inequality. These constitute a classic list of externalities. How does one get the company or the consumer or anyone to internalize these externalities, given the constraints of the existing system? Of course, some of these issues such as guns have higher political valence than others such as obesity and makes resolution of such externalities even harder.

· Who monitors the supposed monitor (the big three institutional investors)?

The myopia problem?

· Mark Roe has an extensive critique arguing that we do not have a myopia problem. Virtually every CEO and investor I have chatted with disagrees with Roe’s assessment. Which version of the world is true? Perhaps both versions. Here is how I think about his critique: Roe is interested in finding an “average” effect for the whole economy. Could short-termism and long-termism co-exist in different pockets of the economy? For instance, the entire literature on earnings management in accounting is concerned with documenting short termism designed to make professional managers look good in the short run and postpone the day of reckoning by one more quarter or a year. At the same time, stock markets are willing to patiently wait for profits on money losing IPOs for years, perhaps for far too long.

o In one of my research projects with co-authors, Sanjeev Bhojraj and Ashish Ochani, we conducted the following thought experiment. Assume that an investor buys the entire company at the IPO price at the time the firm goes public. How long does it take for that investor to recover that capital in terms of future earnings or cash flows? It turns out that the answers are depressing. Of roughly 100 companies that go public, 20% survive after six or so years. Of the remaining 80%, half go bankrupt and hence repay nothing. The other half get bought by someone else who pays a 20-25% control premium over the prevailing stock price. This segment makes a lot of money for the IPO investor. Of the 20% that do survive, around 45% have not made enough by way of earnings to repay the IPO price. The long and shot of this is that we are perhaps simply exchanging pieces of over-valued paper through markets as no one is around to worry about realizing their investments via payback in terms of future earnings or cash flows.

· Moreover, some of the so-called arbitrageurs of short termism in Mark Roe’s model (VCs and PE firms) can themselves be the perpetrators of myopia. Public oil and gas firms with high emissions are selling their most polluting units to PE firms who effectively take these units underground from a reporting standpoint and earn short term returns. VCs reportedly can be willfully blind to misreporting or even downright fraud in startups such as WeWork and Theranos to flip these units over to the public market.

· A key driver of managerial myopia is shrinking CEO and CFO tenure in the U.S. If your life expectancy at the top is 4-6 years, quarterly earnings suddenly become quite important to your longevity in your job. If you happen to report two or three bad quarters in a row, you are canned by the board.

· Given this controversy, it might be useful to ask CEOs and boards whether they think myopia, both managerial and/or investor, is a first-order concern? If yes, how would they respond to the Roe critique that the law of arbitrage ought to work in that someone else will jump in to capitalize on the inefficiency caused by myopic behavior? What, if any, are the barriers, to such arbitrage from working in their experience?

· If CEOs believe myopia is a concern, can we design companies to be less vulnerable to the demands of the capital market actors who operate at a remove from the long-term consequences of business decisions? At the same time, how does one hold management accountable for misallocation of shareholder capital?

· How should the long term be defined? One business cycle, as opposed to arbitrary calendar time based increments? How to define a business cycle?

· What markers should one look for to identify executives that have a bearing and aligned incentives to take a long-term view?

· How should we address the dysfunction potentially engendered by asset managers on a yearly bonus cycle?

Risk management

· What markers should one look for to identify a corporate culture that is equipped to understand the collision of changing expectations among investors and the shifts in social norms and environmental trends on the horizon and that could rebound to the firm?

· How to address deficiencies of the DCF (discounted cash flow) model that misses the possibility that material risks will blow a hole in the spreadsheet?

o A partial answer is my course on deep fundamental analysis of businesses.

Innovation

· Are there management teams out there that encourage curiosity and compassion and are hence better at innovation and inclusion?

· Can you sustain a customer-first or employee-centric culture if the CEO is being paid first and foremost to align her goals with the shareholders – i.e., to maximize the stock price?

Company’s contribution to systemic change

· How does your company contribute to systemic change, positive or negative?

· Does your government relations teamwork for the health of the commons? What issues is your company lobbying for or against, and why? How much political contributions do you make and to whom?

· How do you balance return to shareholders today with investment in the future of the enterprise and the host community?

· One could ask a CEO, “how does your company measure success and over what time frame? What constitutes a high-quality decision that stands the test of time? Who is “downstream” from the business and needs to be consulted in order to assess-an mitigate-risk and eliminate negative externalities?”

· Consider a hypothetical where we ask CEOs or board members about whether they are likely to approve a drug that cures a third world disease but has no sizeable cash flows attached to repay the cost of investing in that drug. It would be interesting to understand how many say yes and why someone would say no.

Thanks for sticking with me if you are still reading this. Perhaps the best way to start making a difference given the audience I am giving the talk to are managers of state pension funds: (i) do you cast your vote on your holdings in the company as opposed to delegating that vote to an upstream asset manager? And (ii) can you encourage CEOs to get a mandate on ESG issues, one way or the other, from shareholders? For instance, if Walmart got a 51% vote on the following question, “should we stop stocking guns in our store and on our website?” no can really object to Walmart pulling guns off its shelves. As always, the central issue to me is, “why have we invested so little in understanding what the real shareholder wants.”

Comments welcome, as always. Thank you for having me.

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