Investment as Usual is Broken [Part 1 of 3]: Valuing ESG factors in equity analysis

Investment as usual is broken. The emergence of environmental, social and governance [ESG] factors in the twenty-first century has challenged the core of business thinking and strategy. Corporations are changing, sustainability has risen to the level of the C-suite, P&G recently appointed their first “Corporate Sustainability Officer”. But the “Chief Sustainability Investment Officer” is much further off. WSJ covers this amongst other "title inflation" items in Dec

Enhancing current investment analysis by integrating material ESG factors will offer better pricing of future risks and opportunities.

Global financial stock now stands at US$140 trillion and growing, according to McKinsey, 2007 based on the latest 2006 data. The value of total global financial assets—including equities, government and corporate debt securities, and bank deposits—expanded to US$140 trillion by the end of 2005, an increase of $7 trillion from a year earlier . But many of the investment decisions are being driven by decision-makers who completed their studies before Google, more influenced by Gordon Gecko of “Wall St” than Al Gore! The sea-change in the way corporations are facing up to our changing world has yet to catch up to the inertia of investment professionals on Wall St, in the City of London and other major investment centers. Investment as usual fails to integrate ESG factors properly. I'm more open for entertainment though - word is there's an update to Wall St, and heck in the past 20 years, cannot say there's no material.

It has become accepted wisdom that “business as usual” will inexorably lead to humans consuming more than the carrying capacity of this one earth’s natural resources, from fossil fuels to potable water to clean air. Investment as usual – the practice of investment management - needs to make a similar adjustment as companies are making in assessing a sustainable future. Matthew J. Kiernan, founder of Innovest Strategic Value Advisors, says traditional financial analysis captures only a quarter of a company's risk and competitive profile. Risk-adjusted returns must reflect a broad and long-term understanding of materiality, within the bounds of fiduciary duty and applied across portfolios and asset classes.

In July, 2007, the United Nations Global Compact annual event keynote address was made by Goldman Sach’s Anthony Ling on behalf of the financial community . It is also true that Hermes has led an engagement on iron and steel companies in the Brazilian supply chain slave labour case. Goldman Sachs presents ten reasons for incorporating ESG factors, three of which were i. experience with risk and return balance, meeting liabilities including identifying global social and environmental challenges, e.g. secure energy supply, climate change, water shortages, BRICs growth, and increasing awareness of ESG issues by analysts and investors. The Goldman Sachs analyst team based in London released a 179-page equity research report titled "GS Sustain" in which it recommended 44 companies based on a combination of companies' ESG performance and fundamentals.

Goldman argued that its picks based on this formulation, both in the U.S. and abroad, outperformed the Morgan Stanley Capital International World Index by 25% over the past two years. A neat approach to selling the quality of your investment ideas. It has been wonderful to watch the London-based team grow from just 2 in 2005, to about 8 now, with more attention from institutional investors than even the GSAM itself. There's an old legend about leaving to find you way, and getting respect in foreign lands, no? Abbey Joseph Cohen will be interviewed by Maria Bartiromo on WSJR next week, maybe it will come up and give the initiative a push...

A recent report by McKinsey indicated investor community ranked only ninth amongst factors leading corporate managers to address societal concerns now and in the next five years. CEOs ranked employees as the stakeholder group that has the greatest impact on the way companies manage their societal expectations. The 391 CEOs surveyed representing 230 organizations in Private/Public, State-owned & NGOs. 90% of company CEOs participating in the United Nations Global Compact said they are doing more than they did 5 years ago to incorporate ESG factors into their strategies. Socially irresponsible business practices might make it harder for companies to attract and retain talented people.

But where is the voice of the investor?

Citi From Leader to Laggard in One Olympic Cycle, keeping the spotlight on

Citi’s [NYSE: C] current saga captured pithily by WSJ on Friday [Citi's Status With Environmental Groups Takes Hit By CLINT RILEY February 9, 2007; Page C3] reminds me of the yawning gulf between being an Olympic or World Cup winner one year, and an also-ran four years later. Rainforest Action Network has majored on Citi’s role as a leading financial institution, potentially tipping the scale from business-as-usual to sustainability, by giving Citi slacker rating despite Citi doing some reasonably good things like ranking on the Environmental Protection Agency's Climate Leaders Program , although interesting to note neither as a charter member nor with GHG limits. RAN's executive director will meet Mr Prince on Valentine's Day for more.

Either RAN has majored on a minor, or Citi has lost its way even while the awards and recognitions based upon Citi's words and early actions still cast a warm glow. No more easy points from NGOs?

The modern Olympics and most World Cups rotate on four-year cycles. It makes the prize incredibly more meaningful, although at the risk of creating a news gap: Lance Armstrong never won Olympic Gold.

WSJ reports that Citi took three years to move from first to last, at least in the estimation of one active NGO.

Rainforest Action Network [RAN] and other environmental groups say they now consider Citigroup a laggard, compared with other big banks, such as Bank of America Corp. and those in Europe. That thinking comes despite the firm's adoption of lending and disclosure policies for environmentally sensitive projects that meet or exceed goals in international agreements such as the Equator Principles, voluntary guidelines based on World Bank and International Finance Corp. policies that are considered a financial-industry benchmark.

RAN is best known in my world for the sharp-witted Victoria’s Dirty Secret campaign that a gifted creative friend in Pennsylvania I met through the Environmental Leadership Network, Libby Kleine Modern, helped to turn to eye-catching graphics. Nothing like juxtaposing some kind of thong with a chainsaw! RAN has a reputation as an outspoken NGO with young talent willing to risk all – even allegedly defecating in the shrubs outside a shareholder meeting [a stunt which crossed them from “stakeholder to engage” to “other”, according to a friend in the SRI community].

I have often used RAN as a reality check for corporates, along the line of my ongoing thesis question - which are you more afraid of: the activist consumer, or the activist shareholder? A simplifying question that clarifies the issue for insulated company types high up on air-conditioned buildings with soft seats is “would you like to engage in dialogue with investors with ESG considerations now, or when RAN comes abseiling past your CEO’s window with a pail of green paint?”.

Backdraft
I never under-estimate the real-life challenges of educating and sensitizing large corporates to how small and seemingly fragmented issues can have major impact when championed by a motivated NGO. As the largest financial services firm in the world by market-cap - depending on where BAC is on the day - Citi will have all the political dynamics of a UN security council resolution, especially when dealing with such "light" issues as climate change. Citi has had some good people on the investments side dealing with ESG, including Mary Jane McQuillen in NYC and Mike Tyrell in London. MJ has been a stalwart for developing SRI competency at Citi and NYSSA, before Citi AM was spun off to Legg Mason in Q1 2006 [she’s now “Director of Social Awareness Investment at ClearBridge Advisors (formerly known as Citigroup Asset Management), a unit of Legg Mason”]. The non-ESG types at Citi In London suddenly found Mike’s team useful when Citi’s utilities analysts were puzzled by gyrating Utilities sector market prices around May 2006 when the ETS mis-pricing played out and the value of carbon credits plummeted from mid-EU20’s to low EU-teens, upending prices factoring in the easy money. Mike and his team have recently updated [January 2007] the seminal “Crossing The River” paper I referenced on SRI-Extra in 2005.

One can only wonder what it was to be a fly on the wall at Citi when the TXU issue blew onto the front page of the WSJ last July As Emission Restrictions Loom, Texas Utility Bets Big on Coal - Planned TXU Plants Raise Global-Warming Concerns; Rivals Try New Technology, Rebecca Smith, Wall Street Journal 21 Jul 2006. Probably not a banner day for their PR, IR or ESG teams, never mind the CSR unit.

Another CFA caught in Citi’s backdraft somewhere between leader and laggard is Fred Wellington at WRI. WRI teamed with Citi in June 2006 on a report entitled “Investing in Solutions to Climate Change” that identified twelve companies set to benefit from global warming by offering products and services in four areas of climate change mitigation. I hope to catch up with Fred soon, but I imagine he must be equally disappointed, whatever his opinion of RAN. Fred was quoted by Bill Baue of SocialFunds.com as saying "Citigroup is clearly a leader on a number of environmental issues. This report represents another area where they see competitive advantage in integrating environmental issues into their business while meeting a demand from their clients". A good thing Fred couched the endorsement with "on a number". Must be his wily experience both inside and outside large money management firms.

Such is Citi’s challenge of being a large institution. Those to whom much is given, much is expected. With people and capital deployed in different investment teams, across different asset classes, in different time zones, now being made to re-engineer toward a sustainability mindset even while making a dollar within today’s rules of the game. Direction must come from the leadership [as even McKinsey will suggest], and the CIO is critical. Citi has not been a happy place to engineeer change: against the backdrop of a share price that over five years has trailed the S&P500 by over 500 bps [C: +17.39% vs SP500: +23.51%], BAC has topped C for market capitalization, and aided by BAC's acquisitions, blown away five year price appreciation [BAC: +74.87% vs C: +17.39%] - although January was a stunner for C. All-in-all, not a pretty atmosphere to engage in re-engineering the internal plumbing.

My work as ESG architect and SRI strategist is substantially easier when dealing with asset manager boutiques, versus large, conglomerated money management firms. Valerie Cook Smith, Citigroup Vice President, Environmental Affairs acknowledged how difficult it is dealing with a sprawling international firm’s corporate citizenship footprint when we shared a cab ride last October. Valerie was a fellow Net Impact panel member at the Net Impact Annual Conference in Chicago.

One may anticipate the enormous challenge of advising a Wall Street firm with operations on all continents – executing ESG criteria consistently down the investment value chain will require a top-notch effort over a 18-36 month timeframe. Valerie is a Net Impact Board member so she is attuned to NGOs, and especially the San Francisco activist community. Her MBA is from a top 10 B-school [UNC-Chapel Hill’s Kenan-Flagler] which has a respected Center for Sustainable Enterprise [a top 10 Beyondgreypinstripes.org school] where I enjoyed leading a seminar on responsible investment and ESG analysis to 40-odd MBAs last weekend.

But I wonder how influential Valerie or Mike or MJ were able to be when the corporate finance team floated the TXU deal, the red flag to environmental activists in this instance? Ahhh, to join the Valentine's discussion...


A Pachyderm's Memory
NGOs will keep the Citigroup sustainability investing initiative - and the Citi corporate effort - honest over time. This is something I noticed time and again in the SRI research business at KLD: companies being caught in the spotlight when determined research analyst asked the simple but tough questions like "have you executed on your promises?" and then scored the company accordingly. One can argue both directions on why the Exxon Valdez 1989 oil spill should still be captured in a research note. But it is only the company that benefits. A bored reader may always skip over an analyst’s paragraph on what the reader considers historical [XOM of course has helped to keep the disaster more material than necessary: it is still fighting against some of the damages awarded, fully 18 years after the event, and the oil is still causing problems Study says Exxon Valdez oil lingering in Sound].

Organizations, especially matured businesses with long and/or loose internal EHS [environmental, health & safety] policies and performance, benefit from short attention spans. Experts and analysts do not. NGOs may be under-resourced, but they develop a truffle-sniffer's nose for spin, and their mission focus generates a fair dose of doggedness. I submit that nothing and no-one is more tenacious than a mission-driven person, with a beef and a laptop. Throw in the Internet, international relationships fostered at college, some rudimentary networking ability, basic research skills, and broadband, and you may or may not have a corporate reputation threat for very little money and a long time.

This is exactly why the one-year anniversary date for the PRI [27 April 2007] is important. I reasonably expect that the PRI [www.unpri.org] will generate some coverage, and I have encouraged James and the PRI team to use that tailwind. Of course, it is unclear whether the NYSE is as interested as April last year, although their engagement with Euronext may suggest sensitivty to Euro-sensitive issues like carbon. I noted with interest that Wall St hosted President Bush a few days back. Aside from graciously attributing the fair economic condition to his policies, President Bush offered the mixed signal of cheering corporate America while indicating the need for trimmed executive compensation. I am not sure how much applause that one got on the street with median $600k bonuses in 2006.

With a PRI anniversary, so too will come a re-examination of the whole issue of ESG in investment, along with the "who's who" that have already signed on. There has been talk of ejecting more names from the PRI - at least one organization has been "downgraded" to date, and UNEP is keen to keep the appearance of running a credible program with meaningful standards. Frankly, I am all for dropping the passengers, making sure the cohort stays near the sharp end of the field, stretching for improvement, not just hanging on.

Bottom line for Citi and other majors: with many not-for-profit, for-profit and thought leaders using NGOs as early warning systems, it is important to always maintain the initiative by staying proactive in engagement. Citi must have some substantive internal messaging ready by mid-April, even if it decides not to be external. The authenticity will be available, invaluable if a respected NGO requires some material representation. If the ongoing imbroglio with the Bartiromo and HNW unit, or the shuffle of Ms Krawcheck, proves to be distracting, Citi may at least lean on some hoped-for forthcoming positive commentary on their ESG effort.

Using External Rhythms to Drive Internal Disciplines
In working with money mangers on their ESG architecture, I strongly recommend the ESG project remain clear on the annual anniversaries of stakeholder initiatives and high-profile events by influential NGO's and SRI networks [CERES, INCR, PRI, IGCC, ICCR]. ICCR's annual shareholder advocacy agenda is a particularly useful resource, see [www.iccr.org/shareholder/proxy_book07/07statuschart.php]]. In my experience, NGO’s are willing to offer points for material efforts. A proactive approach for Citi may be to shadow the quarterly information flows around investor conference calls or reporting to SEC. With minimal internal changes, the ESG initiative may map internally to regular investor reporting.

For the money manager and its corporate parent, a regular reporting tempo with a simulated audience helps to generate the internal disciplines from behind the security of an internal process. It also teams the ESG approach with colleagues' regular processes, reducing the peculiarity factor. But if/when Citi needs to adopt a more market-facing, investor- and NGO-friendly approach, the corporate behavior and reporting pattern will already be imbued in the firm's DNA.

The actions and activities of each business unit and each asset class need to map to the overall sustainability and ESG approach. Citi is finding out the hard way. Champion status [in the minds of all NGOs] can slip away effortlessly in the course of an Olympic, four-year cycle.

As a sobering reminder to Citi and their measures of greatness - whatever RAN's opinion - an anecdote from the peleton: while Lance Armstrong is respected for his seven straight Tours de France victories, in his only Olympic podium, Lance shared it grimly with his self-professed arch-rival Jan Ullrich [Sydney 2000] BUT from one step lower on the Time Trial podium than Jan. Jan had also won the Road Race Gold. No Olympic Gold, together with Lance's lack of victories in Spring Classics cycling races, means he ranks as a great bike rider, but in a cohort with others, and below a consensus all-time legend like Eddy Merckx.


Afterword
Talk of World Cups reminds me: this summer in France I hope to enjoy some fine Rugby Union at the sixth Rugby World Cup. The Springboks may or may not show up [such is the sad state the Boks ended last season, despite the gritty win at Twickenham]. It will also be the fifth iteration of the All Blacks ongoing saga of being the tournament favorites who manage to self-destruct before they can lift the Webb Ellis trophy. A knowing wince by Hamish, a Kiwi at the Boston Sports Club [BSC] South Station Spinning class the other Wednesday, reminded me of the New Zealanders’ national torment each fourth year brings...