As company lifespans shorten and it becomes harder to identify long-term survivors, investors can no longer ignore sustainability factors.
The resurgence of interest in environmental, social and governance factors is significant. Investors will do well to pay attention to ESG even if there is no clear consensus on how to approach the theme from an investment perspective.
Yet a focus on ESG or SRI (socially responsible investing) has historically been a marginal consideration for most mainstream investors. This is not surprising: issues flagged by evaluation processes only had a loose empirical translation to economic profits and shareholder returns. Additionally, some of the most attractive buying opportunities for long-term investors arise in the wake of episodes of mismanagement, poor capital allocation, accounting scandals and industry dislocation. Reflexive exclusion is not a sensible approach.
Given that some of the challenges above are just as true today, why should issues around sustainability become a mainstream consideration for investors?
A significant factor is that average company lifespans are shortening. Current forecasts, based on the S&P index, predict company lifespans will drop to a historic low of 14 years over the next decade — a decline that would have been even more pronounced had it not been for the growth in index trackers and exchange traded funds, which channel flows primarily towards the existing benchmark structures and almost certainly slow the extent to which market capitalisations would otherwise be shifting. This is a particularly arresting finding, both for investors and for management teams. It shows that, over the long term, the pace of the creative-destructive cycle is increasing.
We all recognise this phenomenon; we spend much of our days interacting with technologically enabled goods and services that have rendered stalwart institutions obsolete (Eastman Kodak anyone?).
Yet over recent years, this process has been taking place at a slower rate than might have been expected in normal conditions. Measures taken to repair the solvency of the global financial system in the wake of the crisis have led to exceptionally low funding rates, with banks keeping more uneconomic companies afloat than would otherwise have been the case. This has weakened the bear market’s cleansing process in which assets pass from weak to strong hands.
With a rapid decrease in lifespan expected, duration — both of a company’s lifespan and its economic returns — should be top of investors’ minds when determining the price they are willing to pay for an equity. But the concept of a stable, widely applicable cost of equity (ie the theoretical return investors receive accounting for the risk taken) is an increasingly blunt tool as the moats around companies grow and shrink at a faster pace.
As we enter an environment where customers have low switching costs, where brands can gain and lose their saliency in remarkably short periods, and where industries and sectors become increasingly hard to define, the factors that determine genuine duration become broader and more intangible. Companies facing similar end markets or trading in similar products could well experience radically different fortunes that are not explained by conventional analysis. This is why investors need to centre their analysis on the way in which a business looks after all stakeholders in order to assess areas of vulnerability and marginal advantage.
There are a number of ways in which a focus on ESG factors can improve investment processes but let’s examine two key ones. At the moment, risk analysis is dominated by statistical models that are based on a normal distribution of outcomes and assume the relatively recent past is the best guide to the future. However, what most investors really care about is permanent loss of capital, which is most likely to occur if there is a sudden re-evaluation of the duration or quality of a company’s earnings. So there may be greater value in a risk process driven by issues such as employee welfare, corporate governance, engagement with regulators and the quality of financial reporting. These can reveal where vulnerabilities reside.
Second, most listed companies pursue a regular dialogue with their shareholders but these conversations tend to centre on the performance of the business and the medium-term outlook for profits. Considering that the average company lifespan is set to shrink to two business cycles on current forecasts, companies’ engagements would ideally encompass an evaluation of their “societal license” to operate. This would also enhance the relationship with existing and potential investee companies, allowing investors to play their analysis of longer-term vulnerabilities back to the management team. While it would require a shift in focus, there’s little to be lost — and much to be gained — from this approach.
As competition intensifies, company lifespans shorten and returns to marginal advantage rise, identifying companies with genuine duration will take centre stage. This requires expanding company analysis and dedicating more resources to cover sustainability issues. The industry needs to roll its sleeves up and engage.
Paras Anand is head of European equities at Fidelity International, the UK asset manager