Capitalism will not change if those of us providing the capital don't begin to remove financial incentives for short-term behavior. We need a model of management and investment analysis that moves companies away from a shareholder-centric capitalism towards one that focuses on a continuous exchange of value amongst all stakeholders.
We are experiencing a crisis of confidence in capitalism today. People simply don’t believe that the capitalists in America or elsewhere care about the welfare of the rest of us. There was a time when that was accepted since, hey, this is just business. No longer. We are evolving as a society and many of us have decided that the old shareholder-centric model of capitalism doesn’t serve us any longer. We want the companies we work for, buy from, invest in and let operate in our communities to take heed of how their actions affect us all and recognize their duty to contribute to our overall well-being. Not only by providing us useful goods and services at reasonable prices, but also by taking responsibility for their myriad impacts on society at large.The essence of Long-Term Capitalism is embedded in a company's ability to address the needs of all its core stakeholders, while also providing exceptional returns. In fact I believe the most effective way to prodce those returns is in creating purpose filled, endearing companies. But how do can we as a society manifest this reality in our businesses?
I put forth a model both for business strategy and investment decisions based on what has become known as the Multi-stakeholder Management System (MsMS), which moves companies away from a shareholder-centric view of capitalism towards one that focuses on creating a continual exchange of value amongst all stakeholders as a way to create long-term value and societal benefit. Particularly I discuss how investors can help the MsMS take hold and why it is important to do so.
If the United States is to flourish again and we want to escape this new normal of higher unemployment and increasing income disparity brought on by globalization and hyper productivity, then capitalism will need to be transformed to expressly address the needs of a broad swath of stakeholders. Many investors and corporate leaders have begun responding to this reality evidenced by the multitude of ESG-related investment products and corporate social responsibility (CSR) programs that are coming in and out of vogue. The tags are many: Socially Responsible Investing, Sustainable Capitalism, The Triple Bottom Line and Blended Value, to name just a few. While I think this trend towards more ethical and environmentally responsive practices is a good start, I believe it is insufficient from the standpoint of corporate performance, generating investment alpha and most importantly transforming capitalism such that we consistently can generate societal as well as financial value. In order to fully capture the longing of society for a more humanistic form of capitalism, and the resultant societal benefits, competitive advantage and investment performance, executives and investors need to embrace the holistic concept of the Multi-stakeholder Management System (MsMS). In this system, companies view themselves as a key player in an interdependent network of stakeholders, where the real job of the corporation is not simply to maximize return for shareholders, but to do so primarily by striving to create value for all stakeholders. By operating in a manner where customers, employees, communities and suppliers are sustained by the sublime experience of interacting with each other in elegant harmony, these companies create societal value as well as outsized returns for investors. In their 2006 book, Firms of Endearment; How World Class Companies Profit from Passion and Purpose, authors Raj Sisodia, David Wolfe and Jag Seth, offer stark evidence that operating from this more holistic perspective can do more to increase shareholder wealth than maintaining a myopic focus on Shareholder value as it has come to be defined. In fact, I believe endearing behavior by a company towards its stakeholders is one of the most decisive competitive differences ever wielded in a capitalistic enterprise. These companies have accepted responsibility for becoming “instruments of service to society” in addition to their obligation to make returns for their owners.
In my attempt to consider how investors can contribute to supporting this movement, I’ve considered a basic question: How can we inspire and enable executives to do the hard work of what's come to be known as Conscious Capitalism? With so little interest from traditional capital market players in businesses that operate with a long-term mindset; with a prevalent and traditional view of capitalism that sees the intersection of societal performance and corporate performance as being at odds; with so many businesses being rewarded by Wall Street for seeming to operate without strong ethical values or a purpose larger than their own profits - how do we begin to help executives both see the value of this business model and contribute to its broader adoption?
I address here what I consider to be the three pillars for supporting and promoting Conscious Capitalism. The first is to recognize that Conscious Capitalism is a complex polarity that needs to be continually managed. Second is that management system innovation is at the heart of Conscious Capitalism. And finally, I investigate how the current capital reward system is inadequate for inspiring the types of behaviors required of conscious capitalists, and the changes required by investment managers and beneficial owners.
A great deal of my professional thinking has been influenced by author Barry Johnson, who wrote Polarity Management: Identifying and Managing Unsolvable Problems. I think Barry would undoubtedly point out that being a conscious capitalist requires us to be able to hold these two seemingly polar positions simultaneously in our minds. Obviously one can’t be chosen over the other. This is primarily what sets this notion of capitalism apart from “market fundamentalists” as well as those who would champion Corporate Social Responsibility as the savior of capitalism. They both get to narrow their field of vision and choose a course of action: Business either has as its sole responsibility to be a vehicle for shareholder profit or, since business is the cause of many societal ills, it must “give back” no matter the impact on value creation or competitive advantage. Certainly, by definition, conscious capitalists must focus on both consciousness and capitalism in equal measure. Finding or creating, at the core of their businesses, a way to foster exceptional shareholder and societal value, while minimizing the downsides of both approaches. The real conflicts that arise from being both conscious and a capitalist, requires executives to constantly manage their businesses so they experience the upside of both these seemingly divergent poles. It requires agility, awareness and a continuous vigilance that keeps the organization from moving entirely in one direction or the other. Rather, the business must continually focus on the intersection of the two in order to achieve what Michael Porter has called Shared Value for all stakeholders.[i]
After more than 30 years in the management consulting business, where I helped build casual models showing the connection between stakeholder engagement and financial performance in various industries, as well as the work I did with the Authors of Firms of Endearment I have developed strong convictions about what it means to be a Conscious Capitalist. My beliefs are inextricably tied to the notion that businesses, whether large multi-nationals or the corner hardware store, affect the lives, fortunes, health and welfare of a broad range of stakeholders in a direct and concrete fashion. Employees who bring their talents to bear for the benefit of the company, customers who spend their hard-earned dollars for the companies goods and services, partners and suppliers who bring innovations and raw resources that the company needs to do it’s business, local communities who allow the company to operate via public license, and shareholders and debt-holders who fund innovation and provide much needed cash—all have a stake in the company’s success and are affected by the company’s actions. A growing number of businesses are recognizing that aligning and responding to the needs of this constellation of stakeholders is indeed the essence of their business. Unlike philanthropic CSR initiatives, which can often be ineffective and strategically dubious “bolt-on” solutions to problems that the company helped create, a focus on stakeholders is an integrated approach to fulfilling the highest societal as well as financial purpose of any commercial organization. I contend that operating with this multi-stakeholder mindset has become requisite for creating long-term economic value, and presents a clear path to Conscious Capitalism.
As I speak to practitioners and academics on the issues surrounding Conscious Capitalism, a clear set of themes has emerged. First, the notion of operating with a fundamental higher purpose is a central theme. Additionally there is a sense of a shared responsibility that speaks to the duty of the company to be mindful of and proactive about its impact on society. Importantly there must be a mandate to treat customers and employees with dignity and respect. Each point is focused on the best way to create healthy, sustainable companies that create real long-term economic, societal and cultural wealth.
In the end, this all seems to be about operating our businesses based on a set of values that respond to our shared humanity. To achieve these aims, multi-stakeholder based companies continually strive to create well-paying jobs that engage and inspire employees. They create cultures of innovation so customers crave what they produce, they engage customers in value-centered, emotional relationships that keep them coming back and willing to pay a premium and they tend to the needs of the local community so that they are welcomed as neighbors and not faced with constant civil and regulatory barriers to entry. In addition, they treat suppliers as partners and not as indentured servants thus unlocking a path to their best ideas, pricing and cooperation as well as consistently creating economic value and wealth for shareholders. Aligning these competing, complimentary and sometimes even mutually exclusive needs requires a management team to constantly look beyond the day-to-day. Any given decision will have the potential to put the needs of one stakeholder ahead of another, and only by operating from a mindset that seeks to maximize the long-term exchange of value amongst all stakeholders can a manager adjudicate short-term needs and make truly conscious decisions.
The Capital Markets: Long-Term Needs; Short-Term Rewards:
Although many of you reading this are either practitioners or advocates of Conscious Capitalism, this is clearly an emerging notion of how businesses ought to operate. Many of my colleagues, particularly in the CSR world, tend to focus on the ‘conscious’ part of the equation, rather than the intersection of the two. We need to consider how and why these two parts must operate as one. Much focus is placed on turning businesses into conscious organizations, but lest we forget, Conscious Capitalism is still very much about capitalism and capital.
As “purveyors” of capital then, what is required of us if we want to be practitioners as well as evangelists for the Conscious Capitalism movement? First I think recognizing some simple realities are in order: Market-based capitalism is here to stay. I, like many others, believe that the intersection of liberal democracy and free market capitalism has indeed won the great battle of the 20th century. It is evident that capitalism has much to add to the betterment of society and so far, is systematically without peer. Recent occurrences that highlight the flaws in the currently ubiquitous form of capitalism do not signal its demise. Rather, they highlight the need for capitalism, like all complex systems, to evolve. As R. Edward Freeman, Professor of Business Administration at The University of Virginia and Academic Director of the Business Roundtable Institute for Corporate Ethics has stated, “The alternative to capitalism as we know it is not socialism, but a better form of Capitalism – one that recognizes the existence of the commons and acts to prevent the single minded individualism capable of destroying it.”[i] My colleagues and I see Conscious Capitalism as the next evolution of the capitalist system. The nature by which capital will be allocated in the future will be key to whether Conscious Capitalism firmly takes hold or fizzles out.
For many organizations requirement for capital means seeking out investors; either in the form of private equity, structured debt or approaching Wall Street and the daunting world of the public equity markets. This type of money represents a significant dilemma for practicing or aspiring conscious capitalists in that the current system of capital allocation on Wall Street has an inherent flaw for these types of businesses: it has come to be dominated by a short-term mindset that runs specifically counter not only to the notion and practice of Conscious Capitalism, but to promoting a mutual exchange of value between all players. The notion of sustainable corporate health through ethical, prudent corporate governance and executive behavior, is too often at odds with the quarterly earnings ethos so important to Wall Street. A pervasive mindset has emerged on the Street and in turn within much of corporate America that views smooth and predictable quarterly earnings as the most reliable metric of performance and for understanding companies’ future prospects. While searching for a single and relatively simple performance metric may seem reasonable, I believe earnings are often misleading and don’t tell the entire picture. In fact, it’s likely we’d all agree there are many perfectly legal ways companies can manipulate their financial statements. Additionally, for reasons ranging from equity-based executive compensation to individual reputation risk, an unintended consequence of playing the quarterly earnings game can be a certain form of management myopia that develops around responding to this reward system and the actions often manifested therein are antithetical to the practice of Conscious Capitalism.
The problem that exists on the “capital” side of the equation is Wall Street’s obsession with short-termism leaves very little room for the type of long-term thinking (and actions) required to operate a multi-stakeholder business. As a result we see that even for conscious capitalists, the pull of Wall Street and frankly the counter-productive demands of investors are hard to resist. When CNBC commentator Jim Cramer opines, “When it comes to the stock market…joblessness in the U.S. isn’t such a bad thing”[ii] we all need to sit up and take notice. Wall Street has long been obsessed with last quarter’s earnings and in many ways, the simplicity of this metric has allowed analysts to neglect the hard work of really understanding the underlying health of the business and how those earnings were created. Capital is allocated and companies are rewarded for cutting costs with little regard for the long-term implications. Employees are laid off even in light of record earnings, suppliers are squeezed as companies focus on price and forsake quality; services are eliminated as real customer-focused interaction is replaced with automated systems at increasing rates. The term shareholder value has been appropriated by managers and analysts to be synonymous with maximizing short-term stock price. It seems evident that as long as executives perceive there is more reward to be had from short-term gains and a view of the shareholder as the primary stakeholder we shouldn’t expect much to change in the way they behave.
Now I certainly know that all Wall Street analysts are not created equal. I am quite likely to receive pushback on the notion that they generally dismiss, or aren’t concerned with, the underlying health of the companies they cover. This is an arguably fair criticism. Even in our business, we turn to industry and company analysts who have deep knowledge of macro-economic trends and the particulars of the companies in their sectors. If you listen in on earnings conference calls, you will hear many questions and lengthy discussions about product launches, quality issues, management changes and efficiency programs. But ultimately the discussions turn to, and decisions are based on that all-important metric of quarter-over-quarter earnings. For Multi-stakeholder companies and conscious capitalists, the earnings number simply doesn’t tell the story well enough to fully grasp the nature of the business and its prospects for the future. It’s a number that must be understood through the prism of the intangibles and the relationships that actually create earnings. Architect Robert Venturi, in his seminal work Complexity and Contradiction in Architecture, proclaimed that he was for “messy vitality over obvious unity.”[iii] I believe he was referring to the notion that truth requires an understanding based in totality; that truth is arrived at through “the difficult unity of inclusion rather the easy unity of exclusion.”[iv] Although many if not most analysts will agree with this notion and claim to place a high value on their thorough understanding of the underlying health of the company, I challenge anyone to show me an instance where management explained an earnings miss, based on the execution of a viable, long-term growth strategy and was rewarded with an increase in the stock price or an upgrade in an analyst’s view of their company. If it has happened, I would bet the instances are few and far between. It’s my belief that doing the hard work and getting to the truth about the nature of a company’s relationships with stakeholders yields a far better understanding of that company’s future prospects and ability to generate long-term economic value than anything Wall Street now analyzes or anything that is currently required to be reported.
Not only does this focus on earnings not tell us the entire truth, it has unintended consequences that can actually be detrimental to creating long-term value.
Peter Drucker once said, “Profit is not the explanation, cause or rationale of business behavior and business decisions, but rather the test of their validity.”[v] We think that quote is telling in terms of where Wall Street is today. In focusing on earnings as a proxy for corporate health it seems that the street has lost sight of the true importance of business behavior as a means of creating competitive advantage. If the predominant metric is going to be smooth and predictable quarterly earnings, we’ve seen this measurement regime can counter-intuitively drive executives to do just about anything to deliver as the analysts expect. Even if that means real earnings management associated with activities like cutting R&D, laying off valuable employees despite possible future productivity consequences or postponing and even eliminating value generating projects, if doing so will help meet the current quarter’s earnings targets. In their eye opening Study, Value Destruction and Financial Reporting Decisions, John Graham and Campbell Harvey of Duke University and Shiva Rajgopal of The University of Washington report that an astounding 78% of the executives surveyed for their report would legally destroy economic value in exchange for smooth and predictable quarterly earnings.[vi]
Focusing predominantly on the earnings number itself, particularly quarterly earnings per share, puts all stakeholders, even shareholders in a decidedly inferior position to the powers that be on Wall Street. In doing so, it simply becomes much easier for executives to sacrifice the needs of employees, suppliers, communities and even customers if that helps meet the earnings numbers. Graham, Harvey and Rajgopal assert that more value is destroyed legally by firms striving to hit earnings targets than what has been lost in all the recent high-profile cases of fraud.[vii] I also suggest that all of the earnings manipulation is substantially misleading to investors; Enron had been rated as a “buy” or “strong buy” by various investment houses almost right up to their filing for bankruptcy.[viii]
A Change Needs to Come:
All this leads me to conclude it certainly takes a great deal of courage to operate as a conscious capitalist. At least in regard to attracting public capital, executives and companies who want to live by this ethos will find themselves at odds with the current capital reward system. Getting Conscious Capitalism to the next level requires a change in the mindset of the financial world in order to provide cover (and capital) to these brave executives. If we are to counteract the tremendous pull of short-termism on Wall Street we must begin to get truly patient money flowing to those companies who seek to operate as conscious capitalists.
And what about those companies? Who are they and how do we find them? It’s always interesting to me that when I speak with small-business owners or even very large, privately held companies, they generally have an intuitive understanding of why operating from a multi-stakeholder mindset makes sense and even how to do it. They know that customers must come first; and if you don’t treat your employees with dignity and respect, or like they really are your best asset (as many an annual report claims), they won’t perform and your customers won’t be happy, or profitable for very long. However, amazingly enough this isn’t just about the mom and pop store on the corner or the new-age green companies. Some of the largest, most profitable companies in America understand this mindset and have fashioned their businesses with a broader sense of purpose. I suggest they are large and profitable indeed because they have learned how to align the needs of stakeholders, becoming vehicles of profit and societal benefit, raising all boats and not just the yachts. Simply put, the problem I see is an inverse relationship between the long-term mindset needed to build a really great company that contributes to shareholders and society and how capital is allocated in order for businesses to grow. Case in point, in the days and months following September 11th, many in the airline industry announced job cuts of up to 20%, sometimes more. Southwest Airlines, however, took a different tact. You see, having the right types of employees is the lifeblood of the Southwest strategy. They take their culture and commitment to the well-being of employees seriously. So while their competitors turned first to those who can least afford the hit in order to cut costs and prop-up faltering earnings, Southwest executives looked everywhere else and layoffs were never considered:
“We were willing to suffer some damage, even to our stock price, to protect the jobs of our people” said then-CEO James F. Parker, in an article for BusinessWeek: October 8, 2001
In fact, there have been a number of recent studies that suggest layoffs don’t work the way many managers think they do, in terms of productivity, cost-reduction and even stock performance.[i] But these myths persist on Wall Street and in much of corporate America, contributing to the destruction of families, local communities and indeed, shareholder wealth. For Conscious Capitalism to thrive, a new paradigm must emerge.
[i] For an excellent treatise on this see the article by Stanford Professor Jeffrey Pfeffer, Lay Off the Layoffs, The Daily Beast, http://www.thedailybeast.com/newsweek/2010/02/04/lay-off-the-layoffs.html (February 4, 2007)
[ii] One idea I’ve seen is using a rolling 3-5 year financial return analysis coupled with qualitative measures - like key staff retention and style consistency – along with setting reasonable thresholds for yearly performance, in order to focus managers on long-term health as well as short term performance of their portfolio. This has been used by some progressive organizations (See: the Public Employees Retirement System of Idaho; http://www.thedailybeast.com/newsweek/2010/02/04/lay-off-the-layoffs.html)
[iii] The Aspen Institute Business and Society Program. “Overcoming Short-termism: A Call for a More Responsible Approach to Investment and Business Management” September 9, 2009. Corporate Values Strategy Group. Print.
[iv] Foner, Philip S. History of the Labor Movement in the United States: The T.U.E.L. to the End of the Gompers Era. New york: International Publishers Co, 1991, p. 361-362.
[i] R. Edward Freeman and Jeanne Liedtka, Corporate Social Responsibility: A Critical Approach – Corporate social responsibility no longer a useful concept; Business Horizons Magazine, (July – August 1991).
[ii] CNBC Mad Money; 2010
[iii] Robert Venturi, Complexity and Contradiction in Architecture, (New York, NY Museum of Modern Art 1966)
[v] The Essential Drucker: The Best of Sixty Years of Peter Drucker’s Essential Writings on Management, (New York, NY Collins Business 2003)
[vi] John Graham, Campbell Harvey and Shiva Rajgopal Value Destruction and Financial Reporting Decisions, (September 2006)
[viii] On October 31, 2001, just two months before the company filed for bankruptcy, the mean analyst recommendation listed on First Call (which compiles and distributes analyst recommendations) for Enron was 1.9 out of 5, where 1 is a “strong buy” and 5 is a “sell.” Even after the accounting problems had been announced in October 2001, reputable institutions such as Lehman Brothers, UBS Warburg and Merrill Lynch issued “strong buy” or “buy” recommendations for Enron. : Paul M. Healy and Krishna G. Palepu: The Fall of Enron: Journal of Economic Perspectives: Volume 17 – Number 2 (Spring 2003): Page 19
[i] Harvard Business Review; January 2011
Where to Begin:
So how can we begin to change the reward system and enable companies to be conscious and still attract capital? First, let’s take a look in the mirror shall we?
Shareholders themselves hold more than a little responsibility for this situation. It’s clearly time for them, particularly large institutional shareholders, to face up to the challenge of changing this pervasive culture of short-termism.
As institutional investors have pursued investment returns they’ve created a compensation system for their intermediaries - hedge funds, mutual funds, private equity and other investment managers - that focuses these groups on short-term earnings as the key investment metric as opposed to the underlying health of the companies in their portfolios. I know of some mid-sized hedge funds that turn over their portfolio in dollar terms on a monthly basis, averaging close to a billion dollars in trades everyday! Why? Because the purpose of their jobs has become the exploitation of minute, constant and instantaneous changes in stock prices instead of investing in great, well-run companies that will endure over time and accrue benefits to employees, suppliers, customers, communities and shareholders. In this world, investment managers are compensated by their clients for returns; out-performance of their benchmark, quarter-over-quarter and year-over-year. This has a direct cause-and-effect on executive behavior and most certainly on the issue of the day: executive compensation. If companies aren’t producing those quarterly earnings investors sell off their stocks, depressing the value and by extension impacting a major portion of executive pay. In a world where the only thing that matters is short-term stock price appreciation and where a large portion of managers’ pay is based on stock price, why then would we expect managers to focus on much else?
Clearly my focus here is on major institutional investors such as private and public union pension funds and college endowments. In that regard, not only is this system of investment manager compensation and reward not in the best interest of society or our economy for that matter, it’s generally not in the best interest of the ultimate investor: the union plumbers, laborers, teachers, local communities and university students who depend on long-term returns to fund their futures. Now, I can imagine many of you are thinking this is a pretty self-serving argument. If investors didn’t focus on how their investment managers perform, our jobs would be a lot easier (I also imagine there would be a significant amount of mediocre investment managers setting up shop as well). But patient capital is not the same as dumb capital. I’m not suggesting that investors need not be diligent about market and financial fundamentals or that short-term losses don’t pose their own set of risks and challenges. With union membership diminishing, retiring baby-boomers making demands on fund levels, and recession plagued, cash-strapped companies and state governments contributing to under-funded pensions, pressure on yearly performance is indeed a real and immediate issue. Performance clearly matters. I suggest however that institutional investors also have a tremendous cultural stake in supporting multi-stakeholder businesses and they need to work with those managers who have a particular competence at identifying those types of businesses. What I am advocating is that investors who claim to covet the type of behavior demonstrated by Southwest’s Mr. Parker need to begin their analysis with the notion of supporting conscious companies …not end it there. They need to make it known that business executives who run their organizations with a multi-stakeholder mindset will be the core of their investment strategy and no longer be immediately penalized for operating with passion and purpose. They then need to work with the investment management community to develop new models of analysis, performance review and compensation that serve to focus attention on truly healthy, sustainable companies that will generate growth and returns now and for years to come.[ii] With this as a starting point, companies will be able to focus on long-term health while investment managers use the additional fundamental tools at their disposal to create strategies and portfolios that seek to manage this polarity – investing for the long-term while also creating products that preserve capital in the near-term.
A Few Big Ideas:
So how do we make this happen? I’ve been giving this question some thought as it pertains to investment managers, institutional investors and conscious capitalists themselves. Below I highlight what I believe are possibly a few helpful ideas.
First, A Thought on Disclosure:
If we want capital to flow from the public markets to conscious capitalists, there needs to be a way to identify them; a simple idea but right now, an incredibly difficult thing to do. Sure, we’re in a technological age where actions become more transparent everyday. However, for professional investors who need swift, prudent, rigorous and repeatable research processes—both so we can be relatively certain we’re identifying the right types of companies and so we can live up to our statutory and fiduciary responsibilities—there is a true dearth of pertinent information. The essence of the Multi-stakeholder Management System is nothing less than the nature of the company’s culture and how that culture manifests itself in the relationships that company has with its constituents. Do employees really care about the place to the point of being willing and able to give discretionary effort? How loyal are the company’s customers? Can I easily track the labor and human rights practices in every corner of the company’s supply chain? And can I compare all of this across companies and across industries?
It can be done, in fact if companies would be willing to report on two issues: the level of employee engagement and a measure of the company’s culture (and how each is moving over time) most of the disclosure issue would be solved. But someone needs to take the lead on making this information readily available to the investment community. We think that responsibility lies with both the companies themselves and with like-minded investors.
If conscious capitalists want the support from the finance world that I believe they deserve, they need to take the lead on creating a disclosure framework that allows us to identify them. There has been some movement on this. Recently I was asked to be a part of a large group of investment managers, consultants and human resource professionals assembled by the Society of Human Resource Management (SHRM). The group has been charged with developing an ANSI (American National Standards Institute) approved guideline for reporting human capital metrics to investors. The guideline will initially be voluntary and it’s not perfect. But it is a step in the right direction.
The bottom line here is clear: If institutional investors want to promote companies that not only generate financial returns but also accrue societal benefits to their constituents, they need to demand a change in the disclosure framework so they can know when they’ve invested in a conscious company, and when they have not.
Answering those stakeholder relationship questions also provides investors with a related benefit: better risk management. By their very nature, conscious capitalists are less likely to be involved in financial fraud or other types of financial shenanigans which contributed to the financial meltdown of the last few years. We propose that the risk inherent in a decline in employee engagement or the mass defection of loyal and economically profitable customers is perhaps a greater risk to company performance (and the performance of the portfolios in which those companies may reside) than most things being reported today.
Ideas for Investors:
As you may surmise, I believe institutional investors need to back up their stated values by investing in what they believe. As the saying goes, put your money where you mouth is! Consider this statement from the AFL-CIO Office of Investment Website:
“Capital stewardship means investing based on the principle that the long-term, sustainable value of any investment requires mutually beneficial cooperation among all those involved, including workers, managers, investors, customers and members of the community. Capital stewardship means that when investors are choosing among comparable investments, workers and their benefit funds have the right to choose those that support working families and their communities and are aligned with their view of value.”
This statement is indicative of a growing and pervasive sentiment among many institutional investors and leaders in corporate governance and business ethics. In fact, in an even more strident manner, many leading institutional investors, such as John Bogle, Founder of The Vanguard Group, AFL-CIO President Rich Trumka, Warren Buffet and Jack Ehnes, CEO of the California State Teachers’ Retirement System (CALSTRS) came together recently in partnership with the Aspen Institute Business & Society Program’s Corporate Values Strategy Group (CVSG) to “endorse a bold call to end the focus on value-destroying short-termism in our financial markets and create public policies that reward long-term value creation for investors and the public good”.[iii]
However, by focusing so strongly on “public policy” solutions, it is my contention that investors aren’t using the full spectrum of the power available to them in terms of influencing corporate behavior. By demanding a new paradigm in disclosure and becoming active financial supporters of the multi-stakeholder model and Conscious Capitalism, along with what they already do in terms of influencing public policy and exercising proxy voting rights, institutional investors have a new opportunity to change the nature of capitalism in America. Furthermore, they can possibly change it in a way that isn’t simply about a political or social agenda, but finally aims to create market-based incentives that simultaneously create superior economic and societal wealth.
By adding the arrow of investing in Conscious Capitalism to their quiver, institutional investors have the power and capital to influence behavior on a large scale. To provide incentives and rewards for companies who operate with a mindset of beneficial cooperation among all those involved. To do this, we believe they need to dedicate a significant portion of their assets, political power and knowledge resources towards promoting the notion of Conscious Capitalism. Lowering the cost of capital for those companies that operate as they are correctly advocating creates a virtuous circle. These companies can innovate and out-compete their peers, resulting in increased returns at significantly lower levels of risk for the institutional investors. As this movement grows, those companies who refuse to embrace the multi-stakeholder model will be marginalized within their industries and more will turn to this model, unleashing a new wave of innovation, economic growth and societal benefits.
Expand Your Return Horizons
An old mentor of mine once proclaimed “WGMGD!” or, What Gets Measured Gets Done! As such, asset managers - like all other professionals – will work towards the measures that allow them to maintain their assets and receive fair compensation. As we said earlier, yearly performance is important, as is creating an incentive system that inspires your managers to invest for the long-term. Start by insisting your managers develop an investment process by which they identify companies that both perform in the short-term and have a long-term value creation ethos. Then measure investment performance over extended periods to capture the managers’ ability to generate near-term returns while also focusing on long-term sustainability.
In order to do this you must be rigorous in your evaluation of all parts of their investment methodology:, First emphasize the need to start with a fundamental research process that identifies long-term, ethically minded constituents for their portfolios. Then they should continue with more standard valuation methodologies that capture short-term stock out-performance and finally ending with risk management processes that preserve capital in prolonged bear markets.
Don’t Get Spooked by Lock-Up Periods:
If investors do what I suggest, their managers will be held to a much higher standard of research rigor than the average asset manager. Until the disclosure issue is solved this means a much more expensive research process. This will have an effect in terms of asset management fees but more important to the notion of moving the needle on Conscious Capitalism, patient capital will be key. Managers will need the ability to invest for the long-term and that’s difficult to do when capital takes flight if the manager has one down quarter or one down year (see the corollary to this idea in the Fund Managers Ideas section: Be Transparent). Again, this doesn’t suggest that a mere ‘buy-and-hold’ strategy is prudent and that managers should stick with companies no matter what happens to the stock price. Managers need to create products and be held responsible for making prudent decisions which allow them to move in and out of the market or particular equity positions as the broad-market fundamentals dictate. However, if investors and managers start with the notion that Conscious Capitalism in the form of the Multi-stakeholder Management System is the foundation of their investment strategy, I believe executive behavior will respond to this focus and investment managers who invest in this manner will know they’ll be afforded patience through market cycles. They won’t then have to chase peer performance for the sake of survival. They’ll be able to invest prudently for the long-term rather than trade opportunistically for the next quarters’ reporting cycle.
Ideas for Conscious Capitalists:
The ideas here can probably be summarized in a single simple phrase: Take the lead! Because of the power of this business model, conscious capitalists have a tremendous amount to gain from a true mutually beneficial relationship with Wall Street and institutional investors. Our advice: don’t sit back and wait, carpe diem! Again, disclosure and equally as important, transparency will be key if we as conscious capitalists are to aid in this catalyst.
In this regard Executives need to join the discussion in substantive ways about new disclosure standards, focused on intangible assets and creating a much broader definition of “risk”, to include stakeholder associated risk. This includes voluntarily disclosing metrics about culture measurements, employee engagement statistics, customer loyalty (not customer satisfaction), supply chain and labor and human rights issues and community interaction. As conscious capitalists, we need to extend the discussion beyond talking only to ourselves about each other and professionalize the discussion by tying what “the Street” sees as touchy-feely concepts to hard and quantifiable metrics about risk and performance.
Stop Giving Earnings Guidance.
If you want investors to focus on what matters, you must tell them about what really matters. If you want to give guidance start giving guidance on year-over-year employee engagement numbers or customer loyalty ratings. Hone your customer, employee, supplier and community listening systems and let investors know how you’re managing these relationships so investors stay focused on the levers of long-term value rather than the next quarter
Ideas for Investment Managers:
My colleagues and I have often said that fund managers should be taking a decidedly un-activist approach in terms of investing in conscious capitalists. What we probably should be saying is that their activism needs to be much more subtle and nuanced than direct investor activism and in the end I hope it will be much more persuasive. I believe the change in corporate behavior and benefits for society will come about because more and more investment managers are seeking out conscious capitalists, investing in them and forsaking those companies still living in the Darwinian, zero-sum world of Capitalism 1.0. And because the clients of these forward thinking investment managers will be reaping the benefits of higher returns, as customers, employees and partners seek to be associated with conscious capitalists, these companies already hold a competitive advantage. As that competitive advantage manifests itself in the form of lower capital costs due to increased investor interest, and greater returns for investors with significantly less risk, I believe more executives, managers and board members will begin to see the light.
Samuel Gompers, the founder of the American Federation of Labor once said, “No lasting gain has ever come from compulsion…”[iv]. Conscious Capitalism is a movement that aims to empower all of the stakeholders in the capitalist system with the opportunity to thrive in a system of mutually beneficial value. But if this method of persuasion as opposed to compulsion is to be successful, significant assets will need to be redirected toward conscious capitalists. Indeed, I believe that for all of the societal and economic benefits that accrue from companies who practice this business model, investing in support of Conscious Capitalism or the Multi-stakeholder Management System should grow as large if not larger than the SRI strategy. Currently, depending on how you calculate the numbers that’s more than three trillion USD.
Expand Your Research Paradigms:
Investment managers need to work to create the next level of investment analysis; one that transcends both the current notion of fundamental as well as the current notion of Socially Responsible Investing. Gaining a real understanding of not just the balance sheet or P&L, but of the important and real intangible assets that are the foundation of the underlying health of the businesses in which you invest. This is hard work but in the end it gives investors a much clearer picture of the business in its entirety. Identifying real tangible risks and opportunities for explosive growth.
In order for a catalyst to take hold, people need to see it, hear it, feel it and touch it. Celebrate and let it be known that you support these types of companies. Revel in your contrarian positions and become an evangelist for Conscious Capitalism.
Transparency Version 2:
Investing this way is going to be a leap of faith for some of your clients in the beginning. Faith requires trust…so give them as many reasons to trust as possible. How? Act like conscious capitalists; create reasonable fee structures based on your real costs and let your clients understand what those costs are; give up on lock-up periods, tell your clients they can have their money at anytime if they are unhappy with your performance; be as transparent as possible with your clients as to the nature of your positions and don’t penalize everyone because you’re guarding against that one client who may take advantage of you.
When friends ask my colleagues and I what we think caused the recent financial crisis, our response often takes them by surprise. - the people involved simply didn’t care about, or for, each other. Mortgage brokers cared more about short-term profits than their customers’ ultimate ability to pay. Wall Street players, who then packaged those loans for investors, didn’t care about the impact on those investors due to the fact they were selling securities that looked risk-free when they clearly knew otherwise. As the sub-prime market began to implode and investors started to see the writing on the wall, the fire spread to other asset classes that had nothing to do with mortgages. Reassessment of risk on one asset class led to reassessment of risk on all asset classes. The lesson here is that capitalism is an eco-system – an ecology of supply and demand, production and support, financing and consumption. Without a soul and a sense of shared humanity, that eco-system becomes unstable and we all bear the risk. The pursuit of profit, unmoored from a higher societal purpose creates an environment where this type of behavior can flourish. As long as this is the norm we can expect more Enrons and Worldcoms; more Bernie Maddoffs and bank bailouts; more TARP programs more bubbles and more busts. Conscious Capitalism is a game-changing and unifying concept that has the power to put us back on track, moving towards an age of prosperity and abundance. It provides a platform to reinvigorate capitalism with a sense of shared purpose while also being the most effective way of providing long-term value for shareholders. If Conscious Capitalism is to flourish, investment managers, investors and conscious capitalists all must work to evolve the eco-system and usher in the age of Capitalism 2.0.