Journal of APPLIED CORPORATE FINANCE

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1 VOLUME 27 NUMBER 2 SPRING 2015 Journal of APPLIED CORPORATE FINANCE In This Issue: Sustainability and Shareholder Value Meaning and Momentum in the Integrated Reporting Movement 8 Robert G. Eccles, Harvard Business School, Michael P. Krzus, Mike Krzus Consulting, and Sydney Ribot, Independent Researcher Sustainability versus The System: An Operator s Perspective 18 Ken Pucker, Berkshire Partners and Boston University s Questrom School of Business Transparent Corporate Objectives A Win-Win for Investors and the Companies They Invest In 28 Michael J. Mauboussin, Credit Suisse, and Alfred Rappaport, Kellogg School of Management, Northwestern University Integrated Reporting and Investor Clientele 34 George Serafeim, Harvard Business School An Alignment Proposal: Boosting the Momentum of Sustainability Reporting 52 Andrew Park and Curtis Ravenel, Bloomberg LP Growing Demand for ESG Information and Standards: Understanding Corporate Opportunities as Well as Risks 58 Levi S. Stewart, Sustainability Accounting Standards Board (SASB) ESG Integration in Corporate Fixed Income 64 Robert Fernandez and Nicholas Elfner, Breckinridge Capital Advisors The Science and Art of High Quality Investing 73 Dan Hanson and Rohan Dhanuka, Jarislowsky Fraser Global Investment Management Intangibles and Sustainability: Holistic Approaches to Measuring and Managing Value Creation Tracking Real-time Corporate Sustainability Signals Using Cognitive Computing 87 Mary Adams, Smarter-Companies 95 Greg Bala and Hendrik Bartel, TruValue Labs, and James P. Hawley and Yung-Jae Lee, Saint Mary s College of California Models of Best Practice in Integrated Reporting Robert G. Eccles, Harvard Business School, Michael P. Krzus, Mike Krzus Consulting, and Sydney Ribot, Independent Researcher

2 VOLUME 27 NUMBER 2 SPRING 2015 In This Issue: Sustainability and Shareholder Value A Message from the Editor 2 Executive Summaries 4 Meaning and Momentum in the Integrated Reporting Movement 8 Robert G. Eccles, Harvard Business School, Michael P. Krzus, Mike Krzus Consulting, and Sydney Ribot, Independent Researcher Sustainability versus The System: An Operator s Perspective 18 Ken Pucker, Berkshire Partners and Boston University s Questrom School of Business Transparent Corporate Objectives A Win-Win for Investors and the Companies They Invest In 28 Michael J. Mauboussin, Credit Suisse, and Alfred Rappaport, Kellogg School of Management, Northwestern University Integrated Reporting and Investor Clientele 34 George Serafeim, Harvard Business School An Alignment Proposal: Boosting the Momentum of Sustainability Reporting 52 Andrew Park and Curtis Ravenel, Bloomberg LP Growing Demand for ESG Information and Standards: 58 Understanding Corporate Opportunities as Well as Risks Levi S. Stewart, Sustainability Accounting Standards Board (SASB) ESG Integration in Corporate Fixed Income 64 Robert Fernandez and Nicholas Elfner, Breckinridge Capital Advisors The Science and Art of High Quality Investing 73 Dan Hanson and Rohan Dhanuka, Jarislowsky Fraser Global Investment Management Intangibles and Sustainability: Holistic Approaches to Measuring and Managing Value Creation 87 Mary Adams, Smarter-Companies Tracking Real-time Corporate Sustainability Signals Using Cognitive Computing 95 Greg Bala and Hendrik Bartel, TruValue Labs, and James P. Hawley and Yung-Jae Lee, Saint Mary s College of California Models of Best Practice in Integrated Reporting Robert G. Eccles, Harvard Business School, Michael P. Krzus, Mike Krzus Consulting, and Sydney Ribot, Independent Researcher

3 A Message from the Editor This is the third issue of the JACF devoted to what we are calling sustainable financial management. Like the past two issues, this one is also the result of a collaboration with Bob Eccles of the Harvard Business School. (Bob recently completed a four-year stint as Founding Chairman of the Sustainability Accounting Standards Board a position now filled by Michael Bloomberg and Vice Chair Mary Shapiro, who recently stepped down as Chairwoman of the SEC.) And before saying more about this issue, let me mention that Bob and I have decided to revisit this subject of sustainable management in each Spring issue for the foreseeable future. Why so much attention to this subject? As I wrote three years ago when introducing the first in our series, The globalization of business during the past 20 or 30 years, together with the growing evidence of climate change and the recent worldwide financial crisis, has intensified the popular demand for business to play a larger role in addressing environmental and social problems. And adding to the challenge faced by corporate CEOs, as I said when introducing the second in the series, Even as companies are being asked to devote more resources to protect the environment and support local communities, our capital markets continue to exert more pressure for increases in operating efficiency and returns on capital. All of which raises the question: how can companies make significant contributions to sustainability while maintaining enough profitability and value to keep attracting the investor capital that will enable them to sustain themselves? The contributors to our first sustainability issue were a mix of academics and practitioners whose main focus was corporate programs designed to protect the environment while at the same time preserving or, in some cases, even increasing value for shareholders. Among the most memorable was an article in which the CFO of American Electric Power, the largest emitter of CO 2 in North America, teamed up with an MIT Ph.D. student to explain the rationale for and workings of the company s highly successful stakeholder management program a program that has been well received by equity analysts and institutional shareholders as well as the regulators and consumers most directly engaged by it. The focus of the second of the series was large influential investors and the growing role of ESG (short for environmental, social, and governance) criteria and information in their decision-making. One of the main messages of that issue is the potential for public companies to find partners among a small but distinguished group of business value investors who have made ESG analysis a critical part of their stock valuation process, and who are predisposed to see significant economic value being created through corporate ESG investments. Reinforcing this message, an article in that issue called ESG Investing in Graham & Doddsville makes a persuasive case that the world s best-known business value investors starting with Graham and Dodd in the 1930s, and including their best-known disciple Warren Buffett have long incorporated what we would today describe as social and governance considerations into their investment decisions. As presented in both of these issues, sustainable financial management means making significant investments of management s thought and energy and, in many cases, investor capital. Although the returns from some ESG investments show up fairly quickly in corporate P&Ls, the main purpose of most other initiatives is to strengthen the commitment of non-investor corporate stakeholders employees, suppliers, regulators, and local communities all with the ultimate aim of increasing a company s long-run value and staying power. For corporate managements, committing to such investments can be a challenge since many of them require difficult trade-offs between shareholders and stakeholders and what appear to be sacrifices of value, at least in the near term. Having made investments that are likely to reduce their reported earnings for a while, CEOs and boards must work hard to explain those decisions to the markets. Think about Wal-Mart s recent decision to raise employee wages, which the company s CFO in a recent earnings call described as an investment. In cases like this, management must succeed in gaining the confidence and commitment of a group of investors who are not only responsive to the ideals that inform these decisions, but also sophisticated and far-sighted enough to see the possibility of combining social and economic goals in this way. And that brings us to the main focus of this issue the promise of integrated reporting in helping companies communicate with and attract long-term, business value investors the kind who buy large stakes in a company s shares and hold them for years if not decades. These are the kinds of investors who are likely to place higher values on companies that commit to making ESG investments and, by so doing, to provide managements with the confidence to carry them out. 2 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

4 But what do we mean by integrated reporting, and in what sense is it new? After all, since the late 1990s many of the world s largest multinationals have been producing sustainability reports touting their environmental and social activities and accomplishments and in fact, almost 90% of S&P 500 companies filed such reports in First of all, although sustainability reports contain lots of information about corporate environmental and social programs, such reports are issued separately from and generally three to six months after their required financial statements. More important, the tendency of such reports is to catalogue all corporate initiatives, with almost no attempt to identify their relative importance or expected effects on corporate profits and market values. By contrast, the goal of integrated reporting is to get large organizations to produce reports that include in their financial statements detailed accounts of just their material environmental and social risks and of their plans and efforts to manage them while demonstrating the expected effects of both on long-run profitability and value. In other words, the main focus of integrated reporting is the link between ESG investments and shareholder value. Or such is true at least of the version of integrated reporting that is now being promoted by the International Integrated Reporting Council (IIRC), a global nonprofit coalition of financial institutions and investors that was formed in In 2013 the IIRC published an <IR> Framework that provides a set of guidelines for companies intent on producing integrated reports. And with the help of this framework, the IIRC has established a pilot program that now includes more than 140 large multinational companies supported by a network of some 35 IIRC-vetted long-term investors. But in addition to the IIRC framework, there are a large number of less value-oriented versions of integrated reporting. And in our lead article, Bob Eccles, Mike Krzus, and Sydney Ribot, the authors of the first book-length study of integrated reporting, argue that the best way to ensure the continuation of the IR movement s current upward trajectory is for the many NGO participants, if not to adopt the IIRC s framework and set of standards, then at least to aim for some degree of consistency with them. As one example of constructive variation, the authors hold up the SASB as a U.S. version of the IIRC approach that is largely consistent with it (and another article in this issue provides a nice illustration of how SASB standards have improved ESG disclosure in the U.S. processed foods industry). What can we expect the IR movement to accomplish, and how will we know if it s working? As stated earlier, the main answer provided in this issue is that integrated reporting, by helping companies to communicate the value proposition underlying their ESG investments, should help them attract the longer-term, business value investors who are likely to place higher values on companies that find ways to make such investments. And in an article in this issue called Integrated Reporting and Investor Clientele, HBS professor George Serafeim presents the findings of his recent study showing that companies filing sustainability reports during the past decade have indeed experienced significant increases in the proportion of dedicated holders institutional investors with smaller numbers of (large) equity positions and long holding periods in their shareholder base. To the extent that integrated reporting represents an advance over sustainability reporting, this investor migratory pattern should become only more pronounced over time. And that will be good news for companies with value-based ESG programs. One last note: In keeping with the mission of the JACF to provide a bridge between the theory and practice of finance, we recently reached an informal agreement with the McCombs School of Business at the University of Texas to provide regular coverage of the many interesting conferences sponsored by McCombs School centers that include the following: the Hicks, Muse, Tate & Furst Center for Private Equity Finance; the Energy Management and Innovation Center; the Real Estate Finance and Investment Center; and the AIM Investment Center. Along with the annual Alternative Investments conference, which is sponsored jointly by these four organizations, the best-known events are the annual conference on Private Equity, hosted by the Hicks, Muse, Tate & Furst Center, which is directed by finance department chairman Bob Parrino; and the annual conference on Energy Finance, hosted by the Energy Management and Innovation Center, which is directed by Sheridan Titman. Professors Parrino and Titman have been frequent contributors to the JACF over the years and they, along with their UT colleague and corporate governance authority, Laura Starks, have agreed to join our editorial advisory board. We look forward to this new collaboration. The next four issues will be devoted to the following: (1) activist investors and corporate management; (2) German capital markets and corporate governance; (3) enterprise risk management; and (4) sustainable financial management. Manuscripts should be sent to me at don.chewnyc@gmail.com. DHC Journal of Applied Corporate Finance Volume 27 Number 2 Spring

5 Executive Summaries The Integrated Reporting Movement: Meaning, Momentum, Motives, and Materiality Robert G. Eccles, Michael P. Krzus, and Sydney Ribot In this summary of their recently published book, the authors provide an update of the state of the integrated reporting (or <IR>) movement, whose aim is to persuade companies to provide fuller disclosure of material nonfinancial (or ESG ) factors and how they are likely to affect the organization s ability to create value over time. After noting that <IR> proponents are focusing their efforts on a combination of market and regulatory approaches, the article offers four recommendations to accelerate the widespread adoption of <IR> principles and practices: 1. The International Integrated Reporting Council should establish a process for companies to get voluntary certification of whether their integrated report and website qualify as integrated reporting according to the IIRC. 2. Members of the integrated reporting movement should establish a global strategy to speed the adoption of integrated reporting, while adapting the strategy to country and sector requirements. 3. The Big Four firms should work with other accounting firms and professional accounting associations to create awareness and understanding of integrated reporting among their clients and to develop assurance standards for integrated reporting. 4. CDP, GRI, IIRC, and SASB should work together to explain to companies, investors, and other stakeholders how their missions relate. Sustainability versus The System: An Operator s Perspective Ken Pucker After describing the pioneering efforts and initial successes of Timberland in measuring and managing its environmental imprint, a former Chief Operating Officer of the company discusses the limitations of those successes and the challenges that continue to confront corporate attempts to address environmental problems. Despite opportunities to improve corporate ESG performance by leading through the lens of sustainability, few companies seem to be taking advantage of them. And those that are leading a shift toward sustainable management appear to be making only modest gains. In reflecting on his 15 years at Timberland, the author concludes that the main obstacles to progress are systemic, including a timing mismatch between market cycles and quarterly reporting, the absence of mechanisms to capture and price externalities, and a gap between consumers stated intentions and their actual purchasing behavior. To address these challenges, the author recommends a number of potential solutions, including: (1) internalizing externalities through taxes and regulations that effectively charge corporations for carbon emissions; (2) widespread adoption of integrated reporting, in which companies provide as part of their financial statements an accounting for the social costs and benefits of their operations; and (3) other possible innovations in financial communication that can help companies attract investors with longer-term holding periods and horizons. Transparent Corporate Objectives A Win-Win for Investors and the Companies They Invest In Michael Mauboussin and Al Rappaport The continuing debate about the primacy of shareholders versus stakeholders fails to address the essential problem in current corporate governance. Neither companies that claim to prioritize the interests of shareholders nor those that claim to prioritize the interests of stakeholders operate with a transparent governing objective that communicates what they are fundamentally trying to achieve. As a consequence, managers have no sound basis to make decisions; and without knowing how managers decide, boards and investors are finding it difficult to hold them accountable for what they decide. Boards of directors, investors, and proxy advisory firms have no effective benchmark for evaluating a company s resource allocation decisions and its performance. And as a consequence of all this, investors find it unnecessarily difficult to assess investment risk when valuing shares. The authors propose that companies follow three essential steps to create a more efficient market for corporate governance. First, companies should choose a clear governing objective. Second, companies should commit to a set of policies, including the use of financial and non-financial metrics in performance evaluation and incentive compensation plans that encourage behavior consistent with the governing objective. Managements of stakeholder-centric companies may prioritize an objective other than creating shareholder value, but they need to disclose the acceptable limit for trade-offs 4 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

6 they are willing to make at the expense of their shareholders. Third, companies should publicly disclose the chosen governing objective. This includes the time horizon the company will use in its planning and decision-making processes, as well as its policy for resolving trade-offs when the interests of stakeholders conflict with one another. Integrated Reporting and Investor Clientele George Serafeim Although corporate executives often complain about investor short-termism, they have only recently begun to actively manage the composition of their shareholder base in ways designed to attract longer-term investors. This article argues that given the difficulties in forecasting performance over long time horizons, companies that want to attract long-term investors may find it helpful to communicate information about ESG policies and other indicators of management s time horizon that can be especially important when assessing long-run corporate profitability and value. In support of this hypothesis, the findings of the author s recent study show that companies that have practiced some version of sustainability or integrated reporting for the past decade or so have succeeded in increasing the proportion of longer-term investors in their shareholder base. Moreover, as might be expected, this effect of integrated reporting has been most pronounced for certain kinds of companies: (1) those with higher price-to-book ratios, whose total value is thus more heavily weighted toward future growth opportunities than current operations value ; (2) those currently facing strong social pressure to respond to perceived social problems; (3) those with dispersed ownership (as opposed to family-owned and other closely held companies, whose concentrated ownership is believed to help overcome the time horizon problem); and (4) those demonstrating a consistent commitment to integrated reporting practices. Also attracting longer-term investors are companies that provide more information about the six forms of capital identified by the IIRC as critical to corporate success (along with financial capital, the others are natural, human, intellectual, manufacturing, and social relationships ) while adhering to other of the IIRC s guiding principles. As the author sums up the main message of his study, companies with effective ESG programs have the power and means to change their shareholder base in ways that can help insulate management from pressure for short-term performance at the expense of long-term value, including corporate investments in sustainability initiatives. An Alignment Proposal: Boosting the Momentum of Sustainability Reporting Andrew Park and Curtis Ravenel In an article published in this journal three years ago, the authors described the challenges of integrating sustainability information primarily environmental, social, and governance ( ESG ) data into mainstream investment decision-making. Part of the discussion touched on the critical role of standards and disclosure of ESG data in enhancing its comparability and completeness. In this article, the authors focus on the community of non-profit organizations dedicated to standardizing sustainability reporting, arguing that while the proliferation of disclosure frameworks reflects the growth of the space, it also signals a need to examine whether market confusion stemming from multiple organizations with overlapping missions could at this point be undermining market uptake. There are a number of questions yet to be resolved: What does materiality mean? What is the geographic scope of different reporting frameworks? And which frameworks are best suited to which audiences investors, regulators, or other stakeholders? Writing from Bloomberg LP s unique perspective as an independent data provider positioned between issuers and investors, the authors provide a view of how an alignment process to reduce this market confusion could unfold, thereby creating greater coordination among these organizations and clarifying overlapping concepts and terms. Against the broader backdrop of the global sustainable finance movement, the authors argue that such an alignment process could help maintain the momentum of sustainability reporting with an eye towards making capital markets more efficient through greater transparency. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

7 Executive Summaries Continued Understanding Corporate Performance: Investor Demand for ESG Standards Levi S. Stewart For decades if not centuries, information about corporate governance and the environmental and social effects of corporate activity have arguably played an important role in investors decision-making. But today more than ever, investors are using such information less as a screen to disinvest in companies whose activities are viewed as anti-social or unethical than as a way of anticipating changes in corporate performance and value, including those resulting from new growth opportunities as well as risk exposures arising from ESG issues. With numerous studies having established a positive relationship between ESG information and corporate operating performance and market values, there is growing demand by investors for effective disclosure of this information. In response to this demand, a number of organizations, including the Sustainability Accounting Standards Board (SASB), the CDP (formerly the Carbon Disclosure Project), the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC), CERES, and the UN Principles for Responsible Investment (UNPRI), have been established to improve the usefulness of ESG disclosures. SASB in particular has made considerable progress in achieving its mission of establishing industry-specific standards for disclosure of material ESG information in corporate 10-K and 20-F filings. Using a selection of SASB s standards for the Processed Foods industry, the author shows how standardized ESG disclosure can contribute to investors analysis of the risks, opportunities, and general business environments in which corporations operate. The Processed Foods industry is of special interest because of its position at the center of two global megatrends. Confronted with growing concern over the water-food-energy nexus and increasing awareness of diet-related non-communicable diseases, the industry faces two major sources of risk and opportunity. As examples of the latter, the author cites a recent call by Campbell s Soup with investors noting its sales growth of organic products of 9% during the past year as well as a statement by General Mills in its 2015 Global Responsibility report citing its development of more than 300 certified organic products. ESG Integration in Corporate Fixed Income Analysis Robert Fernandez and Nicholas Elfner In this account of their firm s bottom-up credit research approach to investing in corporate bonds, the authors argue that in-depth fundamental analysis plays a critical role in the ability of Breckenridge Capital Advisors to carry out its primary investment mandate of preserving capital, building sustainable sources of income, and seeking opportunistically to improve total return. Not surprisingly, the firm s credit analysts are particularly sensitive to the goal of limiting credit risk. But as the authors also report, the firm s emphasis on risk management coupled with its long-standing commitment to fundamental credit research made its decision to integrate ESG into its investment process in 2011 a natural one that, in the authors words, has enhanced our efforts to mitigate and appropriately price risk. Other important advantages of ESG analysis include the low positive correlation of ESG ratings with Moody s ratings as well as the steadily growing importance of ESG management and sustainability in corporate strategy. Finally, both the firm s credit research and its ESG analysis have been strengthened by its practice of periodic engagement calls with its corporate borrowers. The firm believes that such engagement leverages its voice as a stakeholder to bring greater focus on the borrower s stewardship of investor capital. During these discussions, the firm s analysts gain a better understanding of the credit and ESG profiles of the borrowers of their material issues and the risks and opportunities that arise from them. In sum, the firm s integration of ESG into its credit analysis reflects its belief that a company that works to manage its material ESG risks and create value for all its stakeholders may be a more stable credit and a better investment for its clients. The Science and Art of High Quality Investing Dan Hanson and Rohan Dhanuka Most of the popular quality investing metrics have limited effectiveness in predicting stock returns, and have showed little persistence. In some cases historically effective signals have been arbitraged away. One exception is high ROIC, which is a quality metric associated with positive alpha and whose predictive power persists over a three-year period. 6 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

8 The authors also attempt to examine the predictive power of non-financial metrics, such as indicators of corporate culture, integrity, and ESG-related KPIs. The authors main finding is that such indicators appear to be strongly correlated with indicators of effective corporate governance, as well as persistently high ROICs. While the intersection of financial and nonfinancial metrics may provide clues to potential future high quality corporate performance, constructing a persistently high-quality investment portfolio relies ultimately on the art of forward-looking judgmental analysis. Intangibles and Sustainability: Holistic Approaches to Measuring Value Creation Mary Adams The intangibles and sustainability movements have been developing in parallel. Today, these movements are increasingly understood as interconnected phenomena, especially with the increased adoption of integrated reporting. The author of this paper describes how the frameworks of the two movements fit together using the integrated reporting framework, and then examines how an integrated model can be used to develop a holistic view of a company s value creation system and how that system can be measured using a combination of macroeconomic and firmspecific data. Tracking Real-time Corporate Sustainability Signals Using Cognitive Computing Greg Bala, Hendrik Bartel, James P. Hawley, and Yung-Jae Lee The authors argue that what is known as big data analytics using cognitive computing a set of capabilities and techniques that include natural language processing, machine learning, and artificial intelligence can be applied to the analysis of corporate environmental, social, and governance issues. The use of such technology has the potential to greatly expand the scale and reach of the ESG research that is now done almost entirely by human analysts. The primary output of such analysis takes the form of multiple real time data points, or dynamic sustainability signals, which in turn can be subjected to a form of quantitative analysis called sustainability trend analysis. The authors illustrate this analysis with an example of 12 companies tracking trends in the effectiveness of their employee engagement practices. Using data spanning a six-month period, the authors report finding (statistically) significant shortterm variations in environmental and social indicators with potentially material effects on value. Models of Best Practice in Integrated Reporting 2015 Robert G. Eccles, Michael P. Krzus, and Sydney Ribot In March of this year (2015), the authors reviewed the integrated reports of 25 multinational companies that participated in the International Integrated Reporting Council s (IIRC s) Pilot Programme Business Network. Because it was not until December 2013 that companies had any form of guidance for how to prepare an integrated report (from the International <IR> Framework), 2014 was the first reporting year in which this framework could be applied. The authors undertook this review using early reports available in the first quarter of 2015 by companies from a variety of countries and sectors. This article provides a brief summary of the approaches and quality of this first batch of reports, as well as a sampling of best practices. The authors assumed that there are three main distinguishing features of a truly integrated report that is, a report that makes ESG considerations an integral part of corporate strategy and performance: (1) an explanation of a company s value creation strategy and how it uses and affects the IIRC s concept of six capitals (Financial, Manufactured, Intellectual, Human, Social and relationship, and Natural); (2) a clear and detailed explanation of the relationships between financial and nonfinancial performance; and (3) identification and effective presentation of the material ESG risks and opportunities facing the company. If clarifying the link between corporate strategy and ESG risks is a hallmark of the best integrated reports, the holy grail is Connectivity of information : the extent to which a report succeeds in quantifying the relationship between a company s ESG performance, its profitability, and its value proposition. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

9 Meaning and Momentum in the Integrated Reporting Movement by Robert G. Eccles, Harvard Business School, Michael P. Krzus, Mike Krzus Consulting, and Sydney Ribot, Independent Researcher* M any exciting developments have taken place since we published the first book on integrated reporting five years ago. We called the book One Report: Integrated Reporting for a Sustainable Strategy. Our main argument was that companies needed to better understand and report on the relationship between their financial performance and their environmental, social, and governance (ESG) performance. This connectivity of information is the essence of integrated reporting. Although ESG performance is often referred to as nonfinancial performance, a number of ESG factors are increasingly affecting companies financial performance and thus their ability to create value for their shareholders over the long term. Shareholders and other stakeholders want to know what companies consider to be their material ESG issues, and what they are doing to manage them. The problem, however, is that both the companies that are providing this information and the investors and others who would use it have been hampered by the absence of general measurement standards and reporting requirements of the kind that have long governed and guided financial disclosure. In the case of financial reporting, such a measurement and reporting infrastructure has been in place for decades, with, of course strong support from the state. Without such reporting infrastructure, we wouldn t have the deep and liquid capital markets that we have today. But without the equivalent infrastructure for nonfinancial performance and an understanding of how it is related to financial performance, we may not have the capital markets we need to support the society we want today and in the future. Fortunately, some exciting developments have occurred in the past four years that are helping to put in place the infrastructure necessary to support high-quality integrated reporting. The International Integrated Reporting Council (IIRC) was formed in 2010 with the declared aim of making integrated reporting part of mainstream business practice in the public and private sectors. 1 The Sustainability Accounting Standards Board (SASB), whose mission is to develop and disseminate sustainability accounting standards that help public corporations disclose material, decision-useful information to investors, 2 was started a year later. In 2012, the Climate Disclosure Standards Board (CDSB) updated its 2010 Climate Change Reporting Framework. And in 2013, Global Reporting Initiative (GRI) released its G4 guidelines to help reporters prepare sustainability reports that matter. 3 Thanks to these developments, integrated reporting is becoming a powerful management process that supports integrated thinking and strategic planning. The goal of such planning is to help companies address pressing environmental, social, and governance issues in ways that enable them to prosper over the long term to the benefit of both their shareholders and society at large. In the rest of this article, we provide excerpts from our second book on integrated reporting, which was published in November We decided to write a second book for two main reasons. The first was to offer our view of how the abovementioned (as well as other) organizations are contributing to the momentum of the integrated reporting movement and we identify it as a movement in part because all of these organizations are nonprofit organizations with no financial or political backing from the state. And it is this absence of state support that is the basis of the second main reason for writing another book: namely, to present specific recommendations to accelerate the widespread adoption of integrated reporting. We begin by discussing what we identify as the four phases of meaning in the integrated reporting movement, a movement whose beginnings are traced to the early 2000s. Next, we describe the main sources of momentum for the movement. In the third and final section we make four specific recommendations aimed at accelerating this momentum and bringing about the widest possible adoption of integrated reporting. The Four Phases of Meaning We view the integrated reporting movement as evolving through four continuous, overlapping phases, each conveying a somewhat different meaning and message to a somewhat different, though steadily growing, audience (see Figure 1). The first phase is identified with the efforts of a handful of public companies in the early 2000s to produce their first integrated report. This development, which we refer to as company experimentation, represents the initiation into practice of the idea of integrated * The Integrated Reporting Movement: Meaning, Momentum, Motives, and Materiality; Robert G. Eccles, Michael P. Krzus, and Sydney Ribot: Copyright 2014 John Wiley & Sons, Inc. Excerpts reprinted with permission of John Wiley & Sons, Inc accessed April accessed April accessed April Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

10 Figure 1 Four Phases in the Evolution of Integrated Reporting Meaning Company Experimentation Novozymes (2002) Natura (2002) Novo Nordisk (2004) Expert Commentary New Wine in New Bottles (2005) Integrated reporting: Issues and implications (2005) One Report (2010) Codification IRC of South Africa Discussion Paper (2011) IIRC Consultation Draft (2013) International <IR> Framework (2013) Institutionalization King III (2009) EU directive on non-financial reporting (2014) UN Sustainable Development Goals (targeted for 2015) reporting. The second phase, which we call expert commentary, was launched by consultants, academics, and other experts who began to establish basic principles of integrated reporting based on their observations of corporate practices. Featuring lessons about the costs, benefits, and challenges of integrated reporting and how to overcome them, this theory-building phase started in the mid-2000s. The beginning of the third phase, codification, takes place in the late 2000s when NGOs begin to work with companies, investors, and accounting firms to develop frameworks and standards. The fourth and most recent phase, which we call institutionalization, consists of efforts launched in the past few years by many of the same groups to influence both the regulatory and the market environment to make them more conducive to the practice of integrated reporting. The main focus during this phase has been on formulating voluntary codes of conduct and, in some instances, encouraging the passage of regulations and laws. Company Experimentation: Examples from the First Integrated Reports Like many new management ideas, integrated reporting was begun by corporate practitioners. 4 When companies began to produce integrated reports in 2002, the idea of combining financial and nonfinancial data in a meaningful way arose independently and simultaneously. The earliest integrated reporters were two Danish companies, Novozymes and Novo Nordisk, and a Brazilian company, Natura. Each of these three companies offered essentially the same reason for the change: sustainability issues had become essential to the long-term success of the business, and integrated reporting was the best way to communicate this new reality. The value of an integrated report lay in its capacity to help a company demonstrate to its investors that it was managing sustainability from a business perspective, and that such corporate investments, aimed in part at addressing environmental and social problems material to the company, did not merely represent transfer payments from shareholders to stakeholders. Because integrated reporting was a new practice, general understanding of what it meant or represented was quite limited as investors struggled to understand the content of an integrated report. As a consequence, further questions arose about the content and structure of such reporting. Although the then newly organized Global Reporting Initiative (GRI) was providing companies and investors with guidance on sustainability reporting, there was nothing at that time to guide companies intent on preparing integrated reports. Expert Commentary: The First Reflections on Integrated Reporting Not long after the first integrated reports were published, a think tank, a consulting firm, and an academic working with an accountant began to reflect on the experiences of the pioneering companies. In 2005 two publications, an article 5 and a report by a consulting firm 6 that appeared within a few months of each 4. Mol, Michael J. and Julian Birkinshaw. Giant Steps in Management. London: Financial Times Prentice Hall, 2007, pp. 2, 3 and Bloomberg Business. A History of Big Ideas, accessed May White, Allen L. New Wine, New Bottles: The Rise of Non-Financial Reporting. A Business Brief by Business for Social Responsibility, 2005, accessed May Although White s piece primarily focused on nonfinancial reporting, he explicitly mentioned the term integrated reporting. He did not specifically define the concept but described it as embryonic compared to the pre-adolescence stage of nonfinancial reporting. 6. Solstice Sustainability Works, Inc. Integrated reporting: Issues and implications for reporters, August 2005, accessed January The report defined integrated reporting as a fusion of financial and sustainability reporting into a single document: The working definition of integrated reporting for this research was reporting that meets the needs of both statutory financial reporting and sustainability reporting. In practical terms, this will usually mean one annual report containing sustainability performance information and financial statements. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

11 other, initiated the second phase of meaning for the movement: expert commentary. 7 Five years later, the first book on integrated reporting was published by two of the present writers. 8 Although each of these three publications provided a somewhat different definition of the concept of integrated reporting, they all identified the benefits and challenges facing companies adopting it, and made suggestions about what would be needed to be done to bring about large-scale adoption of the practice. Codification: Creating Common Meaning Following the efforts of individual companies or commentators to formulate and express their own views, the next phase in defining the meaning of integrated reporting involved the emergence of bodies with sufficient authority and influence to set up a multi-stakeholder process whose aim is to produce an agreed-upon meaning of the concept of integrated reporting a concept that can then be supported by principles and guidelines for implementation. If the authoritative body that establishes the meaning of integrated reporting is an organ of the state, the legitimacy and acceptance of the concept is assured. But if the standard-setting body is an NGO or other private organization, then other organizations are of course free to decide whether to adopt this view or not. The degree of credibility necessary for codification to occur will depend upon the perceived legitimacy of the process for fashioning it, as well as the expertise, status, and influence of the individuals and organizations involved in the process. The first attempt at codification was a Framework for Integrated Reporting and The Integrated Report Discussion Paper 9 that was produced in 2011 by the Integrated Reporting Committee of South Africa a multi-stakeholder group. An integrated report, as defined in the paper, tells the overall story of the organisation. It is a report to stakeholders on the strategy, performance and activities of the organisation in a manner that allows stakeholders to assess the ability of the organisation to create and sustain value over the short-, medium- and long-term. An effective integrated report reflects an appreciation that the organisation s ability to create and sustain value is based on financial, social, economic and environmental systems and the quality of its relationships with stakeholders. 10 The second major codification effort and the most globally significant one to date was The International <IR> Framework (<IR> Framework), which was published in December 2013 by the International Integrated Reporting Council (IIRC). 12 Based on a foundation of seven Guiding Principles and eight Content Elements, the <IR> Framework s definition of an integrated report was very similar to that of South Africa s IRC. An integrated report, it says, is a concise communication about how an organization s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value over the short, medium and long term. 11 But unlike the South African version, the IIRC s 37-page Framework does not present an integrated report as a fusion of a financial report and a sustainability report. In fact, the word sustainability appears only three times in the IIRC document. 12 Sources of Momentum Although the universal adoption of integrated reporting is by no means assured or inevitable, its current trajectory is encouraging. Though less mature than sustainability reporting, integrated reporting is at its core a social movement. 13 When put into practice by companies and used by the audience of investors as well as other important corporate stakeholders, it has the potential to transform the way resource allocation decisions are made inside companies and markets across the globe. Its social goal is to use corporate reporting as a means to influence both companies and investors in such a way that they consider the consequences of the positive and negative externalities associated with corporate investment and operating decisions (particularly those that concern the social and environmental issues that generally come under the rubric of sustainability 14 ), all the while recognizing the growing importance of intangible assets such as corporate brand and reputation. A critical step in realizing such goals is success in fostering longer-term corporate thinking strategic planning that takes explicit account of all six 7. Given the timing of the White and Solstice papers, it is highly unlikely that either author knew about the other s work. This is yet another example of how separate events occur simultaneously when an idea s time has come. 8. Eccles and Krzus, One Report: Integrated Reporting for a Sustainable Strategy, The Integrated Reporting Council of South Africa Discussion Paper, published in January 2011, should not be confused with the IIRC Discussion paper, which was released in September Integrated Reporting Committee of South Africa. Framework for Integrated Reporting and the Integrated Report, January 25, Portals/0/IRC%20of%20SA%20Integrated%20Reporting%20Guide%20Jan%2011. pdf, accessed January International Integrated Reporting Council. <IR> Framework, p. 7, theiirc.org/international-ir-framework/, accessed May The first mention seems to refer to the sustainability of the capital markets: The cycle of integrated thinking and reporting, resulting in efficient and productive capital allocation, will act as a force for financial stability and sustainability. Ibid. p. 2. The second time is to emphasize that an integrated report is more than producing a single report that contains information on both financial and sustainability performance: An integrated report is intended to be more than a summary of information in other communications (e.g., financial statements, a sustainability report, analyst calls, or on a website); rather, it makes explicit the connectivity of information to communicate how value is created over time. Ibid. p. 8. The third time is in saying that information in the integrated report should be compatible with information in other reports: For example, when a KPI covers a similar topic to, or is based on information published in the organization s financial statements or sustainability report, it is prepared on the same basis, and for the same period, as that other information. <IR> Framework, p Encyclopedia Britannica. Social Movement, accessed January Sustainability has many definitions. For us, we focus on defining it from the perspective of a company. A sustainable strategy is one that enables a company to create value for its shareholders over the long term while contributing to a sustainable society. It is one that can meet the needs of the present generation without sacrificing those of future ones. 10 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

12 Figure 2 Number of GRI Reporters Data Source: Global Reporting Initiative. Excel Spreadsheet of Sustainability Disclosure Database. of the different forms of capital (financial, manufactured, natural, human, intellectual, and social and relationship) that companies make use of and impact in the process of creating value. We evaluate the momentum of integrated reported using three criteria: adoption, accelerators, and awareness. Because the company is the unit of analysis for integrated reporting, we use its adoption by companies outside of South Africa, the only country in which integrated reporting is mandatory, as a litmus test of the movement s progress. Accelerators of momentum include regulation, multi-stakeholder initiatives and organizations, and endorsements of integrated reporting by prominent organizations and individuals. 15 Finally, awareness reflects the extent to which integrated reporting has received broad visibility in the business world and public sphere. Accelerators help to speed the adoption of integrated reporting, which in turn works to raise the level of awareness. Adoption While it is difficult to assess the number of companies that have embraced integrated reporting or the rate at which this is happening, we have found three rough indicators of the level of adoption: (1) the increasing number of corporate sustainability reports; (2) the small but growing number of self-declared integrated reports; and (3) the increasing presence in corporate annual reports of information that is clearly consistent with the spirit of integrated reporting. At present, there are two main difficulties in identifying growth in the last two categories: (1) the lack of clear criteria for what qualifies as an integrated report; and (2) difficulty in determining how many annual or other types of reports fit these criteria. Trends in Sustainability Reporting Companies that publish sustainability reports have taken a big step towards voluntary transparency. In many cases, they have implemented systems to gather nonfinancial performance information. For this reason, they represent a pool of candidates that are likely to be receptive to integrated reporting. Most companies that today issue integrated reports have done so only after publishing sustainability reports for a number of years. 16 Although only 1.3% of the world s 46,000 listed companies were self-declared integrated reporters in 2012, 17 many more companies have been producing sustainability reports for years, and their numbers are still growing rapidly (as can be seen in Figure 2). In 1999, only 11 companies produced a sustainability report using GRI Guidelines. By 2012, the number of such reports had grown to 3,704, for a compound annual growth rate of 56.5%. The growth rate in Asia (68.3%) was higher than in Europe (54.0%) and North America (43.5%), indicating a growing interest in sustainability reporting there. According to Peter DeSimone of the Sustainable Investments Institute, although only eight S&P 500 companies issued an integrated report in 2013, 89% (450) of the S&P 500 engaged in sustainability reporting, up from 76% in What s more, in % of the S&P 500 made 15. These accelerators can act both directly and indirectly from a company-push (i.e., encouraging or demanding companies to practice integrated reporting) or demand-pull (e.g., encouraging shareholders, stakeholders, and regulators to call for integrated reporting by companies) perspective. 16. As the relationship between integrated reporting and sustainability is better understood, however, this could change. Using the GRI database, the average number of years a company produces a sustainability report before publishing an integrated report is 2.1. Global Reporting Initiative. Excel Spreadsheet of Sustainability Disclosure Database, accessed April Based on the World Federation of Exchanges, the number of listed companies in 2012 was 46,332. World Federation of Exchanges, 2012 WFE Market Highlights, accessed April Definition: Number of companies which have shares listed on an exchange at the end of the period, split into domestic and foreign, excluding investment funds and unit trusts. A company with several classes of shares is counted just once. Only companies admitted to listing are included. World Federation of Exchanges, Number of Listed Companies definition, accessed April Based on GRI data, 596 companies in 2012 produced integrated reports approximately 1.29% of all listed companies. 18. This includes all companies who voluntarily report sustainability information on their websites, from a policy or two or summaries of practices to full-blown reports with five-plus years of data on key metrics. Peter DeSimone, correspondence with Robert Eccles, January 26, Journal of Applied Corporate Finance Volume 27 Number 2 Spring

13 use of GRI Guidelines, up from 36% in Even in the U.S., the strong trend towards sustainability reporting could provide momentum for integrated reporting. 20 Self-Declared Integrated Reports Although integrated reporting principles were discussed as early as 2005, the first formal definition with reporting criteria did not appear until, as already noted, the Integrated Reporting Committee of South Africa published its 2011 discussion paper. There is no database that attempts to track how many reports fit these criteria. Nevertheless, Global Reporting Initiative s (GRI) Sustainability Disclosure Database for the period provides a useful indicator of the rise in the number of integrated reporting companies one that is based on self-declared integrated reports. According to the GRI database, the number of organizations that either self-declared or were identified by GRI staff as having published an integrated report grew from 287 in 2010 to 596 in In 2013 for which we did not have a complete count at the time of this writing 61% of the organizations making such a declaration were listed companies; 31% were unlisted, for-profit entities; and the remaining 8% were other organizations such as non-profits and municipal governments. Two-thirds of these organizations were classified by GRI as large and another quarter as multinationals. While the main focus of the integrated reporting movement is listed companies, these statistics reveal that the idea has broader application notably, for instance, to city governments. The Spirit of Integrated Reporting In 2009, RobecoSAM, the organization that has prepared the Dow Jones Sustainability Indices (DJSI) since 1999, began to look for evidence of integrated reporting. 21 Using annual reports for 2011 and 2012, RobecoSAM recently conducted a Corporate Sustainability Assessment 22 of 2,000 of the world s largest companies in which the main point was to determine the number of companies that provided data on environ- mental and social initiatives that have led to cost savings or increased revenues. While not the same as a fully integrated report, this is an indicator of companies putting some of the principles of integrated reporting into practice, particularly the <IR> Framework s connectivity of information. 23 It is consistent with the spirit if not the letter of integrated reporting. Reasoning that only data from the main sections of annual reports signify true integration whereas data in a sustainability section suggests a combined rather than integrated report RobecoSAM found that only 12% of the companies provided an example of environmental or social cost savings or revenue generation in Still, this was up from 8% in 2011 a 50% increase. 24 Seventy-four percent of the 2012 examples concerned environmental initiatives, which were split evenly between cost savings and revenue generation. Two-thirds of the social initiatives involved revenue generation and one-third produced cost savings. 25 In support of our use of these examples, a far greater proportion (72%) of them were part of strategic, group-wide initiatives related to the company s core business, as opposed to sustainability programs focused on non-core business activities or activities carried out isolated in a single location (28%). 26 But reflecting the difficulty in quantifying these relationships between financial and nonfinancial performance, 60% of these examples were discussed entirely in qualitative terms that is, with no supporting numbers. 27 Accelerators In any given market, the momentum of the integrated reporting movement can be either aided or limited by the interactions of four market and regulatory forces: regulation, multi-stakeholder initiatives, organizations, and endorsements. At the moment, these interactions all appear to be working in the right direction. Regulation As the only accelerating force to invoke the power of the state, regulation changes company behavior directly. But a regulatory 19. The criterion used was that the company declared its annual report to shareholders to also be their sustainability report. The eight companies were AEP, Clorox, Dow Chemical, Eaton, Ingersoll Rand, Pfizer, Southwest Airlines and United Technologies Corporation (UTC). Only UTC was not a GRI reporter. Data for 2012 are from IRRC Institute and Sustainability Investments Institute. Integrated Financial and Sustainability Reporting in the United States, accessed May Data for 2012 are from IRRC Institute and Sustainability Investments Institute, Integrated Financial and Sustainability Reporting in the United States and data for 2013 are from Peter DeSimone, correspondence with Robert Eccles. 20. Global Reporting Initiative. Excel Spreadsheet of Sustainability Disclosure Database. 21. We are grateful to Cecile Churet and her colleagues at RobecoSAM for providing us the data to do this analysis. Founded as the first asset manager focused exclusively on Sustainability Investing, SAM was acquired by Robeco Group in 2007 in-line with Robeco s strategic ambition to further develop into the thought leader in the field. With Robeco s global presence, SAM has grown into one of the world s most prominent Sustainability Investment groups. In 2013, SAM was renamed RobecoSAM as part of Robeco s strategy to further align its group-wide Sustainability Investing activities. With approximately 130 specialist staff located in Zurich and Rotterdam, RobecoSAM offers clients a comprehensive range of differentiated and complementary Sustainability Investing solutions including indices, actively managed diversified and thematic equities, private equity, active ownership and corporate sustainability benchmarking services. RobecoSAM s long-standing experience in assessing companies and developing and managing successful sustainable investment strategies and Robeco s more than 80-year history of serving institutional investors and private investors with investment solutions across a broad range of asset classes are ideally complementary to each other. Leveraging Robeco s global network of sales, service and investment professionals, our Sustainability Investing products and services are represented in over 20 countries. RobecoSAM, accessed April For detail on the CSA methodology see Eccles, Robert G. and Cecile Churet. Integrated Reporting, Quality of Management, and Financial Performance Journal of Applied Corporate Finance, Winter 2014, Volume 26 Number 1, p. 2 and com/en/sustainability-insights/about-sustainability/robecosam-corporate-sustainability-assessment.jsp, accessed February The Guiding Principle of Connectivity of information states, An integrated report should show a holistic picture of the combination, interrelatedness and dependencies between the factors that affect the organization s ability to create value over time. International Integrated Reporting Framework, accessed April Ibid, p Ibid., p Ibid., p Ibid., p. 11. Roughly two-thirds of the program examples were qualitative for both program and strategic examples. 12 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

14 Sustainable Stock Exchanges Initiative As noted by Ernst Ligteringen, former CEO of GRI, Stock market regulators are uniquely placed to drive change in [the sustainability arena] by smart regulation through listing requirements. 37 In most countries, the local stock exchange has regulatory powers that are conferred directly by legislation or deeded to it by the local securities commission. Because exchanges can change the behavior of every company listed on them, they are good targets for multi-stakeholder initiatives. The Sustainable Stock Exchanges Initiative 38 (SSE) is one of the most important and promising. 39 Pressure exerted through stock exchange listing requirements represents a moderate form of compulsion. Although companies can choose to delist if they do not want to comply, delisting or moving to another exchange is not always easy. Over the past 10 years, the number of environmental and social reporting requirements led by stock exchanges around the world has increased 40 the best known of these being the Johannesburg Stock Exchange s apply or explain requiremandate is likely to be a double-edged sword. To the extent that mandating integrated reporting risks relegating it to the status of a compliance exercise, many companies, constrained in their ability to tell their own story, may well respond by adhering to the letter rather than the spirit of the law. Although only South Africa requires integrated reporting, regulations that support sustainability reporting are increasingly cropping up around the world. In a joint 2013 report called Carrots and Sticks, KPMG, the Centre for Corporate Governance in Africa, Global Reporting Initiative, and the United Nations Environment Programme considered some 180 policies in 45 countries. The study reported finding that, by 2013, 72% of the policies had become mandatory, as compared with 62% of the policies in 32 countries examined in 2010, and 58% of the policies in 19 countries in The most recent piece of legislation covering a large geographical territory was initiated on April 16, 2013, when the European Commission announced proposals 29 to amend the Fourth 30 and Seventh 31 Accounting Directives to improve business transparency and corporate performance on social and environmental issues. A year later, on April 15, 2014, the plenary of the European Parliament adopted this Directive by a vote of 599 to 55 from its 28 member states. The Directive specifies that listed companies with 500 or more employees will need to disclose information on policies, risks and outcomes as regards environmental matters, social and employee-related aspects, respect for human rights, anti-corruption and bribery issues, and diversity in their board of directors. 32 The Directive is expected to affect some 6,000 companies, including some unlisted firms as well as listed companies. 33 At the time of the legislation, only around 2,500 large EU companies were disclosing environmental and social information on a regular basis. 34 Moreover, such companies could choose whether to include this information in their annual report (at least leading to a combined report ) or in a separate report. 35 They could also choose among various standards and guidelines for reporting this information, but were not required to do so. Multi-Stakeholder Initiatives Multi-stakeholder initiatives change behavior by influencing those who can do so directly (the state) or indirectly, such as a club or industry association that can use moral suasion, membership criteria, and their recommended best practices to encourage companies to adopt a practice. Two initiatives particularly important to the integrated reporting movement are the Sustainable Stock Exchanges Initiative (SSE) and the Corporate Sustainability Reporting Coalition (CSRC) KPMG, Centre for Corporate Governance in Africa, Global Reporting Initiative, and UNEP (United Nations Environment Programme). Carrots and Sticks: Sustainability reporting policies worldwide today s best practice, tomorrow s trends, 2013 edition, accessed February 2014, p European Union. DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL, amending Council Directives 78/660/EEC and 83/349/EEC as regards disclosure of non- financial and diversity information by certain large companies and groups, accessed January The Fourth Directive provides the requirements for content and presentation of annual accounts and reports. European Union. Fourth Directive: annual accounts of companies with limited liability, businesses/company_law/l26009_en.htm, accessed January The Seventh Directive provides the requirements for the consolidation of company accounts. European Union. Seventh Directive, Seventh Directive: consolidated accounts of companies with limited liability, accessed January European Commission. The EU Single Market, Accounting, Non-Financial Reporting, htm, accessed April Unlisted companies include banks, insurance companies and other companies that are so designated by Member States because of their activities, size or number of employees. European Union. Europa, Press releases database, press-release_memo _en.htm, accessed April Ibid. 35. Examples cited were the UN Global Compact, ISO 26000, and the German Sustainability Code.: ec.europa.eu/internal_market/accounting/non-financial_reporting/ index_en.htm, accessed April 16, Though materiality was not defined by either one of these initiatives, it was highlighted in the CSRC. While not directly about integrated reporting, the CSRC is focused on changing corporate reporting in a way that helps shape the context to make it easier for companies to adopt integrated reporting. 37. CK Capital Trends in Sustainability Disclosure: Benchmarking the World s Stock Exchanges, October 2013, Foreword by Ernst Ligteringen (no page number). 38. Sustainable Stock Exchanges Initiative. accessed May A similar initiative was announced not long before this book was sent to the publisher. The Ceres-sponsored Investor Initiative for Sustainable Exchanges is seeking to engage global stock exchanges via the World Federation of Exchanges (WFE) to establish possible uniform reporting standards for sustainability reporting by all exchange members. accessed April The recommendations are contained in the report Investor Listing Standards Proposal: Recommendations for Stock Exchange Requirements on Corporate Sustainability Reporting, investor-listing-standards-proposal-recommendations-for-stock-exchange-requirementson-corporate-sustainability-reporting/view, accessed April Initiative for Responsible Investment at Harvard University. Our Work, Global CSR Disclosure Requirements, accessed January Journal of Applied Corporate Finance Volume 27 Number 2 Spring

15 ment for integrated reporting. 41 To provide a platform for collaboration among investors, regulators, and companies, and to address corporate transparency-related ESG issues, the UN launched the Sustainable Stock Exchanges Initiative in Today, the SSE Partner Exchange comprises nine exchanges: in addition to the Johannesburg Stock Exchange, the others are the BM&FBOVESPA in Brazil; Bombay Stock Exchange Ltd.; Borsa Istanbul Stock Exchange; Egyptian Exchange; NASDAQ OMX; Nigerian Stock Exchange; NYSE; and Warsaw Stock Exchange. 43 Corporate Sustainability Reporting Coalition Convened by Aviva Investors and announced in a September 20, 2011 press release, the Corporate Sustainability Reporting Coalition (CSRC) 44 used a series of timely and informative publications to play an integral role in facilitating the dialogue that surrounded both the 2014 EU Accounting Directive and the UN Conference on Sustainable Development in 2012 (Rio + 20). 45 With a membership that includes investors, 46 companies, NGOs representing a range of environmental and social interests (including GRI and the IIRC), accounting organizations, and UN-affiliated organizations, the CSRC seeks to influence legislation that serves as the basis for regulation. While the SSE focuses on mobilizing existing regulators and stock exchanges, the heavy contingent of NGOs has made the CSRC more campaign-oriented. Organizations Accelerating organizations include entities whose main mission is the adoption of integrated reporting notably the IIRC and those whose mission is supportive of and broadly consistent with it, such as CDP, CDSB, GRI, and the Sustainability Accounting Standards Board (SASB). In addition to these two groups are organizations whose recommendations carry some weight of authority, including the Financial Accounting Standards Board (FASB), the International Accounting Standards Board (IASB), the Big Four and other accounting firms, and the professional accounting associations. All of these organizations have the potential to speed adoption by lending institutional legitimacy to the concept, and by encouraging companies to adopt it, and providing them with frameworks, tools, education, and advice. While a number of NGOs play key roles, we regard the IIRC as the principal accelerator because its explicit mission is global adoption of integrated reporting through its <IR> Framework. GRI, SASB, CDSB, and CDP, in its role as Secretariat to the CDSB, support its efforts by pursuing missions that involve developing standards and frameworks for the measurement and reporting of nonfinancial information that can be used in integrated reporting. Complementing the various reporting programs is the Global Initiative on Sustainability Ratings (GISR), whose mission is to accredit sustainability ratings that use as input for their analytical models information that is reported according to the standards of the above organizations, as well as other sources. Unlike SASB, whose standards are designed for companies listed on a U.S. stock exchange, both the IIRC and GRI promote standards that are intended for global adoption and use. With an appropriate level of collaboration, the differences in jurisdiction and approach among these organizations should give each of them enough space to operate effectively, while complementing the work of the others. The accounting firms Deloitte, E&Y, KPMG, and PwC, and accompanying professional accounting organizations (of which each country has one or more) increase momentum through their direct engagement with companies and, more specifically, by working with them on questions of materiality. Although the Big Four are primarily concerned with materiality in terms of auditing of financial statements, they and some major accounting associations have addressed it in sustainability and integrated reporting. 47 PwC, for example, has also produced its own materiality matrix. 48 Awareness General awareness of integrated reporting as a concept and a movement can provide further, although modest, additional momentum. Compared to adoption, where actual counts (whatever their limitations) can be taken, and accelerators, where the existence of regulations, multi-stakeholder initiatives, organizations, and public statements can be definitively 41. The South African Institute of Chartered Accountants (SAICA). An integrated report is a new requirement for listed companies. SAICA, News, News Articles and Press & media releases, accessed January Specifically, it was launched under the auspices of the United Nations Global Compact Office, the United Nations Conference on Trade and Development, the United Nations Principles for Responsible Investment, and the United Nations Environment Programme Finance Initiative. United Nations Environment Programme Finance Initiative. accessed January Sustainable Stock Exchanges. Partner Exchanges, partners/stock-exchanges/, accessed January Corporate Sustainability Reporting Coalition. item/aviva-convenes-corporate-sustainability-reporting-coalition-13023/, accessed May Aviva Investors. News Releases, Aviva convenes Corporate Sustainability Reporting Coalition, accessed January These investors represented $1.6 trillion in assets under management at the time of announcement. Aviva Investors. News Releases, Investor led coalition calls for UN declaration requiring companies to integrate material sustainability issues into reporting, accessed April Deloitte. Disclose of long-term business value: What matters? accessed March 2014; Deloitte. Does materiality matter? Should the principle of materiality be applied more consistently to non-financial reporting?, accessed March 2014; Ernst & Young. The concept of materiality in Integrated Reporting, concept_of_materiality_in_integrated_reporting/$file/ey_ Materiality %20in%20Integrated%20Reporting%20April% pdf, accessed March PricewaterhouseCoopers. Materiality choosing our sustainability priorities, accessed March Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

16 Figure 3 Number of Articles Published established, awareness is difficult to measure. Nevertheless, we can assess it in two simplistic ways. First, we looked at the number of academic and practitioner articles in the literature (shown in Figure 3). Between 1999 and 2009, the count of articles was minimal and flat. But the year 2010 saw a substantial increase. This number doubled during the years 2011 and 2012, and 2013 again saw a steep increase to an amount triple that of While it is impossible to link the accelerators discussed above directly to this increase, integrated reporting articles have grown dramatically over the last four years. The second way we assessed awareness was through word counts of the terms integrated report and integrated reporting (shown in Figure 4). During the period , there was little awareness and only a very modest growth rate. This increased slightly for the period Between 2008 and 2010, word count spiked, slowing somewhat and even flattening out in 2012 and Time will tell if the publication of the Framework and other contributors to momentum will reinvigorate this index of awareness. The rising number of appearances of the term International Integrated Reporting Council in academic and practitioner journals yielded evidence of increasing awareness as well. Reflecting the creation and growing awareness of the IIRC, this count increased from virtually 0 in 2010 to 4 in 2011, 119 in 2012, and 268 in Given the mission of the IIRC to spread the adoption of high-quality integrated reporting, this increasing awareness is encouraging. The extent to which the awareness of the IIRC and integrated reporting itself continues to grow will be influenced by the motives of all the other actors involved in the movement. 49 Conclusion: Four Recommendations Given its current level of adoption, the accelerators in place, and its present visibility, it is unlikely that the movement will disintegrate any time soon. But persistence is a necessary, not a sufficient, condition for progress. Members of the integrated reporting movement want tangible, substantive changes in corporate reporting practices to influence resource allocation decisions in companies and markets. By fostering a broader, longer-term view in these decisions, they hope to help create a more sustainable society. As discussed earlier, exactly what the movement s strategies and priorities should be in order to achieve these goals is the subject of an ongoing debate among its participants. Many necessarily pursue individual goals that do not map directly onto those of the IIRC. Participants must balance their activities and in particular, the extent to which they should expend resources in collaboration with each other. 50 Adding to the social movement s collective but sometimes conflicting conversation, interested observers will express Figure 4 Growth in Awareness of Integrated Report and Integrated Reporting These counts are based on the Factiva database of general press articles. There is no overlap between this database and the one used for counting article citations. 50. Because social movements are an agglomeration of a variety of actors with different objectives, they necessitate tradeoffs, particularly when it comes to resource allocation and mobilization. That is, a certain amount of disagreement is inevitable. McCarthy, John D., and Mayer N. Zald. Resource mobilization and social movements: A partial theory. American Journal of Sociology (1977): Journal of Applied Corporate Finance Volume 27 Number 2 Spring

17 their opinions about who should be doing what. As both actors in and observers of the movement, we have our own views of what should be considered the critical issues facing integrated reporting today and how to address them. To be clear, these are our personal views; the people and organizations alongside which we work are free to agree or disagree. Balancing Experimentation and Codification Because the balance between experimentation and codification must be well managed before market and regulatory forces can be properly addressed, this strategic issue is of primary importance. We earlier described how integrated reporting first emerged through company practice, after which it was studied and codified, most recently in the <IR> Framework. We also described how attempts at codification continue to be informed by practice, such as in the IIRC s Pilot Programme Business Network, which had expanded to over 100 companies 51 by the time the Pilot Programme ended its work in September Early efforts at codification should be tested in practice so that these frameworks can be improved, but standards must eventually be set in order to move from codification to institutionalization, the fourth and final stage of meaning-making. Recommendation Number One: The International Integrated Reporting Council should establish a process for companies to get voluntary certification of whether their integrated report and website qualify as integrated reporting under the brand of the IIRC. Balancing Market and Regulatory Forces Adding and changing reporting regulations is a constant source of struggle between companies and those demanding information from them. Both parties put pressure on the state based on their own concerns. Although listed companies accept reporting requirements as a prerequisite for access to capital markets, they still resist additional reporting burdens. Virtually any additional reporting requirement being considered by a country s legislature or a regulator 52 becomes the subject of a fierce debate. Companies argue that it will be costly to implement, may be irrelevant, will put them at a competitive disadvantage, or increase litigation risk raising the question of just where the sweet spot falls between the extremes of irrelevance and risk. Companies insist that a proper cost-benefit analysis be done before they are required to report and point out, with some justification, that reporting requirements are never eliminated, even for issues that are no longer salient. Those in favor of a new reporting requirement will have equally strong arguments about the benefits to a particular group of having this information. Because the struggle between these forces represents the ongoing negotiation between the corporation and the state over the responsibilities of the former given by the license to operate granted by the latter, this tension is ongoing and inevitable. Recommendation Number Two: Members of the integrated reporting movement should engage in a dialogue to establish a global strategy for the balance and timing of market- and regulatory-based strategies to speed the adoption of integrated reporting, adapting this strategy to take account of country and sector context as necessary. Greater Advocacy from the Accounting Community With deep expertise in financial accounting and reporting and, increasingly, sustainability reporting, accounting firms and associations have a critical role to play in the integrated reporting movement. Possessing the capabilities and global scale to conduct audits of the world s major corporations (whose combined market cap is close to 100% of equity held by investors), the Big Four accounting firms Deloitte, E&Y, KPMG, and PwC are especially important. The integrity of the world s capital markets depends upon audits that ensure the quality of the information investors are using to make decisions. To the extent that investors and ultimately regulators believe that this information can be more effectively delivered through integrated reporting than separate financial and sustainability reporting, companies will depend on their auditor to help them issue reports with the appropriate level of assurance. But these firms must become stronger advocates for all aspects of integrated reporting, including the necessity for integrated assurance. Recommendation Number Three: The Big Four firms should work with other accounting firms and professional accounting associations to establish a proactive campaign to create awareness and understanding of integrated reporting among their clients and to develop assurance standards for integrated reporting. 51. There were 107 companies in the IIRC Pilot Programme Business Network as of April 29, International Integrated Reporting Council. IIRC Pilot Programme, IIRC Pilot Programme Business Network, accessed April The IIRC Pilot Programme came to an end in September 2014 after three years of developing and piloting the principles and concepts behind <IR>. In its place, the IIRC established a business network of organizations committed to the adoption of <IR>. org/ir-networks/ir-business-network/, accessed May For example, additional reporting requirements are established by the Ministry of Finance in China and by the Securities and Exchange Commission in the U.S. HSBC Global Connections. Home, Tools & data, Country Guides, hsbc.com/united-kingdom/en/tools-data/country-guides, accessed April Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

18 Achieving Clarity Regarding the Roles of Key Organizations The IIRC plays a central role in the integrated reporting movement, receiving strong support from GRI, SASB, and CDP. Together, these four organizations are creating the institutional infrastructure necessary for integrated reporting. They are also, however, creating some confusion in the marketplace as companies, investors, and stakeholders struggle to understand their missions and how they relate to each other. Are they complementary or competitive entities? Understandably, companies, investors, and stakeholders are also often confused about what exactly they are supposed to do in order to respond effectively to the entreaties each organization is making of them. Recommendation Number Four: CDP, GRI, IIRC, and SASB should work together to clarify for companies, investors, and other stakeholders how their missions are related to each other; they should also form collaborations which are mutually beneficial in support of the movement. Final Reflection If success is defined as near-universal adoption by all listed companies, will the integrated reporting movement be successful? We are cautiously optimistic. The challenges may be great, but the necessity is even greater. While integrated reporting is not a panacea that will create a sustainable society, it is an important management practice that can contribute to this goal. We are personally dedicated to this cause as active participants in the movement. Robert G. Eccles is a Professor of Management Practice at the Harvard Business School, as well a Visiting Lecturer at the MIT Sloan School of Management. He is also the Chairman of Arabesque Partners, an ESG quant fund based in London and Frankfurt. Michael P. Krzus is an independent integrated reporting consultant and researcher. Prior to founding Mike Krzus Consulting in 2011, Mike worked for 38 years in industry and public accounting at Arthur Andersen, BDO Seidman, Checkers Simon & Rosner, Grant Thornton, and Illinois Central Railroad. Sydney Ribot is an independent integrated reporting researcher. A former Research Associate at Harvard Business School, she is based in Istanbul where she is developing a film series on developing megacities. She received a B.A. in English and Asian & Middle Eastern History from Dartmouth College in Journal of Applied Corporate Finance Volume 27 Number 2 Spring

19 Sustainability versus The System: An Operator s Perspective by Ken Pucker, Berkshire Partners and Boston University s Questrom School of Business 1. Recognition flowed to Timberland during this period. Business Ethics magazine recognized Timberland as a top 100 Best Corporate Citizen for seven consecutive years. Fortune magazine cited Timberland repeatedly as a top 100 Best Company. I t is hard to conceive of a company and brand better positioned to demonstrate the compatibility of profit, people, and planet than Timberland. Publicly traded and privately controlled (with Class B shares with 10:1 voting rights), Timberland was founded and led by three generations of the Swartz family. The founder of the predecessor company to Timberland was Nathan Swartz, a Russian immigrant who ran a factory in Roxbury, Massachusetts that made private label women s shoes. His son Sidney created the brand Timberland, starting with the iconic Yellow Boot and expanding to apparel and global retail. Sidney s son Jeff, the third Swartz to lead the business, focused his passion on transforming Timberland from a brand to a paragon of sustainable enterprise. Jeff told the Timberland story generationally as one of Boot, Brand, and Belief. An instinct for sustainability was built into Timberland s very nature. Products were designed and made to endure the elements and came with a lifetime guarantee. When I joined the company in 1992, all of Timberland s footwear was manufactured in owned factories. My first day was spent walking a factory floor in Isabella, Puerto Rico, trailing Sidney as he searched for big pieces of leather scrap in the trash buckets of leather cutters. Elimination of waste was practiced as a tenet of Yankee sensibility linked to survival, not a progressive element of environmental sustainability. Inheriting his predecessor s commitment to quality and disposition to frugality, Jeff devoted his energies to elevating Timberland from its status as a premium brand to that of a values-based, sustainable brand. During Jeff s tenure as CEO, Timberland s revenue grew 70% and its market capitalization doubled. Over this same period, Timberland also showed its commitment to people by becoming the first company to grant employees 40 hours per year of paid community service time. 1 In addition, the company developed and implemented an industry-leading code of conduct that governed its relationship with overseas partner factories. 2 Becoming a sustainable enterprise demanded that Jeff also focus attention on Timberland s environmental footprint. To that end, Timberland installed solar panels at its headquarters and distribution centers, and it built renewable energy capacity at its factory in the Dominican Republic. The company made grants to employees who purchased hybrid vehicles, retrofit facilities with LED lighting, and built retail stores to be LEED-certified. While these steps were significant, Jeff recognized that the vast majority of the environmental impact caused by Timberland came from the production of its products. To catalyze efforts to understand, manage, and minimize the negative impact of Timberland s environmental imprint, Jeff borrowed a tactic from the food industry. In early 2004, Jeff gathered a team around a bottle of Russian dressing and directed our focus to the USDA nutrition label on the back of the bottle. He asserted that the transparency mandated by the government should be available to consumers of footwear and apparel and asked that Timberland work to affix the equivalent of nutrition labels to all 20 million boxes of footwear within six months. To accomplish this goal meant that Timberland had to understand the water usage, chemical composition, energy usage, and the greenhouse gas emissions associated with each product. With close to 1,000 footwear styles in the line, an average bill of materials of 30 parts, some commonality in parts and some countervailing dual sourcing of materials, understanding the environmental footprint of each style meant gathering thousands of data points every six months (as the line refreshed). No suppliers from which Timberland purchased inputs had these data, nor did standardized methodologies for calculating impacts exist. To compound the challenge, data on the environmental impact of the many transportation lines for the supply chain were also not established. Notwithstanding these obstacles, in 2006 Timberland did produce the industry s first nutrition labels (called the Green Index ). Instead of six months, the accomplishment took two years. At launch, the labels were featured on a small portion of the line, and provided information about only the energy used to produce the pair of shoes, percentage of renewable energy, community impact, and country of origin (see Figure 1). This was but a first step. Now, almost ten years later, it is clear that Timberland has made consequential advances in its environmental disclosure and spurred collective action aimed 2. As Timberland grew over the 1990s, additional factory capacity was added in Asia at sourced partners factories to complement owned manufacturing. 18 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

20 Figure 1 Timberland Green Index Label at reducing environmental damage. 3 Timberland leveraged insights from the discovery process associated with the Green Index to create the Earthkeepers products line. Launched in 2007, the Earthkeepers line was designed and engineered to deliver products with the lightest possible environmental footprint. Earthkeeper products use materials such as recycled PET (polyethylene terephthalate) linings and recycled Green rubber outsoles, and such products continue to be a core and growing part of Timberland s footwear and apparel offering. In addition, and, more importantly, the original Green Index label inspired collaboration outside the four walls of the company. Work undertaken at Timberland helped motivate the Outdoor Industry Association (OIA) to form a collaborative effort aimed at elevating environmental stewardship within the industry. OIA s Eco Index was launched in Timberland was pleased to share all of its learning with the group and hoped that the invitation to include others would both improve the scope of environmental benefit and create a shared standard that would enable comparability. 4 The Eco Index, in turn, helped spawn the Sustainable Apparel Coalition (SAC), 5 a far bigger coalition comprising brands, retailers, manufacturers, governments, non-governmental organiza- tions, and academic experts representing more than one third of the global apparel and footwear market. Members of the SAC include brands and retailers spanning from Wal-Mart to Burberry. 6 Environmental Footprint Notwithstanding these stories of success, Jeff s original aspirations for environmental sustainability remain largely unfulfilled. Though Timberland is considered a sustainability leader with innovative, best-of-class focus on environmental and social practice and reporting, 7 it is not clear if Timberland s environmental footprint is better or worse than when these initiatives were first conceived. Examination of the Responsibility section of Timberland s website provides measures of progress for the company s environmental objectives. 8 At first blush, examination of Timberland s greenhouse gas (GHG) reductions looks very impressive (see Figure 2). From 2006 to 2013, emissions declined by 50% (from 29,293 to 14,691 metric tons of carbon). However, the improvements in GHG emissions cited cover only Timberland s owned and operated facilities ( headquarters, retail stores, owned factories and distribution centers) and air travel. Emissions associated with sourced factories (from which Timberland contracts the vast majority of its footwear and 100% of apparel) are excluded. 9 So too are emissions associated with inbound and outbound freight and raw materials. In fact, 96% of Timberland s emissions footprint is considered beyond the scope of Timberland reported footprint (see Figure 3). In essence, Timberland s reduction of 50% of its emissions equates to a 2% reduction in overall GHG. 10 Though the Green Index did motivate the Earthkeepers line and a broader industry dialogue, Green Index labels were removed from Timberland s product line this year. After thousands of hours of collaborative work by more than 100 members of the Outdoor industry, the guidelines, indicators, and metrics developed by the OIA morphed into the work of the Sustainable Apparel Coalition (SAC), but without ultimately enabling consumer facing ratings. Finally, thus far, although the SAC has launched modules of the HIGG index for brand and factory level diagnosis and reporting, its product module remains in testing. SAC s current plans call for the launch of a consumer-facing product level index in Jeffrey Ball, Six Products, Six Carbon Footprints, The Wall Street Journal, October 6, Details Timberland s findings focused on the carbon footprint of footwear. 4. The average carbon footprint of a pair of hiking boots is between 66 and 132 pounds of CO 2 and 2,113 gallons of water. Six Products, Six Carbon Footprints Wall Street Journal, October 6, 2008 and AMC Outdoors Online, publications/outdoors/web/water-footprint.cfm At the same time, Timberland served as a founding member of the Leather Working Group, another multi-stakeholder collaborative group including brands such as Nike, LVMH and Pentland as well as tanneries from around the globe. The purpose of this group is to develop a shared protocol to assess, audit and rate tanneries in an effort to improve environmental practice within the tanning industry. 7. Timberland rated second out of 150 companies evaluated by the nonprofit group Climate Counts in Though Timberland has made progress at reducing emissions at tanneries (via the Leather Working Group) and increased the number of GSCP (Global Social Compliance Program) certified factories to almost 60% of its base, measurement is not provided for the 96% of Timberland s GHG footprint. 10. Assuming that total emissions remained flat from 2006 to Yvon Chouinard, Jeb Ellison and Rick Ridgeway, The Sustainable Economy, Harvard Business Review, October, The authors argue that the sum of pricing of externalities, capital flowing to sustainable businesses and indices of sustainable performance are converging to accelerate a different form of capitalism. More than ten years from Jeff s nutrition label, the industry remains without a consumer facing standard enabling comparability. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

21 Though the nutrition label did jolt the industry to focus on its collective environmental footprint, ten years later much remains the same. The green house gas emissions footprint 12 of the footwear and apparel industry continues to grow, 13 fueled by increasing consumption of a growing global middle class, planned obsolescence, fast fashion, and limited improvements in environmental performance. One difference, however, is that Jeff no longer pushes Timberland to become a leadership sustainable enterprise. Timberland was sold in 2011 to VF Corporation for $2 billion. The Case for Sustainable Enterprise Though our current system of capitalism is leading to an increasing pace of ecosystem degradation, many advocates for sustainability point to the opportunity for a triple-bottomline win. Books such as Green to Gold 14 and concepts like the Circular Economy and Creating Shared Value focus on the the mutuality of interests and possibilities for convergence among economic, social, and environmental goals. Arguments for alignment are based on four primary pillars: risk minimization, operational efficiency, opportunity for innovation, and the power of employees and consumers. Figure 3 Timberland Carbon Footprint Source: Timberland: responsibility.timberland.com Figure 2 Timberland Greenhouse Gas Emissions Inventory Source: Timberland: responsibility.timberland.com 12. Greenhouse gases are but one indication of environmental performance. Other impacts include waste, chemical discharge, water use and end of life disposal of products. 13. In addition, social compliance with overseas factories remains a game of cat and mouse. Richard Locke has written extensively on the impact (or, lack thereof) of audits. In his paper Does Monitoring Improve Labor Standards? Lessons from Nike, Cornell University ILR School, 2007, Locke and his co-authors argue monitoring for compliance with corporate codes of conduct alone appears to have produced limited results. 14. Daniel Esty and Andrew Winston, Green to Gold, How Smart Companies Use Environmental Strategy to Innovate, Create Value, and Build Competitive Advantage, (New Jersey: John Wiley & Sons, 2006) 20 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

22 Risk Minimization: The first argument reflects the increasing importance of intangible assets as a driver of value. 15 For many companies, nothing is more valuable than their brand and, hence, their reputation. Dramatic changes in technology and growing numbers of NGOs 16 are driving unprecedented transparency and elevated expectations for companies seeking license to operate. For this reason, enlightened leaders should invest proactively to ensure that their operations and practices are socially and environmentally sound, and that their brands are protected. Operational Efficiency: While reputation and brand are often hard to measure with any degree of precision, the second area of alignment between sustainable practice and triple-bottom-line goals is easier to justify using cost-benefit analysis. Leveraging sustainable thinking, opportunities abound for companies to eliminate waste, reduce water and electricity costs, and improve the efficiency of their operations, thereby serving both the planet and the bottom line. Innovation and Growth: The third area of alignment between profit and planet cited by sustainability strategists is the ability to innovate. Focus on the lifecycle impact of a product from the start of the design process to end of life can lead to innovation. 17 Reconsideration of a business system to make better use of resident assets can also lead to the birth of entirely new companies based on sharing (consider Airbnb or Uber). Power of Employees and Consumers: The last area of natural alignment between sustainability and profitability is the power to attract employees and consumers. One of the key motivations for progressive companies to adopt sustainable thinking is the recognition that to remain an employer of choice with Millennials, enterprises must address the issues that are central to the next generation. 18 I believe that Jeff Swartz genius was elevating mission and sustainability to a central place at Timberland, thereby enabling the company to recruit and retain talent committed to shared values and passionate about working for goals that were purposeful and aligned with their personal lives. Brands such as TOMS and Warby Parker have succeeded in extending the ethos of sustainability beyond employ- ees to consumers. In so doing, they have been able to grow exceptionally quickly without much spend devoted to traditional marketing. Sustainability versus the System With so much opportunity to transform green to gold and deliver a triple bottom line, why is the set of sustainable paragons so limited? Why is the progress of those same paragons insufficient? Why do we find so many illustrations of business behavior that conflict with sustainable practice, and why are our ecosystems being severely compromised at increasing speed? The answers lie in the structure, rules, incentives, market failures, and paradigms that govern our economic model. While there are a small number of enlightened visionaries such as Yvon Chouinard of Patagonia, Paul Polman of Unilever, and Mark Parker of Nike, as well as Jeff Swartz of Timberland, most companies are led by CEOs who are committed to delivering results against today s traditional, single bottom line scorecard. In addition, in-depth examination of the environmental records of even the best of the best corporations often fails to support the case proffered by advocates of sustainable practice. 19 As a result, the output of the current system as practiced by the best of the best and traditional corporations is falling short of humanity s need to forestall the arriving age of ecosystem damage, resource scarcity, and climate change. Our system is one of unprecedented interdependence and connectivity. That said, for simplicity, what follows is a high-level outline of the critical obstacles facing each of the leveraged actors in our system. If we are to create an enduring form of capitalism, a model that does actively consider all stakeholders (shareholders, employees, suppliers, consumers and the earth), we will have to reshape our system to account for these challenges. Corporations The sweeping victory of global capitalism increasingly places the corporation at the center of the discussion. 20 Though there are cogent arguments for companies to behave more sustainably, there are even more powerful forces pulling leaders in the other direction. What follows is a partial list of the realities of our capitalist system that bias action toward the traditional bottom line vs. a triple bottom line. 15. Whereas tangible assets made up 83 percent of a firm s value in 1975, as of 2009, 81 percent of a firm s value was made up of intangible assets. Ocean Tomo s Intangible Asset Market Value Study; Introducing GS Sustain, Goldman Sachs, June 22, 2007, p.25. According to this report, the number of NGOs registered with the UN Economic and Social Council has doubled in the last decade. 17. Nike s Flyknit is a superb illustration of innovation born of sustainable thinking Deloitte Millennial Survey, 2015, about-deloitte/articles/millennialsurvey.html 19. Patagonia is an environmental pioneer and always hailed as an illustration of the compatibility of green and gold. That said, even Patagonia does not presently report annual green house gas emissions or a time series of green house gas emissions publicly, thus making it impossible to evaluate their footprint over time. 20. It is important to note that all of the illustrations of best practice referenced are based in either the United States or Europe, while the fastest growing economies are in Asia. Though there are select illustrations of sustainable thinking in Asia, the EU and US are considerably ahead of practice in Asia. Clearly, for progress to occur at scale, Asia will have to ramp up their commitment to sustainability going forward. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

23 To begin with, corporate leaders are overwhelmed and have limited attention spans. Issues of sustainability are relatively new, complex, pervasive, and often less urgent than important. Compounding matters, few leaders have either sustainability departments or internal experts to turn to. Nor do they have an established professional base (e.g. the equivalent of accountants to support financial reporting) to share standards and guide action. Solutions to many sustainability challenges require the internalization of external costs (such as those coming from pollution) that are not typically borne by competitors and so difficult for leaders to justify. Other economic pressures also limit progress. Investments in sustainability must compete with traditional investments aimed at reducing cost or growing the business. Proposed investments in sustainability are often very hard to quantify with precision. For example, what is the benefit of not having a reputational failure within a global supply chain? What is the benefit of employee retention? And what will be the cost of carbon if regulated in the future? 21 Though textbook corporate finance would have one believe that a rational CFO would accept all investments that exceed the corporate cost of capital, that is not what happens in practice. Instead, the constraints of a fixed capital budget, the priorities of strategy, and constraints on human capital almost always limit even net present value (NPV) positive investments. In the capital allocation process, investments in green process or innovation often get forestalled. 22 At the same time, many of the challenges of sustainability are often distant from corporate headquarters. With the globalization of companies and the increasingly distributed nature of supply chains, resource extraction and the multiple tiers of production are remote, literally and figuratively. Thanks in part to global trade compacts, advances in technology, and improvements in transportation infrastructure, we are experiencing an era of outsourcing and distributed supply chains. Notwithstanding the emergence of a supply-chain auditing business (over 50,000 factories were audited last year according to the New York Times), 23 abuses persist, including unauthorized contracting, use of restricted substances, unlaw- ful chemical disposal, fraud, incomplete inspections, unpaid overtime, and forced overtime. These systemic problems are a function of competing pressures for low-cost, reliable delivery and corporate cash flow optimization, which often conflict with triple bottom line aspirations. Last, but far from least, the leaders of public companies report to their investors every 90 days. This time horizon is not compatible with a cycle of marketing or product development. It also often leads to short termism, delaying investments with longer payback. With an increasing share of executive compensation tied to stock performance, 24 pressure often drives leaders to bias their decision-making toward investments that promise close in paybacks. 25 Consumers Research reports and trends point to increasing interest from consumers in green products. 26 Technology that enables more seamless sharing of information has engendered tools such as Good Guide, a mobile app that allows consumers to see thousands of products environmental, health, and social ratings at point of sale. At the same time, brands such as Timberland and NGOs such as The Sustainability Consortium are devoting resources to making rating information more available; and certification standards groups (such as Fair Trade, the Marine Fisheries Council and the Better Cotton Initiative) are growing and providing shortcuts for consumers to act with their wallets. Notwithstanding these advances, behavior does not appear to be changing much. Joel Makower, co-founder of the media company GreenBiz, is skeptical about the power of green consumers a group he has been paying close attention to since 1991, when he was co-author of a book, The Green Consumer. A small percentage of consumers, by changing their habits, can move markets, Makower says; It s an incredibly compelling notion. I just haven t seen it in the market. 27 Consumer pull has the potential to change corporate behavior. Were consumers more ardent in their pursuit of sustainable goods or more demanding of information, companies would quickly change to meet demand. But there are a number of major obstacles that 21. In his book Getting Green Done, Auden Schendler, VP of Sustainability at Aspen Ski Company (a business whose very business is at risk due to climate change), gives an excellent account of the many practical obstacles that slow the pace of sustainable change. He notes there are many barriers and obstacles in business to capturing those savings, even if they represent $10,000 bills lying on the floor. There are, in fact, many good reasons for not picking that bill up, not the least of which is that you might be able to pick up a $100,000 bill in the same movement by selling something you manufacture. Auden Schendler, Getting Green Done, (New York: Public Affairs, 2009), Compounding the investment conundrum is the question of what discount or hurdle rate is used to determine the efficacy of investment decisions. According to Jeremy Grantham, Capitalism doesn t think long-term very well because of high discount rate structure. If you re a typical corporation anything lying out 30 years literally doesn t matter. Or, as I like to say: QED, your grandchildren have no value. And they usually act as if that was true; even though I m sure they are actually very kind to their grandchildren. Use of an extra high discount rate will bias executives against investments with payouts longer into the future. jeremy-grantham-food-oil-capitalism Brian J. Hall and Jeffrey B. Liebman, Are CEOs Really Paid Like Bureaucrats? Quarterly Journal of Economics, Vol. 113, No. 3, August 1998, For example, the percentage of pay tied to the stock market for the CEOs of U.S. companies was negligible in the early 1980s, rose to about one-quarter in the early 1990s, peaked at roughly one-half in the early 2000s, and remains near 40 percent today. 25. According to a study by MFS, stocks are being held for shorter periods than any time since the 1920s with NYSE traded stocks now being held for only 1.67 years. MFS, Lengthening the Investment Time Horizon. 26. According to marketing agency Cone Roper, a record high 71 percent of Americans now consider the environment when they shop, up from 66 percent in Purchases in the United States of hybrid vehicles peaked at three percent of vehicles sold in 2009 and green household cleaners make up less than five percent of the market Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

24 now stand in the way of the consumer leading the path to a sustainable future. Like corporations, consumers are stressed for time and overwhelmed by the variety of choices they are presented with. Coping with the long list of typical close to home issues is challenging enough. But complex, slow-boil issues such as resource scarcity and climate change do not easily motivate a change in behavior. 28, 29 In addition, industry has done a superb job of decoupling consumption from environmental impact. Resource extraction, smokestacks, and landfills are more often than not remote, and the impacts of climate change are hard to pinpoint. When these issues do get coverage, vested interests such as the fossil fuel industry ensure that obfuscation is the order of the day. In addition, there often is a gap between how consumers want to act and how they do act. This is in part a function of complexity, the scope of the challenge, and the absence of standard modes of communication. Information to guide decision-making is scant (see the ten- year challenge to label footwear and apparel referenced earlier), often inaccurate, incomplete, and not standardized. Seemingly easy decisions, such as the choice between an electric Tesla Model S and a conventional SUV, can in fact be quite complicated. Determining which vehicle emits fewer green house gases depends on where one is powering and driving a Tesla, and on the sources of electricity in that state or region. 30 Investors Investment in Socially Responsible Investment (SRI) has increased dramatically in the past ten years. 31 So too has the number of signatories of the UN Principles for Responsible Investment (UNPRI). 32 Recent research undertaken by Deutsche Bank reached the conclusion, after evaluating 56 studies, that companies with high ratings for environmen- 28. In his quarterly letter to investors in April 2011, Jeremy Grantham hits on many of the obstacles in our human nature, which inhibit our collective ability to address climate change and the resource scarcity. Grantham notes that our challenges with long horizon issues are compounded by the fact that we also became an optimistic and overconfident species. Jeremy Gratham, Time to Wake Up: Days of Abundant Resources and Falling Prices are Over Forever, GMO Quarterly Letter, April These tendencies are compounded by a phenomenon known as the availability heuristic. According to Cass Sunstein, Harvard Professor and former leader of the White House Office of Information and Regulatory Affairs, people tend to evaluate risks by way of the availability heuristic, which leads them to assess the probability of harm by asking whether a readily available example comes to mind. An act of terrorism is likely to be both available and salient, and hence makes people fear that another such event will occur (whether it is likely to or not)... By contrast, climate change is difficult to associate with any particular tragedy or disaster. Sunstein continues, For potentially catastrophic risks whose prevention requires long-term investment, there are built-in obstacles to serious regulatory efforts. If salient events, such as hurricane activity, can be associated with climate change, the likelihood of a response is increased. But for most people most of the time, these associations seem speculative. Cass Sunstein, The Availability Heuristic, Intuitive Cost-Benefit Analysis, and Climate Change, Coase-Sander Institute for Law and Economics, economics. 30. Nathan Weiss, Is The Telsa Model S Green, Seeking Alpha, May 9, Similarly, when considering the environmental impact of a cotton piece of outerwear or a cotton/polyester blend, most concerned consumers would choose the cotton garment. However, a cotton/polyester blend is more likely to leave a lighter environmental footprint tal, social and governance (ESG) factors have a lower cost of debt and equity. 33 While the Deutsche Bank study indicates a strong link between sustainability and rates of return, the authors of the report are careful to note that the statistical studies we have collected cannot or do not establish causality with any degree of confidence. 34 In addition, as Robert Eccles and George Serafeim of Harvard Business School caution, it is difficult to be precise about the real degree of integration of sustainability by both companies and investors. That is to say, the numbers do not tell us much about the extent to which sustainability considerations really influence the content and timing of their resource allocation decisions. 35 The inability to determine the extent to which investors integrate sustainability into their decision-making is a function of a number of systemic challenges. Most importantly, notwithstanding a tripling of the number of Corporate Social Responsibility (CSR) reports filed over the past three years, 36 no standards govern these filings. There remain no single format for reports, no minimum standards for what must be included, no annual requirement for reporting, and no established audit procedures. A recent report examined the over 4,000 CSR reports, rankings and surveys and found unsubstantiated claims, gaps in data and inaccurate figures. 37 No surprise, then, that a recent report published by McKinsey concludes that traditional corporate social responsibility (CSR) is failing to deliver both for companies and for society. 38 Absent mandated, standardized, auditable reporting of non-financial data, it is challenging for investors to understand a company s commitment to sustainable practice and the related results. By way of illustration, consider the reported results for greenhouse gas emissions provided by Timberland. The data seem to tell a good non-financial story. due to the durability of the polyester blend, the recyclability of polyester and the fact that polyester takes less energy to dry. 31. From 1995 to 2012, the US sustainable and responsible investment market has grown by 486% representing 11.3% of US total of $33.3 trillion under investment. Report on Sustainable and Responsible Investing Trends in the United States ussif.org/files/publications/12_trends_exec_summary.pdf. 32. The Principles for the UNPRI signatories are voluntary and aspirational and are intended to offer a menu of possible actions for incorporating issues into investment practices percent of the studies they reviewed showed that companies in high ESG ratings outperform the market in the medium (three to five years) and long term (five to ten years). Mark Fulton et al., Sustainable Investing: Establishing Long-Term Value and Performance DB Climate Change Advisors, Deutsche Bank Group, 2012, dbadvisors.com. 34. Mark Fulton et al., Sustainable Investing: Establishing Long-Term Value and Performance DB Climate Change Advisors, Deutsche Bank Group, 2012, dbadvisors. com. 35. Robert Eccles and George Serafeim, A Tale of Two Stories: Sustainability and the Quarterly Earnings Call, Journal of Applied Corporate Finance, Volume 25, Number companies-now-publishing-sustainability-responsibility-reports/ John Browne and Robin Nuttall, Beyond corporate social responsibility: Integrated external engagement, McKinsey & Company, March, engagement. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

25 It is not until one reads the fine print that one realizes that 96 percent of Timberland s footprint is not considered in the chart. Also, it is not easy for investors to make sense of data stated in units (such as CO 2 emissions in metric tons, kilowatt hours of electricity, BTUs or gallons) that may not be easily translated into dollars. Even for investors who do value sustainable practice and who are able to do effective due diligence on companies and make sense of their reporting, the timing of returns may present a challenge. Given that investment decisions and compensation contracts tend to converge toward more short-term, observable metrics, corporate managers and professional money managers are encouraged to maximize short-term performance. 39 Though there is increasing evidence that longer-term investors are attracted to companies that focus on longer horizons for investment and sustainability, 40 the vast majority of investors and money managers remain focused on less uncertain, shorter-term outcomes. 41 My experience at Timberland with the investment community is consistent with the behavior noted above. For 28 consecutive quarters I sat next to the Jeff Swartz as he delivered Timberland s results to investors. Without fail, Jeff focused the last portion of his remarks on the progress that Timberland had made in its quest to become a leading sustainable enterprise serving all of its stakeholders. Not once did an investor or analyst ask a question of Jeff about the sustainability portion of his address. Government Tax policy and regulation can also influence the behavior of companies, consumers, and investors and correct for market failures such as externalities. The particular challenges of ecosystem decline and resource scarcity, however, are cross-border and global in nature, and so they require a coordinated response. Though there are effective illustrations of coordinated action (a good example is the Montreal Protocol on Substances that Deplete the Ozone Layer), the agreements that govern this action are exceedingly complicated, as evidenced by the failure of several climate meetings in past years. The fact that much of the renewable resource stock of natural capital (in the forms of clean air, water, and fisheries) is shared, and that our present rate of consumption of these resources exceeds the ability of the earth to regenerate them, is problematic and cause for great concern. Add to that challenge the fact that the benefit for each actor of consuming shared natural resources outweighs the cost, and the net result is a pernicious problem (that both economists and historians refer to as the tragedy of the commons ). 42 Solving this problem requires either regulation (in the form of quotas, permits, taxes, incentives or outright bans) or privatization of the commons both complicated options, given the inevitable winners and losers. Putting aside international accords, governments around the world are being pushed to act locally to address issues such as air pollution, drinking water availability, and other quality of life issues. 43 As is true of both corporations and consumers, mismatches between the election cycle (in democracies) and the timeline for addressing ecosystem decline have the effect of delaying necessary action. Politicians are not typically willing to bear costs (in the form of slower growth of increased investment) today in order to ensure prosperity for their grandchildren. In addition, vested interests will continue to spend with vigor to maintain the status quo. 44 Even when governments do act, there is no guarantee that the prescribed action will deliver the intended outcome. Consider the U.S. subsidies for the production of biofuels. Originally conceived and supported by a broad constituency of farmers, big agricultural producers, and environmentalists, biofuel subsidies were enacted to reduce dependence on Middle Eastern oil while limiting carbon emissions. But what legislators and policy makers failed to anticipate were the additional crops that would be planted in razed rain forests, as the demand for corn and biofuel sources soared. The net effect of the policy has been a transfer of wealth from taxpayers to big agriculture, an increase in carbon emissions, and an increased pace of global warming. 45 As if these many obstacles to sustainable practice are not enough, three other challenges are worthy of mention. These challenges are not specific to any key actor, but are endemic to the system as a whole. First, our systems of higher and graduate education have not broadly figured out how to teach a new generation to deal with the challenge and opportunity of sustainability. According to a study by the World Environment Center called Business Skills for a Changing World, sustainability is 39. Sean Silverstone, The High Risks of Short-Term Management, Harvard Business School, Working Knowledge, April, Ibid 41. In the private equity space, where time horizons are often longer than that of investments in the public markets, firms are paying increasing attention to sustainability and environmental, social and governance (ESG) issues. This is principally a function of increasing attention from Limited Partners (LPs). Even so, according to a study conducted by PWC, within the private equity space ESG management is still mainly geared towards risk, and less than 50 percent of the firms surveyed have even one full time employee working on ESG. At a meeting that I attended of the leading private equity firms conducted under Chatham House rules, it was clear that ESG staff were challenged to get an audience with the investment staff and had difficulty making a case for anything beyond risk management or selected cross portfolio cost savings initiatives. Putting a Price on Value, PWC Garrett Hardin, The Tragedy of the Commons, Science 162, no (December 13, 1968): Environmental Protests in China: Volatile Atmosphere, Economist, April China s Environmental Activists, FT Magazine, September For example, the Koch brothers, Charles and David, plan to spend $889 million via a network of conservative advocacy groups in advance of the next election cycle. These funds will, no doubt, be used to advocate for Koch Industries interests in refining and distribution of petroleum, chemicals energy fertilizers and other commodities. Metea Gold, Koch-backed Network Aims to Spend Nearly $1 Billion on 2016 Election, Washington Post, January, Michael Greenwald, The Clean Energy Scam, TIME magazine, May 27, Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

26 not currently institutionalized within the required curricula of many business schools. 46 Gaps in curricula perpetuated by mismatched educational incentives, an inertia-ridden system, and an absence of a natural career track for professionals create a chicken-and-egg problem that remains unsolved. Additionally, mental models that favor immediate results and have a hard time looking beyond the next few quarters compound the challenge of climate change and resource scarcity. In his April 2011 Quarterly Letter, famed investor Jeremy Grantham notes, We don t seem to deal well with long horizon issues and deferring gratification. He continues, We are also innumerate. Our typical math skills seem quite undeveloped relative to our nuanced language skills. One such math skill, in particular that we have not mastered, is our inability to understand and internalize the effects of compound growth. 47 These natural deficits make it hard to motivate action to address climate change, resource scarcity and the decline of ecosystems. Finally, the oxygen of the capitalist system is growth. Companies pursue growth to increase their value, create career opportunities for their employees, and generate funding for investment, creating a positive feedback loop. Governments also measure economic success using Gross Domestic Product (GDP) as the principal marker. In the United States, consumption makes up almost 70% of GDP. For this reason, growing consumption is fundamental to growing GDP. In the developing world, growth is necessary to generate employment to lift people out of poverty. While this growth has noble outcomes associated with it notably, a reduction in hunger and a more literate, healthy, and longer-lived population it is also connected with more purchases of refrigerators, cars, and air conditioners. This is good news for companies seeking growth, but it is a challenge for a world already reaching the limits of its capacity. According to the Global Footprint Network, humanity uses the equivalent of 1.5 planets to provide the resources we use and absorb our waste. This means it now takes the earth one year and six months to regenerate what we use in a year. 48 This is the very definition of unsustainable. Solution Space: A Partial Agenda for a More Complete Capitalism Our economic system has engendered incredible progress. That said, population growth, increasing consumerism, and the consequences of burning fossil fuels have led humanity to bump up against natural limits. As Jeremy Grantham notes: Capitalism does millions of things better than the alternatives. It balances supply and demand in an elegant way that central planning has never come close to. However, it is totally ill equipped to deal with a small handful of issues. Unfortunately, today they are the issues that are absolutely central to our longterm wellbeing and even survival. 49 Notwithstanding the progress and promise of sustainable strategy, I contend that our system is imbalanced and that the pressures to deliver a traditional bottom line continue to overwhelm the allure of the triple bottom line. Our challenge is to maintain the best of capitalism, while adjusting incentives, reimagining structure, and even rethinking paradigms to deliver progress. To do all of this will require the accelerated adoption of a number of leveraged tactics and reforms with the potential to bend our collective path toward a more sustainable future. Chief among such reforms and developments are the following: Shift to Integrated Reporting: There is no shortage of reporting on non-financial metrics. According to UPS, the company responded to 180 requests for such data last year alone. An acronym soup of superb and well intended NGOs, including the IIRC (International Integrated Reporting Council), CDP (Carbon Disclosure Project), and GRI (the Global Reporting Initiative), offer guidance for reporting. Even so, according to a recent study, 97 percent of companies are failing to provide data on the full set of first generation sustainability indicators. 50 The challenge is to develop and reach agreement on a system of reporting that is mandated, standardized, auditable, timely and relevant to all stakeholders. Such reporting also must focus on issues that are material to the performance of the company and that provide important information about each of the six forms of capital that have been identified by the IIRC as critical to long-run corporate competitiveness and value in addition to traditional investor or financial capital, the others are natural, human, manufactured, intellectual, and social and relationship. The good news is that this kind of expanded reporting is gaining momentum. Led by Michael Bloomberg and Mary Shapiro (the former Chairman of the SEC), the Sustain- 46. Business Skills for a Changing World: As Assessment of What Global Companies Need from Business Schools, World Environment Center, In his paper Sustaining Sustainability: Creating a Systems Science in a Fragmented Academy and Polarized World, MIT Professor John Sterman makes this very point. He cites research aimed at understanding people s ability to understand exponential growth processes. They found people tend to extrapolate linearly instead of exponentially, assuming a quantity increases by the same absolute amount per time period, while exponential growth doubles the quantity in a fixed period of time. John Sterman: Sustaining Sustainability: Creating a Systems Science in a Fragmented Academy and Polarized World. 48. In addition, were the rest of the world to reach the level of consumption of the citizens of the United States, it would take four planets to support our collective lifestyle Leo Hickman, Jeremy Grantham on how to feed the world and why he invests in oil, The Guardian, April Jo Cofino, 97 percent of companies fail to provide data on key sustainability indicators, The Guardian, October, Journal of Applied Corporate Finance Volume 27 Number 2 Spring

27 able Accounting and Standards Board (SASB) is developing sector-specific materiality maps and reporting templates that reflect input from industry, accounting, and the NGO sector. This work feeds into the efforts of the IIRC to develop a framework and reporting standards for these data. One sign of the success of such efforts to date was the passage in 2014 of new EU legislation that, if and when it is affirmed by the EU States, will require over 6,000 listed companies to provide material environmental, social and governance data on an annual basis. Adoption of a standardized format for these data is essential. Armed with such data, investors will have time series information that will enable comparability. Equally important, these data will also allow management teams, boards of directors and investors to link sustainability performance more directly to financial performance. To the extent it succeeds in creating this linkage, such standardized and integrated reporting will encourage both companies and their investors to push for progress on the sustainability agenda with the expectation that more sustainable companies will end up with lower betas, lower costs of capital, and higher stock returns. 51 Internalize Externalities: Many have argued that it is good management for companies to internalize externalities that is, to invest in initiatives designed to remedy social problems associated, at least in part, with their own products and services. 52 The Carbon Disclosure Project (CDP) is an NGO that works with companies that voluntarily report their ecosystem impacts. The rationale for disclosure is that knowing one s footprint is a necessary precursor to benchmarking, prioritization, and action, all of which will better position companies for the inevitable regulation. In that spirit, and with that intent, some companies are now incorporating a fee for carbon emissions (ranging from $6/ton at Microsoft to $80/ton at Exxon) in their investment process. Companies such as Microsoft are charging the cost (per ton) of carbon to their operating divisions. These fees are collected by Microsoft at the corporate level and reallocated toward green projects aimed at supporting the company s commitment to become carbon neutral. Such illustrations are rare, however. According to the CDP, less than 100 U.S. companies now include the cost of carbon emissions in their P&L. 53 Though cap and trade and other mechanisms in various states and countries regulate carbon emissions, the practice is not uniform. Notwithstanding progressive arguments for incorporating the cost of externalities, the data suggest that pressures of the system push in a different direction. The majority of leaders working toward a traditional bottom line are not interested in adding burdens to their P&L, especially when competitors are not following suit. That is why I believe that governments must regulate emissions and set proper prices for water to change incentives and corporate behavior. Address Time and Incentives. The actions of Paul Polman, CEO of Unilever, are instructive on this front. The first day that Polman was announced as CEO, he let investors know that Unilever would no longer provide earnings guidance and that the company would report bi-annually instead of quarterly. He subsequently set goals to double the company s revenue while halving its environmental footprint by 2020 and devised very concrete incentives tied to stakeholder objectives. Polman also advised short-term investors that they should not invest in Unilever. Polman (or Captain Planet, as he has been dubbed by the Harvard Business Review) took these steps to address the problems of short term capitalism. 54 Extending time horizons for financial reporting to better align with investment, marketing, and product cycles is a helpful first step. In addition, Polman aligned incentives with objectives and investor communication a managerial necessity, but one that is rarely accomplished in practice. 55 Lacking these concrete linkages, managers tend to default to the metrics measured by the traditional scorecard. These are but a few of the adjustments to our current form of capitalism that would shift corporate focus from shareholders to stakeholders, but in ways that arguably end up serving the long-run interests of shareholders. Other important transformations that will be helpful include a reallocation of U.S. government subsidies from fossil fuel providers to renewable energy innovators; advances in consumer-focused sustainability communications (along In an effort to address these concerns, PUMA worked with PWC and TruCost to deliver the industry s first Environmental Profit & Loss (EP&L) statement in The report detailed the cost of environmental capital that PUMA consumed in Using a cost of 66 per ton of CO 2, PUMA estimated the sum total of its use of natural capital (to include green house gas emissions, water, land use, and waste) consumed to be Euro 145M (only 8M were associated with PUMA s direct operations). This compares to traditional income statement earnings of 301.5M in that same year. Said differently, were PUMA to pay the actual cost of the natural capital that it consumed in 2010, earnings would have been less than one half of those reported. Since issuing this breakthrough report, PUMA s business has weakened and has yet to issue subsequent updates to the EP&L (no correlation implied). The absence of time series reporting makes it hard to assess what PUMA has done with the findings of their work. That said, KERING (PUMA s parent) has committed to issue a group EP&L and individual EP&Ls for all of their brands (including Gucci, Bottega Vaneta, Stella McCartny, Volcom...) in Christopher Mayer and Julia Kirby, The Big Idea in an Age of Transparency, Harvard Business Review, April, Wendy Koch, At least 150 companies prep for carbon prices, USA Today, September Paul Polman, Paul Polman: The remedies for capitalism, McKinsey & Company, Shiela Bonini and Steven Swartz, Bridging discipline to your sustainability initiatives, McKinsey & Company, August Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

28 the lines of the calorie sharing transparency for chain food retailers or the USDA nutrition label); and a reformation of management education systems to make sustainability part of the core curriculum and clear guidelines for board ownership of non financial metrics. Notwithstanding the rhetoric and hopes of Sustainability Inc., the speed of current ecosystem degradation is outstripping adoption of sustainable practice. There are those who accept this premise, but point to the unprecedented rate of technological innovation as the source of salvation. 56 My view is different. Having worked at Timberland for 15 years for a visionary, committed CEO who made only limited progress on the environmental front, I believe that the current form of capitalism needs reshaping in important ways. While innovation in power generation (e.g. distributed solar), product creation (e.g. lab grown leather) and transparency (e.g. crowd sourced factory conditions rating software) have great potential for good, the scope of our systems challenges is such that traditional single bottom line companies will have to become a part of the solution. Gaylord Nelson, a former Senator and Governor from Wisconsin and the founder of Earth Day said it best, the economy is a wholly owned subsidiary of the environment, not the other way around. The sooner that we integrate that insight, the quicker that we can shape policy and practice and create a more lasting form of our economic system. Ken Pucker is an investor, an Advisory Director at Berkshire Partners, and a lecturer at the Questrom School of Business. 56. See the book Abundance: The Future is Better Than You Think, by Peter Diamandis and Steven Cutler as a well researched argument of this case. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

29 Transparent Corporate Objectives A Win-Win for Investors and the Companies They Invest In by Michael J. Mauboussin, Credit Suisse, and Alfred Rappaport, Kellogg School of Management, Northwestern University A t its core, corporate governance should be a system of checks and balances that a company designs to ensure that it faithfully serves its governing objective. Think of a governing objective as a clear statement of what a company is fundamentally trying to achieve. It shapes the organization s culture, communications, and choices about how it allocates capital. With a well-articulated governing objective, executives have a basis for making the difficult decisions that inevitably arise in the dynamic world of business. A solid governing objective also provides a benchmark for investors and other stakeholders to evaluate a company s performance. Academics and consultants have focused most of their analysis of corporate governance on issues such as board size and independence, separation of the positions of chairman and chief executive officer, executive compensation, antitakeover provisions, and classes of stock with varying voting rights. These are topics worthy of debate, but they fail to get to the heart of the matter. The essential problem is that most public companies have extensive governance procedures but no clear governing objective. As a consequence, corporate governance generally fails to provide an established, transparent, and sound basis for managers to make decisions. And without knowing how managers decide, it is difficult to hold them accountable for what they decide. Boards of directors, investors, and proxy advisory firms have no effective benchmark for evaluating a company s choices and performance. Investors, in particular, are left to buy and sell securities in a murky market for corporate governance, making it a challenge to assess investment risk and to value shares. When asked which governing objective guides them, executives commonly answer either maximizing shareholder value or balancing the interests of stakeholders. But these stated objectives are confusing because their meaning differs from person to person. Further, they are misleading when a company evaluates its performance and compensates employees in a way that is at odds with its stated objective. This combination of semantic confusion and conflict between words and actions undermines the effectiveness of corporate governance. It has also contributed to notable failures, including the high-profile corporate scandals of the early 2000s and the more recent financial crisis. Companies were saying one thing and doing something else. Our main goal is to encourage companies to establish a clear governing objective and to ensure that their governance structure supports it. This would close the gap between their words and actions and would thereby create a more transparent market for corporate governance. The dearth of transparent governing objectives is not all that surprising. The law provides a company with wide latitude to conduct business as it sees fit. The courts take this light-handed approach because they recognize that corporate boards and management, not the courts, have the information and expertise to set objectives and make decisions. Unless directors breach the business judgment rule by participating in conflicts of interest or by demonstrating gross negligence in their duty to be properly informed, the courts will not intervene. The business judgment rule doesn t preclude the board from considering the interests of shareholders as paramount; but other than accepting the highest bid when the company is for sale, there is no clear imperative to do so. Although boards and managements have a fiduciary responsibility to shareholders, the law provides them with ample flexibility to consider the interests of other stakeholders, including the public at large. While the law permits broad discretion, executives and scholars have for decades debated the proper purpose of the public company. The prospect for a consensus does not appear to be on the horizon. In 2005, a lively exchange between Milton Friedman, the Nobel-Prize-winning economist, and John Mackey, the chief executive officer of Whole Foods, captured the spirit of the debate. A strong free market advocate, Friedman argued that management s primary responsibility is to serve shareholders by maximizing longterm value within the rules of society. Mackey, in contrast, argued that Whole Foods seeks to create value for all of its stakeholders, including customers, employees, investors, vendors, communities, and the environment. He conceded that there is no magical formula to balance the interests of the stakeholders and that doing so is a dynamic process that shareholders should leave to management s discretion. But there s a difficulty with such ambiguous governing objectives. The law provides no concrete guidance on how to adjudicate the complex trade-offs between the interests of shareholders and other stakeholders. Nor do mission statements or other corporate pronouncements. So investors don t 28 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

30 know whether a company s primary objective is to maximize near-term share price, maximize long-term shareholder value, or balance the interests of stakeholders. Investors therefore have no reliable basis to evaluate a company s strategy and the operating and financing choices its managers make. Distinguishing Value Maximization from the Earnings Game Maximizing shareholder value as a governing objective has come under heavy fire in recent years. Yet much of the corporate governance literature, and discussions by corporate executives and consultants, reveal a complete misunderstanding of the principles that underlie the concept. So let s define it clearly. Maximizing shareholder value means focusing on cash flow, not earnings. It means managing for the long term, not for the short term. And it means that managers must take risk into account as they evaluate choices. Executives who manage for value allocate corporate resources with the aim of maximizing the present value of risk-adjusted, long-term cash flows. They recognize that to create value, a company must generate a return on its invested capital that covers all of its costs over time, including the cost of capital. These executives are not fixated on the short-term stock price but rather on building enduring long-term value that ultimately shows up in a higher stock price. A critical aspect of maximizing shareholder value is embracing a long time horizon. Jeff Bezos, CEO of Amazon. com, maintains that companies that embrace a short time horizon compete against many companies. But those willing to invest using a longer time horizon effectively compete against fewer companies, because not many other companies are willing to do that. Because an organization s success depends on long-term relationships with each of its stakeholders, lengthening the investment time horizon benefits not only shareholders but customers, employees, suppliers, creditors, and communities as well. An extended time horizon promotes ethical behavior and trust between the company and its stakeholders, thereby increasing the firm s long-term value creation potential. In brief, long-horizon value maximization as a governing objective provides a disciplined framework for a company that can help it relate to all of its stakeholders. Critics blame the pursuit of shareholder value for management s counterproductive obsession with the quarterly earnings expectations of Wall Street, the failure to invest adequately in long-term growth, and an unhealthy focus on short-term stock price movements. They are wrong. Companies true to the principles of managing for value are not the culprits. To the contrary, the problem lies with executives who fixate on quarterly earnings and the near-term stock price and effectively hijack the name of shareholder value. We will not close the governance gap by jettisoning the concept of shareholder value, but by aligning the organization s behavior to serve the principle as it is properly understood. One point should be clear: There is a compelling case against unsavory actions that attempt to boost the short-term share price. Dwelling solely on the stock price encourages management to pad the bottom line in the short term in ways that can place the long-term health of the company in jeopardy. Such behavior increases the financial risk and anxiety of investors who are living longer, face higher costs for education, fear greater future tax burdens, and wonder whether government programs, including Social Security and Medicare, will deliver the benefits they promise. The practice of pursuing immediate results rather than managing for long-term value creation is certainly not new. For instance, the seeds of the U.S. automobile industry s troubles in recent decades were sown as early as the 1950s, when unions settled for smaller wage increases in the short term in return for higher pension and health-care benefits for their members over the long term. This increased short-term earnings for the companies but created major competitive challenges in the long term. Things haven t changed much. In recent years, researchers have surveyed executives and found that a large majority are willing to forgo or delay value-creating projects in order to meet the quarterly earnings expectations of Wall Street. In many cases, companies provide guidance that sets those expectations. Sound business decisions fall by the wayside when companies and investors play the earnings game. Companies that fail to invest in long-term, value-creating opportunities ultimately hurt all stakeholders, not just their long-term shareholders. A company that chooses to reduce research and development today may boost this year s earnings, but it will have fewer products to sell in the future. Fewer products translate into lower revenue, fewer employees, less business for suppliers, and reduced taxes for the government. The Problem Facing Stakeholder-Centric Companies We now turn to the other frequently declared objective balancing the interests of stakeholders. Everyone should agree that incorporating the interests of all stakeholders is indispensable to creating shareholder value. However, balancing stakeholder interests cannot serve as a company s singular governing objective because, as Michael Jensen wrote in this journal some 15 years ago, it is impossible to simultaneously maximize the interests of all stakeholders. 1 Consider the decision to set the price for a product. A price that is too low is bad for employees (lower wages), 1. Jensen, Michael C., Value Maximization, Stakeholder Theory, and the Corporate Objective Function, Business Ethics Quarterly, Vol. 12, No. 2 (April 2002), A shorter, less technical version was published in the Journal of Applied Corporate Finance, Vol. 14, No. 3 (Fall 2002). Journal of Applied Corporate Finance Volume 27 Number 2 Spring

31 the government (fewer taxes), and shareholders (less profit) but good for customers in the short run (better value) and suppliers (more demand). Eventually, a company that made such a choice would risk going out of business. What if the price is too high? In the short run it is good for employees, the government, and shareholders but bad for customers and suppliers. And over time, excessive prices are a sure way to lose customers to the competition. So companies that charge too little will have happy customers today but will find it difficult to fund the investments they need to provide better products and services tomorrow. Companies that charge too much will see unhappy customers flee to the competition. The logic of a singular governing objective extends to other decisions. Employees seek competitive compensation and a satisfying work environment. Paying employees too little ensures that a company will have a substandard workforce. Paying too much, as U.S. auto companies discovered, compromises a company s ability to remain competitive. The same thinking applies to suppliers and other stakeholders. Companies that strive to increase value over time can succeed only by taking into account the interests of all their stakeholders. The shareholder value concept draws fire from those who believe that it fails to address corporate social responsibility. Michael Porter, a Harvard professor of strategy, and Mark Kramer, a consultant focused on social change, suggest that the purpose of the corporation is to create shared value. 2 Shared value addresses society s needs such as health, better housing, improved nutrition, help for the aging, and less environmental damage. They contend that linking the success of companies to societal improvement creates opportunities to serve new needs, improve efficiency, create differentiation, and expand markets. Everyone wins when activities that are socially responsible also create longterm shareholder value. Under these circumstances, shared value is entirely consistent with maximizing shareholder value. But when companies fund social initiatives at the expense of long-term shareholder value, shareholders bear the cost through lower returns. The cost also finds its way to consumers through higher prices and to employees through lower wages and fewer jobs. In this case, the concept of shared value clearly conflicts with maximizing shareholder value. Three Steps Toward Transparency The debate about the appropriate governing objective could continue indefinitely without resolution. We believe a better approach is to create an efficient market for corporate governance by prompting companies to close the gap between what 2. Michael Porter and Mark Kramer, Creating Shared Value, Harvard Business Review, January-February they say and what they do. A company can accomplish this by following three essential steps. First, choose a clear governing objective. Second, commit to a set of policies that encourage the behaviors that support the governing objective. Third, publicly disclose the governing objective and the policies that support it in a transparent and clear fashion. Our goal is not to advocate for a particular governing objective, although we do believe that managing for shareholder value is ideal if done properly. Rather, we want to see companies be specific in their objective, make sure that their supporting policies are consistent with that objective, and communicate their approach to all relevant constituencies. Step 1: Establish a Governing Objective Most executives believe that they operate with a governing objective. But finding a clear-cut objective among the mélange of metrics, messages, and motivations within most companies is frustratingly difficult if not impossible. The fundamental problem is that a company s stated objective is almost always too vague, whether it focuses on shareholders or stakeholders. As a result, it is open to a wide range of interpretations and hence falls short of being a useful governing objective. Indeed, even companies that claim creating shareholder value as their governing priority commonly cling to a counterproductive obsession with meeting Wall Street s quarterly earnings expectations and a damaging focus on short-term stock price movements. A recent study of executive remuneration by Credit Suisse HOLT found that only five percent of the companies in the S&P 500 have performance measurement periods in excess of three years, while a recent McKinsey & Company survey revealed that 25% of board members have little/no understanding of what creating value means. 3 Not surprisingly, directors often want management to deliver what they believe institutional investors want steadily rising quarterly earnings to boost the stock price. Stakeholder-centric companies with unclear governing priorities also produce inconsistencies between words and actions. What, for instance, do companies mean when they declare that creating customer satisfaction or customer value is their priority? Would these companies offer products and services to current customers at prices that shortchange the investments they need to service future customers? If so, their actions directly conflict with the governing objective of creating long-term customer value. Many companies try to have it both ways by stating that they aim to maximize customer value while recognizing the need to provide shareholders with a reasonable rate of return. This, too, raises fundamental questions: How do companies measure the success of their customer satisfaction objec- 3. Tom Hillman, Linking Corporate Performance and Valuation to Management Incentives, Credit Suisse HOLT, July McKinsey Global Institute Survey, Improving Board Governance, August Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

32 tive? How do they balance the interests of customers and shareholders as well as other stakeholders in their day-to-day decisions? How do they establish a reasonable rate of return for shareholders? Is it based on company or market metrics? What about companies whose stated objective is to balance the interests of all stakeholders? Balancing stakeholder interests cannot serve as a company s singular governing objective because, as stated earlier, it is impossible to maximize simultaneously the interests of multiple stakeholders. The approach fails to spell out how managers will resolve the competing interests of a company s stakeholders. With no single governing objective serving as a scorecard, management is unaccountable to shareholders and stakeholders. Executives can rationalize virtually any decision. As a consequence, the approach fails to provide shareholders and other stakeholders a means to assess their results. Still, many CEOs embrace the concept because it is fashionable and provides them with maximum decision-making flexibility. Specifying a time horizon is also critical. Executives commonly complain about the market s short-termism. Some executives believe that they have no choice but to be shortterm oriented given that the average holding period for stocks is only one or two years. This reasoning is deeply flawed. What matters for dedicated fiduciaries is not portfolio turnover but rather the time horizons of the ultimate beneficiaries, typically individuals who are saving to meet long-term needs for education and retirement. Those savers have no choice but to take a long-term view, and investment managers are supposed to act in their interests. Regardless of how long an investment manager holds a stock, savers have an extended horizon so long as they remain committed to stocks as an asset class. Some observers contend that focusing on an uncertain long term distracts the organization from what it needs to accomplish in the short term. But it s important to recognize that the short term and the long term are not adversaries in a zero-sum game. The overriding goal should be to focus continuously on what the organization needs to accomplish in the short and intermediate term in order to achieve its goals in the long term. As Peter Drucker, the great management thinker, advised corporate managers in his 2007 book, keep [your] noses to the grindstone while lifting [your] eyes to the hills. 4 Step 2: Implement Policies to Support the Governing Objective Next, companies need to adopt a set of policies that encourage behaviors that support a company s governing objective. This includes financial and non-financial performance metrics, as well as incentive compensation plans, which support their stated governing objective. Developing appropriate performance metrics requires a company to assess how well each metric contributes to the corporate objective. Without rigorous testing, a company may mistakenly adopt metrics that drive short-term performance at the expense of long-term results. Companies that focus on short-term performance metrics do not just squander value by delaying or forgoing investment opportunities. They accelerate their own demise by concentrating on their current businesses while failing to develop the businesses of the future. Undue focus on lofty levels of current sales and earnings can induce complacency and dull management s motivation to respond to changes in the marketplace. Non-financial metrics like safety, product quality, customer satisfaction, and employee retention can also provide important support to the governing objective. Nevertheless, corporate governance scholars Christopher Ittner and David Larcker found that most companies fail to identify non-financial metrics that promote the company s strategy or value creation. They also found that business units within the same company often use different, and sometimes contradictory, methods to measure the same metric. 5 Companies confound the problem of words versus actions when they settle on muddled metrics. Proper metrics enable employees to easily identify the specific actions they must take to serve the broader governing objective. Compensation should encourage behaviors that serve the governing objective. Incentive arrangements for CEOs and other senior corporate executives go far in explaining why corporate short-termism persists. Compensation packages typically include annual and multi-year bonuses, restricted stock grants, performance shares, and stock options. Compensation committees typically award bonuses for meeting or exceeding targets that are unreliably linked to long-term value creation. Restricted stock grants often function as little more than guaranteed pay without performance. Performance shares do require some performance, but not necessarily the performance that delivers long-term value. Standard stock option plans aren t the answer either because executives profit from any increase in share price, and vesting periods of just three or four years or less encourage executives to manage for the short term. With proper incentives in place, pursuing the governing objective becomes an act of enlightened self-interest for all employees. We recognize that designing effective incentives is devilishly difficult and that incentives alone are not the answer. But proper incentives are essential for an organization to faithfully serve its governing objective. Companies that prioritize balancing the interests of stakeholders, social responsibility, shared value, or corporate sustainability cannot disclose their primary stakeholder 4. Drucker, Peter F., People and Performance: The Best of Peter Drucker on Management (Boston: Harvard Business Review Press, 2007). 5. Christopher D. Ittner, and David F. Larcker, Coming Up Short on Nonfinancial Performance Measurement, Harvard Business Review, November 2003, Journal of Applied Corporate Finance Volume 27 Number 2 Spring

33 because they don t have one. But they can disclose their time horizons and explain how they go about managing the diverse interests of their stakeholders. Shareholders of publicly traded companies rely on an implicit contract that management will act in their interests. Unlike other stakeholders who have explicit contracts with the company, shareholders have no explicit rights except for the right to vote. If investors come to believe that company executives will not honor shareholders implicit contract, they will balk at funding companies or will do so only at a heavy discount. Managements of stakeholder-centric companies have every right to prioritize an objective other than creating shareholder value, but to honor their implicit contract with shareholders they need to disclose the acceptable limit for trade-offs they are willing to make at the expense of their shareholders. Would the organization, for instance, invest in socially responsible activities when the expected return is below the minimum acceptable return for creating value? If so, under what circumstances? Would the company delay or forgo valuecreating investments in order to fund social responsibility programs? To support macro-economic employment goals, would the organization keep excessive employees on its payroll at the expense of value creation? How do the company s compensation programs motivate executives, operating unit managers, and front-line employees to support the organization s objectives? A forthright discussion of these questions helps shareholders, as well as other stakeholders, choose the companies with which they wish to affiliate and provides the stock market with a better basis for pricing shares. Step 3: Disclosure A company that discloses its governing objective, the time horizons it will use in its planning and decision-making processes, how it will resolve trade-offs among stakeholder interests, and the specific policies in place that support the governing objective would meet the requirements of the proposed template. Publicly communicating this information creates a discipline that compels companies to thoughtfully select their governing objective and to avoid practices that are at odds with it. Companies today insist that they find it difficult to take a long-term view of their investments because of the market s myopic focus on short- term performance. Our proposal eases this concern because companies would clearly communicate their governing objective and its implementation. CEOs of companies that espouse shareholder value but are caught up in near-term share-price movements understandably do not broadcast their short-term orientation. CEOs would likely lengthen their time horizons were they compelled to disclose them. This disclosure alone might serve as a powerful antidote to corporate short-termism. Companies would then be in a position to invest in more projects with longer-term payoffs, presumably improving resource allocation in individual companies and the economy overall. Better resource allocation, in turn, creates additional jobs, revenues for suppliers, taxes for government, and better returns for shareholders. Another important benefit is that a transparent and consistently implemented governing objective enables companies to attract shareholders with interests that are consistent with those of the company. For instance, the Forum for Sustainable and Responsible Investment, an association of investors interested in promoting social principles, estimates that almost $7 trillion is invested in funds with social goals. Our three-step process accommodates such diversity in investment objectives and allows investors to find companies that have governing objectives consistent with their mission. Who Will Serve as the Agents for Change? Boards concerned with the success and survival of the organization have a duty to advocate a long-horizon point of view. But they often don t do so. In another recent McKinsey survey, nearly 50% of over 600 C-suite executives and directors said that the board was most responsible for shorttermism. 6 In their role as overseers, boards should also insist that management allocate resources to opportunities that serve the governing objective over a long time frame. Here again, boards seem to fall short. A survey of more than 750 directors revealed that only about a third of them fully comprehended the strategy of the company they served. 7 If corporate boards do not step up, the investment management industry and, specifically, investment managers are the logical catalysts for promoting this initiative. Investment managers would, however, need to hold themselves to the same high standards that they insist upon for their portfolio companies. To credibly insist that others change their behavior, investment managers must be clear about their own goals and the supporting governance structures they have in place. To accomplish this investment firms will have to rise above some challenging trends in the industry. The first is the rapid rise of passive investing. In 1980, only a modest sum of capital was run passively. Today, about one-third of assets under management are held by passive funds, including index funds and exchange-traded funds. Further, active managers who are closet-indexers run another one-third of assets under management. The slice of truly active managers is shrinking relative to the total pie. With active managers creating a huge positive externality for passive investors by gathering and impounding 6. Barton, Dominic, and Mark Wiseman, Making Boards Work, McKinsey Commentary, December McKinsey Global Institute Survey, Improving Board Governance, August Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

34 information into stock prices, passive investors have little incentive to participate in corporate governance initiatives. But, there is good reason for passive investors to work alongside active investors to promote the proposed process because both benefit when companies generate meaningfully better long-term returns as a result. The second trend is the shift from the profession of investing to the business of investing, which has been eloquently discussed by industry leaders such as Charles Ellis and John Bogle. 8 The profession is about delivering long-term returns for investors. The business is about gathering assets and generating fees, which when taken to an extreme can be antithetical to fiduciary capitalism. To be clear, a healthy business is necessary to support a healthy profession, but when the pendulum swings too far toward short-term asset gathering and away from longterm returns, investment managers lose credibility in their efforts to propose reforms in corporate governance. Striking an appropriate balance between the profession and the business is essential not only for influencing its portfolio companies but also for the long-term success of the investment industry itself. Finally, the clients of investment management firms have become increasingly short-term oriented. Ample evidence shows that investors, whether retail or institutional, tend to chase immediate results to the detriment of long-term performance. Without a solid base of clients, even the bestintentioned investment firms find following a long-term orientation difficult. Just as the time horizon for corporate executive compensation needs to be lengthened, the same applies to performance evaluation and compensation for investment managers. Conclusion Peter Drucker stressed the critical distinction between management and leadership. 9 He argued that management is doing things right and leadership is doing the right things. A clear governing objective reminds CEOs of this important distinction every day. A company needs a clear governing objective and a supporting structure that makes pursuing the objective an act of enlightened self-interest for everyone in the organization. Further, the company should communicate its intentions to all of its stakeholders so that each can more confidently choose to opt in or opt out. A company that chooses a governing objective and communicates it clearly will attract the support of likeminded shareholders and other stakeholders. Given the significant benefits, there is no better time than now for corporate boards and the investment industry to be at the forefront of the campaign to move companies toward a transparent and long-term orientation. Michael J. Mauboussin is Head of Global Financial Strategies at Credit Suisse in New York City and is an adjunct professor at Columbia Business School. Alfred Rappaport is the Leonard Spacek Professor Emeritus at Northwestern University s Kellogg School of Management in Evanston, Illinois. Legal Disclaimer: The views herein are solely those of the authors, and do not represent the views of Credit Suisse or any of its affiliates. 8. See Ellis, Charles D., Will Business Spoil the Investment Management Profession? Journal of Portfolio Management, Vol. 27, No. 3, Spring 2001, 11-15; and John C. Bogle, The Mutual Fund Industry Sixty Years Later: For Better or Worse? Financial Analysts Journal, Vol. 61, No. 1, January-February 2005, Drucker (2007), cited earlier. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

35 Integrated Reporting and Investor Clientele by George Serafeim, Harvard Business School* I ntegrated Reporting (IR) is a relatively new phenomenon in the world of corporate reporting that has gained significant momentum in the last ten years. The International Integrated Reporting Council (IIRC) has defined IR as a process founded on integrated thinking that results in a periodic integrated report by an organization about value creation over time and related communications regarding aspects of value creation. Such integrated reports contain, along with traditional GAAP-based financial statements, considerable information about a company s environmental and social record as well as information related to intangible assets in the form of social or intellectual capital, including data on variables such as employee turnover and satisfaction, product quality metrics, and water and energy consumption. But unlike the sustainability reports that most of the world s largest companies have been producing for a decade or more, the information provided by integrated reports is expected to be relevant and linked to long-run corporate profitability and value. In the words of the IIRC, an integrated report is expected to provide a concise communication about how an organization s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value in the short, medium and long term. By mid-2015, the IIRC s pilot program included more than 140 large multinational companies that were supported by an investor network with more than 35 members, all of which met the IIRC s criteria for long-term investors a group that is assumed to be the primary audience for IR. In the United States, for example, companies such as Pfizer, American Electric Power, Clorox, and Southwest Airlines have all in recent years published annual reports that they have represented (or selflabeled ) as integrated. At the same time, many more U.S. companies have included nonfinancial data in annual reports that have not been identified or recognized as integrated. While more companies are practicing some form of IR and more investors are starting to use the reported data, we still have a very limited understanding of the effects of IR. In this article, I present the findings of my recent study that investigates the relation between IR and the composition of a company s investor base. More specifically, my study tested the hypothesis that companies that practice IR tend to attract long-term shareholders while possibly discouraging short-term shareholders and, as a result, create a more long-term oriented investor base. Take the case of American Electric Power, one of the first companies in the U.S. to self-declare its report as integrated. The institutional shareholder base of this public utility the largest emitter of CO 2 in North America has significantly lower portfolio turnover than the institutional shareholder bases of other comparable utilities. And the same is true of Dow Chemical s shareholder base relative to those of its competitors. What s more, on April 13, 2015, when Dow CEO Andrew Liveris announced the next (making it the third) generation of the firm s 10-year sustainability goals, the company s stock price outperformed its competitors by some 3.5%, a clear sign of investor enthusiasm about the firm s long-run prospects. But if there is ample anecdotal evidence of a link between IR and investors with a longer time horizon, no empirical studies have as yet attempted to establish such a relation. In this article, I present the findings of the first study to provide broad-based statistical documentation of the tendency of companies that practice integrated reporting to attract longerterm shareholders. In so doing, my research complements the findings of a case study of a biotech firm called Shire that I published in this journal a little over a year ago. That case, which I mention later in this article, shows a fairly dramatic shift in the company s investor base that accompanied its adoption of a number of expanded reporting initiatives focused on product safety, anti-corruption measures, and the recruitment, development, and retention of talent. But if such an in-depth study of one company can provide useful insights, it has clear limitations, especially in providing guidance to other companies facing possibly different circumstances and subject to different constraints. In the study that is the focus of this article, I attempt to examine changes in corporate reporting and investor base across a large sample of companies while controlling for other factors that are expected to influence the * I recognize financial support from the Division of Research and Faculty Development of Harvard Business School. I am grateful for many valuable comments from Mary Barth, Brian Bushee, Gavin Cassar, Bob Eccles, Gilles Hillary, Mo Khan, Steve Monahan, Mark Muffet, James Naughton, Grace Pownall, Shiva Rajgopal, and seminar participants at Emory University, INSEAD, the spring accounting camp at Tilburg University, and the empirical conference at University of Minnesota. Many thanks go to Bob Eccles and Mike Krzus for sharing their data on the contents of integrated reports. I am solely responsible for any errors. I am grateful for research assistance from Andy Knauer and James Zeitler. Contact gserafeim@hbs.edu. 34 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

36 kinds of investors who buy a company s shares. By so doing, my study aims to provide companies considering the adoption of IR with realistic expectations about their ability to replicate Shire s success in attracting long-term shareholders. Beyond Sustainability Reporting into the Financial Mainstream Since the late 1990s, a large and growing number of U.S. publicly traded companies have been providing sustainability reports to a variety of corporate stakeholders. Indeed, in 2014, almost 90% of U.S. S&P 500 companies published sustainability reports. Such reports are issued separately from the firm s financial statements and, in most cases, three to six months later. The IR movement can be seen as a response to widespread criticism that while financial reporting fails to provide information about important non-financial corporate assets, sustainability reporting has so little bearing on a company s financial performance that it offers almost no insight into a company s management processes and plan to create long-run value. Like advocates of sustainability reporting, proponents of IR argue that companies should supplement the GAAP financial information they are now required to report with other nonfinancial information that is of interest to shareholders, such as information about customers, employees, and the environment. Noting that most kinds of financial information are lagging indicators that provide a rear-view mirror of the company s performance, defenders of IR claim that nonfinancial information can provide insights into the company s future performance. And given that the market values of most companies exceed their book values by a wide margin, additional reporting about a company s environmental, social, and governance (ESG) initiatives and investments can provide useful information about the values of intangible assets including human capital, natural capital, corporate brands and general reputation that are not captured on the balance sheet. 1 But at the same time, proponents of IR also argue that separate sustainability reporting, while providing relevant information for different stakeholders, is unlikely to be an effective mechanism for communicating to investors the expected effects of a company s ESG initiatives on its longrun profitability and value. 2 The information provided by most sustainability reports, in addition to being less credible and timely than financial reporting data (which are audited at a higher level of assurance and released sooner), is not placed in the context of a company s strategy and business model. And the concept of the materiality of each of the firm s ESG initiatives and investments is rarely addressed. Many supporters of IR have also argued that because IR 1. Robert Eccles, The Performance Measurement Manifesto, The Harvard Business Review, 69 (1), 1991, p See also Robert Eccles, Robert Herz, Mary Keegan, and David Phillips, The Value Reporting Revolution: Moving Beyond the Earnings Game (New York: John Wiley & Sons, Inc., 2001). 2. Eccles, Robert, and Michael Krzus, One Report: Integrated Reporting for a Sustainable Strategy (New York: John Wiley and Sons, Inc, 2010). could be a more effective way to communicate a firm s capabilities for increasing long-run value, companies that practice IR are likely to attract longer-term investors. But, as already noted, whether IR indeed is a more effective managerial tool for communicating a company s long-term prospects is an open empirical question. Hence the aim of my study: to provide broadly based statistical evidence to support or dismiss the common anecdotal claims that companies that practice IR have had greater success in attracting investors with a longer time horizon. The Case for Attracting Long-term Shareholders But this begs the question: How and why should the time horizon of a company s investors be expected to affect its performance and value? After all, if corporate managers make the same investment and operating decisions regardless of who owns the company s shares, then the holding period of investors should be a matter of indifference, with no expected effects on value. During the past 15 or 20 years, academic research has produced a number of studies suggesting that the type of investors who own the shares of a company can indeed affect managerial decision-making in predictable ways and, by so doing, affect corporate values. 3 In a study published in 2000, Wharton School professor Brian Bushee developed a method for classifying institutional investors that, using just two variables the number of stocks in an investor s portfolio and its average holding period assigns investors into one of three groups: (1) transients those holding lots of stocks with high turnover and short holding periods; (2) quasiindexers those holding lots of stocks with little turnover and long holding periods; and (3) dedicated holders those holding relatively few stocks for long periods of time. 4 In that study, Bushee reported findings that as much as 60% of U.S. institutions had the characteristics of transients, while 30% showed the behavior of quasi-indexers and only 10% could be classified as dedicated holders. But most important for the purposes of this study, Bushee also found that the managers of companies with larger percentages of transients in their investor base were significantly more likely to cut R&D spending to meet an earnings target than managers of companies with larger-than-average ownership by dedicated holders. Two years later, a study by a different researcher used Bushee s classification scheme to show that companies with more transients in their investor base are more likely to avoid negative earnings surprises through either earnings management or frequent adjustments of expectations. 5 Still another study showed that acquiring companies 3. See New York University Roundtable on Corporate Disclosure, 2004, Journal of Applied Corporate Finance 16 (4). 4. See Bushee, Brian J., and Christopher F. Noe, Corporate Disclosure Practices, Institutional Investors, and Stock Return Volatility, Journal of Accounting Research (2000): , and Bushee s personal website for institutional investor classification data, Journal of Applied Corporate Finance Volume 27 Number 2 Spring

37 with larger proportions of dedicated investors experienced stronger post-merger stock-price performance than companies with larger numbers of transients, and were also more likely than such companies to withdraw bids that the market viewed as value-destroying. 6 When taken together, these findings amount to highly suggestive evidence that dedicated, long-term investors can play an effective monitoring role in large public companies. Such monitoring has the potential to discourage the shortsighted investment behavior and earnings management for which U.S. companies in particular are so often criticized, while giving the managers of such companies the confidence to invest in the corporate future. In the case of corporate investments in sustainability, this more far-sighted behavior by companies with disproportionately large ownership by long-term investors seems especially relevant given the identification of short-termism as a major barrier to the willingness of businesses to transition to sustainability. In the 2012 version of The Sustainability Survey, for example, 88% of the 642 representatives of businesses, NGOs, academia, and government who responded cited pressure for short-term financial results as a major obstacle to corporate investments in sustainability or ESG issues. In response to such pressure, some senior corporate managers are now actively trying to find ways to attract investors with longer-term horizons. Among the best known and most vocal of such managers, Paul Polman, the CEO of Unilever, has argued that driving shareholder wealth at the expense of everything else will not create a company that is built to last. You need to attract a shareholder base that supports your strategy not the other way around. We actively seek one that is aligned with our longer-term strategy. 7 Echoing Polman s message, a recent survey of investor relations professionals by Stanford Business School and NIRI found that nearly all companies want a longterm shareholder base, but on average about half of companies shareholder base has a short or medium-term horizon. 8 The Hypothesis Information asymmetry between a company s managers and outside investors creates frictions, or sources of cost, in the capital allocation process that have the effect of restricting access to finance for corporations. 9 The larger the potential gap between what insiders and outsiders know, the more likely it is that investors will demand a risk premium as a reward for allocating capital to companies, especially those companies that are making large commitments of capital today with distant payoffs. Moreover, the greater this information gap, the more costs of monitoring faced by institutional investors increase, which is a further deterrent to long-term investment. 10 But as we have already noted, investors differ greatly in their time horizons, ranging from transients with holding periods as short as seconds to dedicated investors who hold large positions in (typically a relatively small number of) stocks, in some cases for decades. The basic hypothesis of my study is that long-term investors are more likely to buy and hold shares in companies that provide more information about their long-term prospects since for them such information is likely to be useful both when assessing the value of the firm and monitoring management over time. Effectively, because long-term management requires longterm forecasting of future consumer demand, commodity prices, regulatory practices, and macro-economic conditions, a form of forecasting that is more difficult and inherently less accurate than short-term forecasting, firms that provide more information about their long-term prospects are providing a signal of their ability to practice long-term management. Nonfinancial information in the form of ESG data is a relatively new development that has been increasingly reported by a larger number of companies around the world. Along with the number of companies reporting sustainability information, the number of investors using this information has also been growing. The number of signatories to the United Nations Principles for Responsible Investment (UNPRI) has increased from 100 in 2006, representing $4 trillion in assets under management, to more than 1,300 in 2015, representing more than $35 trillion. Investor interest in sustainability is also reflected by the large number of investors who now access ESG data on Bloomberg terminals. 11 While such data could be relevant over any timeframe, it is often argued that they are primarily informative about the long-term prospects of the business. Consistent with this assertion, it is primarily pension funds and investment arms of insurance firms both institutions with relatively longer time horizons that have been the most frequent advocates of disclosure of sustainability data. What s more, academic research has shown that the disclosure of ESG data can have significant economic effects. One recent study found abnormal negative stock price reactions to the disclosure of negative sustainability information. 12 In another recent study, two colleagues and I found that companies that disclose more ESG information have lower capital constraints and greater access to finance Matsumoto, Dawn Management s Incentives to Avoid Negative Earnings Surprises. The Accounting Review 77, no. 3: Chen, Xia, Jarrad Harford, and Kai Li, 2007, Monitoring: Which Institutions Matter? Journal of Financial Economics 86, no. 2: See here for the interview: 8. See here for the results of the survey: files/2014_investment-horizon-final_0.pdf. 9. Hubbard, Glenn, 1998, Capital-Market Imperfections and Investment, Journal of Economic Literature 36: Healy, Paul, and Krishna Palepu, 2001, Information Asymmetry, Corporate Disclosure, and the Capital Markets: A Review of the Empirical Disclosure Literature, Journal of Accounting & Economics 31: Eccles, Robert, Michael Krzus, and George Serafeim, 2011, Market Interest in Nonfinancial Information, Journal of Applied Corporate Finance 23, no. 4: Yu. Kun, Shuili Du, and C.B. Bhattacharya, 2014, Everybody s Talking But is Anybody Listening? Stock Market Reactions to Corporate Social Responsibility Communications, Working paper. 13. Cheng, Beiting, Ioannis Ioannou, and George Serafeim, 2014, Corporate Social Responsibility and Access to Finance, Strategic Management Journal 35, no. 1: Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

38 While the availability of sustainability data has been increasing, there have been several criticisms of their value to investors. Perhaps the most important has been the failure to place the data in the context of the strategy and the business model of the company, thereby obscuring the relation between sustainability and financial performance. 14 Closely linked are widespread complaints about the failure to evaluate or even comment on the materiality of the different sustainability issues. Surveys of institutional investors have reported that 73% of the respondents disagree that sustainability reporting is linked to business strategy and risk, and 93% disagree that sufficient information is provided to assess financial materiality. 15 Another criticism concerns the credibility of the data since separate sustainability reports are generally presented as providing at best limited (if any) assurance instead of the normal standard of reasonable assurance. 16 Moreover, the timeliness of the data is another concern because sustainability reports typically come out well after the financial reports of the firm. And this timing discrepancy reduces the amount of investor focus on and interest in sustainability reports. 17 IR is a new form of reporting that, as discussed, attempts to address all the above deficiencies. And investors seem to be supporting it. Eighty percent of the investors surveyed by Thomson Reuters and GRI said they believed that IR will be useful or very useful in increasing the reliability and relevance of sustainability information. 18 But, of course, IR has a short history. Its practices and uses are still evolving, and only recently has a framework been developed that can provide companies guidance on what constitutes an integrated report. Like most other new management concepts, IR first started in practice. The first companies to produce a selfdeclared IR were the Danish enzymes company Novozymes (in 2002), the Brazilian cosmetics fragrances company Natura (in 2003), and the Danish pharmaceutical company Novo Nordisk (in 2004). 19 Starting in 2010, all South African companies listed on the Johannesburg Stock Exchange were required either to issue an IR or explain why they were not doing so. 20 There is no clear way to measure the number of companies that are now issuing integrated reports. The extent to which a company practices IR is a matter of degree and, hence, subjective judgment. But what seems clear is that a growing number of companies are producing financial reports that, even if not presented by the companies themselves as integrated, nonetheless contain increasing amounts of ESG information. For example, a 2013 report by Responsibility Research Center (IRRC) found that although only seven of the S&P 500 companies labeled their reports as integrated, all but one of the 500 companies provided at least one ESG related disclosure that was linked to financial performance. 21 Similarly, almost two thirds of the S&P 500 companies included ESG-related disclosures with quantitative estimates of their effects or values while over half the companies discussed new product formulations designed to address sustainability challenges. The difficulties of identifying IR and coming up with a universally accepted definition of what constitutes an integrated report are reflected in the fact that, with the exception of a brief document prepared in early 2011 by the Integrated Reporting Committee of South Africa, there were no guidelines on what constituted an IR until December 2013, when the International Integrated Reporting Committee published its International <IR> Framework. A central tenet of integrated reporting, then, is placing the sustainability activities of a firm within the context of an organization s strategy and business model. Therefore, emphasis is placed on the material ESG issues that are most likely to affect the ability of an organization to create value in the future. Materiality is one of the guiding principles in the <IR> framework, and its importance is reflected in the creation of the Sustainability Accounting Standards Board (SASB), whose mission is to establish industry-based sustainability standards for the recognition and disclosure of material ESG concerns of and initiatives undertaken by companies traded on U.S. exchanges. Along with materiality, a complementary guiding principle of IR is the connectivity of information. IR is expected to demonstrate the interrelatedness and dependencies of the different factors, including ESG challenges and initiatives that affect the value creation process inside an organization. 22 And in the two surveys cited above, 92% of investors surveyed agreed or strongly agreed that financial and other sustainability information should be more integrated. 23 Along with the greater relevance to corporate profitability and values of the reported information IR also has the potential to raise the credibility of ESG data since 14. Eccles, Robert, and Michael Krzus, One Report: Integrated Reporting for a Sustainable Strategy (New York: John Wiley and Sons, Inc., 2010). 15. Accounting for Sustainability and the Global Reporting Initiative, The Value of Extra-financial Disclosure: What Investors and Analysts Said. 16. Industry observers have suggested that performing an audit of sustainability data is several orders less expensive than audits of conventional financial data, which is consistent with the lower level of assurance provided. 17. See here for a discussion of the usefulness of ESG data for investors: globalreporting.org/information/events/conference2013/news/pages/updates/2-4. aspx. 18. Accounting for Sustainability and the Global Reporting Initiative, 2012, The Value of Extra-financial Disclosure: What Investors and Analysts Said. 19. One Report: Integrated Reporting for a Sustainable Strategy by Robert G. Eccles and Michael P. Krzus, John Wiley & Sons, Inc. Hoboken, New Jersey, 2010, Chapter Ibid., p Investor Responsibility Research Center (IRRC) and Sustainable Investments Institute (SII) Integrated Financial and Sustainability Reporting in the United States. 22. See NATIONAL-IR-FRAMEWORK-2-1.pdf. 23. Eurosif and ACCA, 2013, What do Investors Expect from Non-financial Reporting? 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39 the information is now part of regulatory filings that are scrutinized by regulators and to a greater extent by auditors. Including nonfinancial data in an annual report does not necessarily mean that the audit opinion provided for the financial numbers applied to the nonfinancial data as well. 24 Nevertheless, the IR process has been shown to improve the credibility and accuracy of nonfinancial information thanks to continuous improvement in the management information systems and control procedures that are now used in collecting the nonfinancial data. 25 And as a number of studies have shown, information that has proved to be more credible is more likely to be used by investors. And that brings us back to the hypothesis of my study: companies that practice IR are likely to attract longer-term investors who are interested in relevant and credible information for assessing long-run prospects and values. Through the practice of IR, such companies can be seen as providing information that helps address the negative effects of the information asymmetry between interested investors and corporate managers that increases monitoring costs and the required cost of capital. Sample and Data To construct the sample of companies for my study, I collected data on IR from a division of Thomson Reuters called ASSET4. ASSET4 specializes in providing objective, relevant, auditable and systematic sustainability information and investment analysis tools to professional investors who integrate sustainability data into their traditional investment analysis. It is estimated that investors representing more than $3 trillion of assets under management use the ASSET4 data, including prominent investment houses such as BlackRock. Specially trained research analysts collect a wide variety of economic and ESG data for every firm covered by the dataset, where all the primary data used must be objective and publicly available. After gathering the data every year, the analysts transform it into consistent units that are designed to be used in quantitative analysis. 26 For every company on which it collects and publishes economic and ESG data, ASSET4 then uses that data to produce a composite score for its IR program that ranges from zero to a high of 100. Those scores, according to ASSET4, provide investors and other corporate constituencies with a measure of management commitment [to] and effectiveness [in] the creation of an overarching vision and strategy integrating financial and extra-financial aspects. It reflects a company s capacity to convincingly show and commu- nicate that it integrates the economic (financial), social and environmental dimensions into its day-to-day decision-making processes. More specifically, the score reflects the perceived effectiveness of a number of different kinds of disclosures, such as whether the company does the following: (1) reports on the challenges or opportunities of integrating financial and extrafinancial issues, and the dilemmas and trade-offs it faces ; (2) explicitly integrates financial and extra-financial factors in its management discussion and analysis (MD&A) section in the annual report ; (3) sets targets or objectives to be achieved on the integration of ESG issues into its strategy and day-to-day decision making ; and (4) explains how it engages with its stakeholders. In addition to this score provided by ASSET4, my study also uses an alternative measure of IR (described in more detail below) that makes use of data from an asset management firm, Sustainable Asset Management. When using the ASSET4 data, the average IR score for my sample of companies, as reported in Table 1, was 39 (100 is a perfect score). At the same time, the standard deviation was 29, which suggests significant variation in the practice of IR (Table 1). Having collected these IR scores for the companies, I then collected data on different types of institutional investors from another division of Thomson Reuters called Institutional Holdings. Although ASSET4 is an international dataset, the data on institutional holdings data are available only for companies listed in the U.S., which dictated that the vast majority of final sample were U.S-listed firms along with a small representation (less than 5%) of Canadian companies. 27 As discussed earlier, Brian Bushee classified U.S. institutional investors into three kinds: transients, who holds lots of stocks and have very short holding periods; quasi-indexers, who also hold lots of stocks, but with very low turnover; and dedicated holders, who amass large stakes in a small number of companies and have long holding periods. In my study, I used two of Bushee s three classifications to come up with a variable I called LT Investor that measures the extent to which the investor base of a company is tilted towards dedicated holders and away from transient investors. LT Investor, which is calculated as the difference between the percentage of a company s shares that are held by dedicated and the percentage owned by transient investors, provides a measure of the relative time horizon orientation of the investor base. Consistent with Bushee s findings, in the average company in my sample 9.4% of the shares were held by dedicated investors and 15.5% by transients, resulting in an LT Investor score of -6% (Table 1). At the same time, quasi-indexers held an average of 46.8% of the shares of my 24. When I collected data from the GRI website on firms assurance practices, I found that for a sample of global companies that file their integrated or sustainability reports with the GRI, the probability of external assurance for the whole report is 45% higher for integrated reports. Moreover, the likelihood of Reasonable assurance compared to Limited assurance increases for firms issuing integrated reports. These results are obtained using logistic regressions with industry and country fixed effects for the years 2012 and Eccles, Robert, and Michael Krzus, 2010, One Report: Integrated Reporting for a Sustainable Strategy. New York: John Wiley and Sons, Inc. 26. Previous studies have used the ASSET4 data, including Ioannou, Ioannis, and George Serafeim What Drives Corporate Social Performance? The Role of Nation-level Institutions. Journal of International Business Studies 43, no. 9: Excluding Canadian firms leaves all results unchanged. Moreover, I later use an international sample and I find consistent results. 38 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

40 Table 1 Summary Statistics Variable N Mean Q1 Q3 St Dev Investor Ownership Data LT Investor 5, Dedicated 5, Transient 5, Quasi-index 5, Institutional 5, Reporting Data IR 5, Disclosure Quantity 5, Sustainability Report 5, GRI 5, Governance Data Classified Board 5, Staggered Board 5, Supermajority Vote 5, Firm Characteristics EESG Score 5, Firm Size 5, Leverage 5, E/P 5, PTB 5, Dividend Yield 5, Sales Growth 5, Beta 5, Volatility 5, Turnover 5, Stock Return 5, Family Firm 5, Sin Firm 5, Shareholder Activism Data Sustainability Engagement 5, Sustainability Reporting Engagement 5, Sustainability Engagement After 5, Sustainability Reporting Engagement After 5, Sustainability Crisis Data Sustainability Crisis 5, Sustainability Crisis After 5, All variables are defined in the Appendix. sample companies. (I did not include quasi-index funds in my LT variable because these funds are less likely to devote significant amounts of time to the information provided by IR because of the diversity of their holdings and the resulting dilution of incentives for and interest in evaluating any one company.) 28 Apart from IR, I also collected data from ASSET4 on governance practices that have been shown to be associ- ated with investor clientele.29 Specifically, I gathered data on whether the board of a company is classified (7% of the sample) or staggered (45%), and whether a supermajority vote is required to make decisions (32%). Moreover, I collected data on the percentage of quantitative sustainability metrics disclosed by a company out of the 121 metrics collected by ASSET4 ( Disclosure Quantity ), as well as whether a firm issues a separate sustainability report ( Sustainability Report ) 28. I replicate all results using the percentage of shares held by transient and quasiindex funds minus the percentage of shares held by transient investors. All results are very similar. Moreover, I find no significant relation between IR and quasi-index funds consistent with these investors paying less attention to a firm s IR practice. 29. Bushee, Brian, Mary Ellen Carter and Joseph Gerakos, 2009, Institutional Investor Preferences for Corporate Governance Mechanisms. Available at SSRN: com/abstract= Journal of Applied Corporate Finance Volume 27 Number 2 Spring

41 Table 2 Correlation Matrix Variable LT Investor IR Disclosure Quantity Sustainability Report GRI EESG Performance Classified Board Staggered Board Supermajority Vote Firm Size Leverage E/P PTB Dividend Yield Sales Growth Beta Volatility Turnover Stock Return Pearson correlation statistics. All variables are defined in the Appendix. and follows the GRI guidelines ( GRI ). The GRI guidelines are by far the most followed principles for sustainability reporting, with over 2,000 companies around the world using them as of As reported in Table 1, the average company in my sample disclosed information about 54% of the ESG metrics followed by ASSET4. Moreover, in 21% of the firmyears, companies filed a sustainability report; and in 13% of the firm-years, they followed the GRI guidelines in the report. In addition, I collected a variety of accounting and stock market data that served as control variables. For example, because larger companies are more likely to be practitioners of IR and have larger percentages of dedicated investors, all the specifications of the models I discuss below include a control for firm size as measured by the natural logarithm of sales. My models also have controls for differences in leverage (defined as total debt over total assets), earnings yield, book-to-market ratio, dividend yield, past one-year sales growth, equity beta, stock return volatility, and past one-year stock return. All these variables have been shown to be associated with the investor base of a firm. 30 (See Table 1 for summary statistics for all variables.) My final sample included 1,114 different companies and a total of 5,726 annual observations between 2002 (the earliest year ASSET4 provides data) and In analyses where I included firm-fixed effects to control for any unobservable firm-invariant characteristic, I required at least four years of data for each firm in the sample to ensure there was enough within-firm variation. Imposing this restriction reduced the sample to 649 companies and 4,684 observations. Analysis and Results In Table 2 I report the univariate correlations among all variables. The basic finding of these correlation measures is that companies that practice more IR (as indicated by ASSET4 scores) and have better combined economic and ESG (EESG) performance, as measured by ASSET4, have a more long-term oriented investor base. Not surprisingly, companies that practice more IR are more likely to issue sustainability reports, follow GRI guidelines, and have better EESG performance. But in what may come as a surprise, although the ASSET4 IR scores exhibit a significant positive relation with the variable LT Investor, all the other sustainability variables mentioned above such as Disclosure Quantity, the provision of a sustainability report ( Sustainability Report ), and adherence to GRI guidelines ( GRI ) actually exhibit a negative relation with LT Investor. As discussed later, this finding represents highly suggestive evidence that the positive relation between IR and 30. Bushee, Brian, and Christopher Noe, 2000, Corporate Disclosure Practices, Institutional Investors, and Stock Return Volatility. Journal of Accounting Research, 38: Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

42 Table 3 IR and Investor Clientele Parameter Estimate t Estimate t Estimate t Intercept IR Disclosure Quantity Sustainability Report GRI EESG Performance Classified Board Staggered Board Supermajority Vote Firm Size Leverage E/P PTB Dividend Yield Sales Growth Beta Volatility Turnover Stock Return Year f.e. Yes Yes No Industry f.e. Yes No Yes Firm f.e. No Yes No Adj R-squared 21.4% 57.0% 13.8% N 5,726 4, OLS regressions with robust and clustered standard errors at the firm level. The dependent variable is LT Investor which is calculated as the difference between percentage of shares owned by dedicated and transient investors for a given firm and year. All variables are defined in the Appendix. IR is defined as in the appendix except for IR in the third specification which is a measure of IR that ranges from 0 to 4 with higher values representing more integration of environmental and social information in financial reporting. LT Investor reflects not simply a positive relation between a longer-term investor base and a larger quantity of sustainability disclosure per se, but between the particular, presumably more effective, kind of disclosure namely, IR and the presence of long-term investors. Table 3 shows the results of a multivariate analysis. 31 The first specification of the model includes industry and year fixed effects as well as accounting and stock market variables as controls. The coefficient on IR is positive and significant, which supports my hypothesis that companies practicing IR have a more long-term investor base. The coefficient is with a t-statistic of The economic effect suggested by the estimates is a roughly 2% increase in LT (or about 20% of the LT standard deviation) for each interquartile increase in IR. This first specification includes controls for the quantity of sustainability disclosures. The estimated coefficient on this variable was insignificant, which suggests that the number of sustainability metrics a firm discloses does not appear to affect the percentage of long-term holders. The specification also includes controls for whether the firm issues a separate sustainability report, whether the sustainability report follows the GRI guidelines, governance aspects of the organization, and the EESG performance score assigned to each firm by ASSET4 all of them might be correlated omitted variables. While the coefficient on sustainability report is negative and significant in the first specification, in the rest of the specifications reported across the tables the relation is insignificant, suggesting the absence of any robust association between the issuance of a sustainability report and the time horizon of the investor base. Also reported in the table is an insignificant coefficient on the EESG performance score, which likely reflects investors use of both positive screening and engagement strategies. In positive screening strategies, investors choose companies with relatively better EESG performance with the expectation that better EESG performance will lead to better stock price performance in the future. By contrast, in engagement strategies, investors choose companies with relatively poor EESG 31. I estimate an ordinary least squares model with clustered standard errors at the firm level to mitigate serial autocorrelation in the errors. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

43 performance with the expectation that after engaging with the company the improvement in EESG performance will lead to better stock price performance. Because investors follow both strategies, their effects cancel out and there is no significant relation between EESG performance scores and investor base. In the second specification of my model, I included firm-fixed effects to test whether potentially a firm-persistent correlated omitted variable causes IR and investor base to be related. However, I reject this hypothesis since the coefficient on IR remains positive and significant. The coefficient is with a t-statistic of The explanatory power of the model increases from 21 to 57%, suggesting that a firm s investor base is fairly stable in terms of long-term orientation. Moreover, while the coefficient on IR continues to be significant, the negative coefficient on Sustainability Reporting becomes insignificant (and in general, the coefficient on Sustainability Reporting is insignificant across most of the specifications in the paper). The same is true for the coefficient on Staggered Board. The economic effect of IR on investor suggested by my estimates is a shift in investor base of about 1% (or about 10% of the LT Investor standard deviation) for each interquartile change in IR. To examine the robustness of these results, I used data from Sustainable Asset Management (SAM), a Swiss buy-side fund management company that constructs the Dow Jones Sustainability index and specializes in sustainable investing. 32 In 2010, SAM began collecting data about the level of integration of environmental and social information in annual reports. 33 More specifically, analysts at SAM collected data about the extent to which environmental or social information and KPIs were being integrated into annual reports. When using the SAM data to construct an index of IR, I assigned one point to all companies for including each of the following four kinds of information in their annual reports: (1) environmental social narrative information; (2) social narrative information; (3) environmental KPIs; and (4) social KPIs. With an index that thus ranges from zero to four, my study gave a score of zero to about 40% of the companies while only 5% of the sample firms receive a score of four. The sample is reduced to 493 U.S. companies when using SAM data. I estimated an ordinary least squares specification with these 493 observations for the year of The results reported in Table 3 for the third specification of the model show that this alternative IR variable is also positively associated with LT Investor. In this case, the economic effect of IR suggested by the estimates is about a 2.5% shift in investor base (or about 25% of the LT Investor standard deviation) for an interquartile change in IR. And so I conclude that the results documented so far are essentially the same as when using an alternative way of measuring the IR variable and using an alternative database. In exploring the effects of including other control variables, the estimated coefficients produced by my models are consistent with those reported in earlier studies. 34 For example, like the early studies, I found that companies with higher stock market liquidity have relatively more transient investors which is to be expected, since these investors need the liquidity in order to move in and out of the stock at a low cost. Moreover, my analysis also shows that companies with better recent past performance have relatively more transient investors, which reflects the momentum strategies employed by such investors. Attempts to Establish Causality While the estimates in Table 3 suggest a robust relation between IR and investor clientele even in the presence of several control factors, the direction of causality is not clear. Companies that practice IR could well be signaling their type and so be attracting investors with similar preferences and time horizons. Alternatively, companies decision to adopt IR (or not) may reflect the communicated preferences of their already well-established investor bases. In other words, in at least some companies, the outsized presence of dedicated investors could force companies to adopt or expand their practice of IR or, more commonly, I suspect, the unusually large presence of transient investors may well discourage companies from practicing IR. To shed more light on the direction of causality, I estimated so-called lead-lag models where I calculated one-year and three-year difference in all variables, and then calculated lagged values for first the changes in IR or then the changes in LT Investor. I calculated both one and threeyear changes because of my uncertainty about how fast investors might react to the information or the companies to increased interest (or pressure) from investors. As reported in Table 4, the first two specifications suggest that the lagged change in IR leads changes in LT Investor. In contrast the last two specifications provided no evidence for a change in investor base that is followed either a year or three years later by the adoption or expansion of corporate IR. In other words, changes in IR lead changes in the investor base rather than the other way round. In sum, these results provide evidence in support of a mechanism where firms practice IR and attract investors that find this information most useful for their objectives. What Kinds of Companies Appear to Benefit Most from IR? The results so far suggest that there is a robust positive association between IR and investor clientele. But the strength of this association is likely to be affected by characteristics of the companies. 32. The data provided by SAM are not publicly available and were provided on a confidential basis. 33. Eccles, Robert, and George Serafeim, 2011, The Role of the Board in Accelerating the Adoption of Integrated Reporting. Director Notes (The Conference Board). 34. Bushee, Brian, 2001, Do Institutional Investors Prefer Near-Term Earnings over Long-Run Value? Contemporary Accounting Research 18, no. 2: Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

44 Box 1: Changes in Shire s Investor Base As already discussed, Brian Bushee has developed a method that assigns all U.S. institutional investors into one of three categories: (1) transients those holding lots of stocks with high turnover and short holding periods; (2) quasi-indexers those holding lots of stocks with little turnover and long holding periods; and (3) dedicated holders those holding relatively few stocks for long periods of time. 35 We applied our own version of this classification scheme to the investor base of a pharmaceutical company called Shire and to the institutional shareholders of eight of Shire s competitors in the pharmaceutical sector. 36 Specifically, for Shire and its competitors, we calculated the variable LT that is, the difference between the percentage of shares held by dedicated holders and by transients for each year from 2006 through As can be seen in Figure 1, in the case of Shire the relative holdings of dedicated holders although outnumbered almost four to one by transients in 2006 increased steadily during the six-year period of our study. And by the end of 2011, Shire s dedicated holders actually outnumbered its transients, which is highly unusual for a public company. Investment managers that are well known for the integration of ESG considerations in the investment process, such as Domini Social Investments, the Norges Bank Investment Management, Scottish Widows, and Aviva Investors, held significant positions in Shire s stock. By contrast, the institutional shareholders of Shire s competitors, while less dominated by short-term momentum types than Shire s investors in 2006, actually became more shortterm oriented over this same period of time. How do we explain this contrast in patterns? One likely cause of Shire s short-term oriented investor base in 2006 was a sustained period of growth and outperformance leading up to that point that may well have attracted a large number of momentum traders. To be sure, this growth and outperformance continued after But it was also around this time that the company increased its emphasis on integrated thinking through top leadership s commitment to managing the environmental and social impact of its operations, a gradual diffusion of integrated thinking throughout the organization, and an increased focus on managing the strategically important stakeholder relations rather than spreading itself thin across myriads of initiatives. These changes were accompanied by an initiation and expansion of integrated reporting practices (although without identifying the reports as integrated ) and, as already noted, a sharp increase in the proportion of dedicated, long-term holders in the company s shareholder base. During this five-year period, moreover, the company continued to outperform its competitors, which by itself would lead one to expect an increase rather than a drop in short-term investor ownership (since past studies have found recent one-year or multiple-year stock return outperformance to be positively correlated with transient investors who are frequently momentum traders). In fact, from 2006 through the end of 2011, the stock price of Shire had appreciated approximately 200% while an index of competitors had appreciated by just over 10% over the same time period. Figure 1 Long-term Orientation of Investor Base Competitors Shire 35. See Bushee, Brian J., and Christopher F. Noe, Corporate Disclosure Practices, Institutional Investors, and Stock Return Volatility, Journal of Accounting Research (2000): , and Bushee s personal website for institutional investor classification data, Competitors with comparative sales to Shire were selected, with average sales ranging from 500 million to 7 billion between 2005 and The competitors included Allergan Inc, Dr. Reddy s Laboratories, Endo Health Solution Inc, Forest Laboratories, Hospira Inc, Medicis Pharmaceuticals, Mylan Inc, and Par Pharmaceutical. Five additional companies met the sales criteria but were left out of the analysis due to lack of investor data. These companies included Actavis PLC, Eisai, Perrigo, Valeant Pharmaceuticals, and Warner Chilcott PLC. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

45 Table 4 Lead-lag Analysis Differences lagged IR Differences lagged LT Investor 3-year 1-year 3-year 1-year Parameter Estimate t Estimate t Estimate t Estimate t Intercept IR Disclosure Quantity Sustainability Report GRI Classified Board Staggered Board Supermajority Vote EESG Score Firm Size Leverage E/P PTB Dividend Yield Sales Growth Volatility Turnover Stock Return Adj R-squared 2.2% 1.7% 1.9% 0.0% N 2,791 2,913 2,791 2,913 OLS regressions with robust and clustered standard errors at the firm level. The dependent variable is change in LT Investor which is calculated as the difference between percentage of shares owned by dedicated and transient investors for a given firm and year. All independent variables are calculated as changes. The first and third specifications calculate changes for all variables over 3-years. The second and fourth specifications calculate changes for all variables over 1-year. In the first two specifications change in IR is calculated for year t-1 (or t-3) while change in LT Investor is calculated in year t. In the last two specifications change in IR is calculated for year t while change in LT Investor is calculated in year t-1 (or t-3). First, I expect that incentives for the supply and demand of IR will be stronger for companies with higher growth opportunities. Since the cash flows supporting the current market capitalization of such companies are generally forecast to materialize further in the future, information about the long-term prospects of such businesses is more important to investors. In exploring this possibility, I used a company s price-to-book ratio as a proxy for the extent and value of its growth opportunities. Second, I expect the relation between IR and investor clientele to be weaker for family-owned companies. The thinking here is straightforward: because such family firms have a more long-term orientation than other publicly traded companies, and so already tend to do a better job of managing their relations with employees, customers and communities, 37 I expected the incremental signaling value of IR to be signifi- cantly lower for family-owned companies. When I define a family firm as a company whose founder (or a member of the family either by blood or marriage) is an officer, a director, or the owner of at least 5% of the firm s equity either individually or as a group, I find that 20% of the observations in my sample are family firms. 38 Third, I expected the strength of the relation between IR and investor clientele to increase with the size and probability of future penalties and risks expected to arise from changes in regulations and social expectations that are likely to disrupt a company s business model. As a proxy for the severity and probability of future penalties, I use a company s presence in sin industries such as alcohol, firearms, tobacco, gambling, nuclear and military businesses (as coded in the KLD database). Twelve percent of the 37. See Le Breton-Miller, Isabelle and Danny Miller, 2006, Why Do Some Family Businesses Out-Compete? Governance, Long-Term Orientations, and Sustainable Capability, Entrepreneurship Theory and Practice 30, no. 6: My definition follows those of Anderson, Roland, and David Reeb, 2003, Founding Family Ownership and Firm Performance: Evidence from the S&P 500, Journal of Finance 58, no. 3: and Villalonga, Belen, and Raphael Amit, 2007, How do Family Ownership, Control and Management Affect Firm Value? Journal of Financial Economics 80: Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

46 Table 5 IR and Investor Clientele: Moderating Effects Panel A: Levels Specifications Parameter Estimate t Estimate t Estimate t Estimate t Estimate t Intercept IR IR* PTB IR* Family Firm IR* Sin Firm IR* High IR Volatility Firm Controls Yes Yes Yes Yes Yes Year f.e. Yes Yes Yes Yes Yes Industry f.e. Yes Yes Yes Yes Yes Adj R-squared 20.7% 20.7% 21.0% 21.0% 21.4% N 5,726 5,726 5,726 4,123 4,123 OLS regressions with robust and clustered standard errors at the firm level. The dependent variable is LT Investor which is calculated as the difference between percentage of shares owned by dedicated and transient investors for a given firm and year. All variables are defined in the Appendix. Panel B: Changes Specifications Differences lagged IR Differences lagged LT Investor 3-year 1-year 3-year 1-year Parameter Estimate t Estimate t Estimate t Estimate t Intercept IR IR* PTB IR* Family Firm IR* Sin Firm IR* High IR Volatility Firm Controls Yes Yes Yes Yes Adj R-squared 2.9% 2.0% 1.9% 0.0% N 2,334 2,556 2,334 2,556 OLS regressions with robust and clustered standard errors at the firm level. The dependent variable is change in LT Investor which is calculated as the difference between percentage of shares owned by dedicated and transient investors for a given firm and year. All independent variables are calculated as changes. The first and third specifications calculate changes for all variables over 3-years. The second and fourth specifications calculate changes for all variables over 1-year. In the first two specifications change in IR is calculated for year t-1 (or t-3) while change in LT Investor is calculated in year t. In the last two specifications change in IR is calculated for year t while change in LT Investor is calculated in year t-1 (or t-3). The moderator variables are calculated as levels at the end of the starting year that the difference of the IR (first two specifications) or the LT Investor (last two specifications) is calculated. All variables are defined in the Appendix. observations in my sample are classified as operating in sin industries. Fourth, I expected the relation between IR and investor clientele to be weaker for companies that have been inconsistent in maintaining their commitment to their IR practice. Companies that fail to demonstrate their commitment to IR thereby decrease its credibility, which in turn should limit its ability to attract longer-term holders. Using the standard deviation of firm-specific IR over the past three years as a measure of inconsistency, I designated the top 10% of the distribution as High IR Volatility. In Panel A of Table 5, I report my findings of the effects of these four variables in weakening what I hypothesize to be the normal relation between IR and investor clientele. As expected, the relation between IR and LT Investor is stronger for both companies with higher price-to-book ratios and companies that operate in sin industries. A one standard deviation increase in price to book increases the economic effect of an interquartile change in IR by a 1% shift in the investor base, or LT. For sin companies, the economic effect translates into a 4% increase in LT, with the implication that those companies that make an effort to disclose their ESG problems and their plans to deal with them are more likely to attract long-term holders. As also predicted, the positive Journal of Applied Corporate Finance Volume 27 Number 2 Spring

47 Table 6 Investor Engagement, IR and Investor Clientele Dependent Variable 3-year IR change 1-year IR change IR LT Investor Parameter Estimate t Estimate t Estimate t Estimate t Intercept Sustainability Engagement Sustainability Reporting Engagement Sustainability Engagement After Sustainability Reporting Engagement After Predicted IR Firm Controls Yes Yes Yes Yes Year f.e. No No Yes Yes Firm f.e. No No Yes Yes Adj R-squared 1.5% 0.4% 68.7% 59.0% N 2,982 4,757 4,684 4,684 OLS regressions with robust and clustered standard errors at the firm level. In the first specification all variables are calculated as changes over a 3-year period except for Sustainability Engagement and Sustainability Reporting Engagement. In the second specification all variables are calculated as changes over a 1-year period except for Sustainability Engagement and Sustainability Reporting Engagement. The third and fourth specifications show the first and second stage of an instrumental variables regression and they are estimated in levels not changes. The third specification predicts the effect of investor engagement on sustainability issues on IR. The fourth specification shows the effect from investor-induced increase in IR on future long-term investor ownership. All variables are defined in the Appendix. relation between IR and longer-term investors is less evident for family firms and companies with an inconsistent IR record. For non-family firms, an interquartile change in IR shifts the investor base towards long-term investors by almost 3% (as compared to 2% for the entire sample). The same finding is true for companies that do not exhibit high IR volatility. These results show that the positive relation between IR and investor clientele is affected in predictable ways in some cases magnified, in some cases reduced by corporate growth opportunities, ownership structure, the social legitimacy of the business, and commitment to disclosure. In Panel B, I report my estimates of the lead-lag specifications for the same four interaction terms identified here. My results show that lagged changes in IR lead changes in investor base (at the 1 percent level of statistical significance) for companies in sin industries and with high growth opportunities, using both 1- and 3-year windows. For non-family firms and those with highly variable commitment to IR, lagged changes in IR lead changes in investor base at the 5 percent level of statistical significance, using both 1- and 3-year windows. For none of these four classifications of companies do changes in investor base lead the changes in IR. Sustainability Events Past research has attempted to identify what causes companies to improve their environmental or social performance and increase transparency on those issues. 39 In this study, I used the findings from this line of research to understand how sustainability events lead to increases in IR and how this change in IR relates to future changes in investor base. Specifically, I considered the role of shareholder engagement with the company on environmental and social issues and how firms respond to sustainability-related crises. Shareholder Engagement While the results reported so far suggest that changes in IR lead to changes in investor base rather than vice versa, investor engagement on sustainability issues has been steadily increasing. An interesting question is whether such engagement is effective in influencing companies to practice IR and in turn whether such investor-led increases in IR then lead to changes in investor base. To explore this possibility, I collected data on engagements by institutional investors on social and environmental issues from RiskMetrics that I then used to construct two variables. 40 The first variable, which I call Activism, takes the value of one if an investor has filed a proxy on a social or environmental issue for a company; otherwise it takes the value of zero. As reported in Table 1, 18% of the firm-year observations in the sample received shareholder proposals on social or environmental issues (Table 1). The second variable, Reporting Activism, takes the value of one if the variable 39. Eccles, Robert G., Kathleen Miller Perkins, and George Serafeim, How to Become a Sustainable Company, MIT Sloan Management Review 53, no. 4 (Summer 2012). 40. Not all investor engagements are public. Many investment funds engage privately with companies and I am unable to include those private engagements. If these private engagements are more effective at increasing IR, then the estimated coefficient on the activism variables is likely to be biased towards zero and I will be unable to reject the null hypothesis. 46 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

48 Activism is one and the investor demands that the company report more information; otherwise it takes the value of zero. Five percent of the firm-year observations in the sample had reporting-related social or environmental shareholder proposals. My expectation was that both variables would be related positively to changes in IR. The dataset included proposals that came to a vote as well as those that did not (for example, because they were withdrawn by the proponent or allowed to be omitted from the proxy by the SEC). As can be seen in Table 6, investor engagement is indeed positively associated with changes in IR. Both 1- and 3-year changes in IR are related to both activism and reporting activism. The result suggests that in general activism around environmental or social issues leads to an increase in the IR score of about 2 points over a one-year, and about 5 points over a three-year period. Activism that relates also to reporting practices further increases IR by 4 or 6 points over 1- and 3-year periods, respectively, thus representing a cumulative effect of from 6 to 11 points. The third specification of the model documents a similar effect in a levels specification with firm-fixed effects. Investor activism variables in this case are constructed as indicator variables that take the value of one for the year of and after investor engagement to differentiate between years before and after the engagement. In sum, each of the three specifications of the model produces economically large estimates, which suggest that activism has a large effect on IR. But in such cases of investor activism, what if any effect does IR have on the companies investor base? Extracting the predicted component from the fixed effects specification allowed us to test if this activism-led change in IR is associated with a change in investor base. The results of the fourth specification reported in Table 6 show that this incremental IR attributable to investor activism is related to higher levels of long-term investor holdings. The coefficient on predicted IR, from the first stage in the third specification, is significant and positive. This result is interesting in the light of a recent study that provides evidence that investor engagements on environmental or social issues lead to operating improvements and superior stock price performance for the firm. 41 Sustainability Crisis Past research has shown that major concerns about corporate conduct and the impact of companies on the environment or society have often been the main catalysts for corporate engagements with sustainability. 42 It is likely that such sustainability challenges could lead to more IR as companies attempt to explain how they are dealing with the problems and managing risks associated with future events. To explore this possibility, I collected data from KLD, 41. Dimson, Elroy, Oğuzhan Karaka and Xi Li. 2013, Active Ownership,. Working Paper. which provides data on the number of concerns a company faces regarding human rights, diversity, employee relations, and product, governance and environmental issues. I simply calculated the sum of those concerns and then identified the top quintile of companies as facing a crisis. Companies that face a large number of concerns are more likely to receive negative media attention and pressure from civil society to address these concerns. Although the number of total concerns for the median firm in my sample was two, the companies I designated as facing a sustainability crisis had at least five concerns and as many as 18. As can be seen in Table 7, the presence of a crisis is positively associated with changes in IR. Both 1 and 3-year changes in IR are related to the crisis variable. My results suggest that a crisis around environmental or social issues leads to an increase in the IR score of about 1 point over a one-year period, and of 5 points over a three-year period. The third specification reported in Table 7 documents a similar effect in a levels specification with firm-fixed effects. As before, the indicator variable is transformed in this specification to take the value of one for years on and after the presence of a crisis. Once again, the numbers reported in Table 7 are economically significant estimates, which represent compelling evidence that crisis helps to stimulate the use of IR. And as we did in our tests of investor activism, extracting the predicted component from the fixed effects specification allowed us to test if this crisis-led change in IR was associated with a change in investor base. The findings of the fourth specification reported in the table show that this incremental IR attributable to the presence of a crisis is related to higher levels of long-term investor holdings. As companies practice more IR in response to a crisis and engage with sustainability issues, the holdings of long-term investors tend to increase. Do Certain Parts of the IR Carry More Weight with Long-term Investors? Up to this point, the analyses have demonstrated a robust relation between IR and the investor base of companies in the sense that companies that practice more IR attract relatively more long-term investors. In the final stage of my study, I performed a content analysis of the integrated reports of 97 global companies. All reports were for the fiscal year end of Because I was unable to use Bushee s classification system for companies outside the U.S., I relied on data from Bloomberg on ownership type. Bloomberg terminals have information about the type of ownership and the percentage of shares held by each type of owner. Owner types include banks, investment advisors (that is, mutual funds), hedge funds, pension funds, insurance compa- 42. Eccles, Robert G., Kathleen Miller Perkins, and George Serafeim, How to Become a Sustainable Company, MIT Sloan Management Review 53, no. 4 (Summer 2012). Journal of Applied Corporate Finance Volume 27 Number 2 Spring

49 Table 7 Sustainability Crisis, IR and Investor Clientele Dependent Variable 3-year IR change 1-year IR change IR LT Investor Parameter Estimate t Estimate t Estimate t Estimate t Intercept Sustainability Crisis Sustainability Crisis After Predicted IR Firm Controls Yes Yes Yes Yes Year f.e. No No Yes Yes Firm f.e. No No Yes Yes Adj R-squared 1.1% 0.1% 68.7% 59.0% N 2,982 4,757 4,684 4,684 Adj R-squared 1.5% 0.4% 68.7% 59.0% N 2,982 4,757 4,684 4,684 OLS regressions with robust and clustered standard errors at the firm level. In the first specification all variables are calculated as changes over a 3-year period except for Sustainability Crisis. In the second specification all variables are calculated as changes over a 1-year period except for Sustainability Crisis. The third and fourth specifications show the first and second stage of an instrumental variables regression and they are estimated in levels not changes. The third specification predicts the effect of firm sustainability crisis on IR. The fourth specifications shows the effect from crisis-induced increase in IR on future long-term investor ownership. All variables are defined in the Appendix. nies, and government investment funds such as sovereign wealth funds. I classified hedge funds and investment advisors as more short-term oriented relative to banks, pension funds, insurance companies, and government investment funds. A number of studies seem to support this classification. For example, a 2004 study by Bushee provides evidence that investment advisors have larger percentages of transients and fewer dedicated holders than banks, insurance companies, and pension funds. At the same time, hedge funds as a group are considered to be among the most short-term investors with the highest portfolio turnover. Moreover, the most frequent advocates for a long-term orientation in capital markets are pension funds and insurance companies. These are the types of institutions that also tend to be the most active in socially responsible investing. For this reason, I calculated the time horizon of a company s investor base as the sum of the percentage of shares held by banks, pension funds, insurance companies, and government investment funds and subtracted from it the sum of the percentage of shares held by hedge funds and investment advisors. This variable, which I refer to as LT-BBG, was calculated as of the end of calendar year At that time, the average of LT_BBG was 6.7 with a standard deviation of My analysis proceeded in two steps. First, I confirmed that the IR variable that I had used so far was indeed positively associated with this alternative construction of the long-term orientation of the investor base. I merged IR scores from 2010 (the most recent year for which I had ASSET4 data) with the ownership type data from The merge yields a sample of 3,483 firms around the world, which suggests that Bloomberg has ownership data for more than 90% of the companies included in the ASSET4 dataset. Next I estimated a model similar to the one whose findings are reported in (the first column of) Table 3, but in this case including country-fixed effects to accommodate my international sample. I found that the coefficient on IR was positive and significant. Moreover, the economic significance is comparable to the significance of the estimates in Table 3. A one standard deviation increase in IR is associated with approximately 3% increase in shares held by long-term investors. To test the robustness of the results to how I classify different types of institutions, I constructed an alternative variable that is measured as the difference in percentage of shares held by pension funds and government funds, and hedge funds since these investment vehicles are frequently viewed as occupying the opposite spectrums of long-term versus short-term investing. The results are very similar when I use this alternative variable. Having established that the dependent variable based on ownership type is also associated with the IR variable, I then set out to understand the association between the different components of IR and the horizon of the investor base of a firm. The three main components of an integrated report, which are set forth in the <IR Framework>, consist of the following: (1) the content elements; (2) different forms of capital; and (3) guiding principles. In their recent book on Integrated Reporting, Bob Eccles and Mike Krzus discussed the extent to which integrated reports include the content elements, discuss the different forms of capital, and 48 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

50 Table 8 IR Components and Investor Type Parameter Estimate t Estimate t Estimate t Estimate t Intercept IR Content Elements Capitals Guiding Principles Firm controls Yes Yes Yes Yes Country f.e. Yes Yes Yes Yes Industry f.e. Yes No No No Sector f.e. No Yes Yes Yes Adj R-squared 40.3% 25.9% 27.0% 31.1% N 3, OLS regressions with robust standard errors. The dependent variable is LT BBG which is calculated as the difference between percentage of shares held by pension funds, government funds, insurance companies, and banks minus percentage of shares held by hedge funds and investment advisors for a given firm and year. Content elements, capitals and guiding principles are scores of how much disclosure firms provide around the content elements, the different forms of capital, and the extent to which they follow the guiding principles as described in the <IR> Framework of the IIRC. All variables are defined in the Appendix. follow the guiding principles. Eccles and Krzus analyzed 124 reports 24 produced by companies in South Africa (where IR is mandatory) and 100 by organizations in other countries. Reports were selected if they were self-declared to be an integrated report, published by a company of any size listed on a stock exchange, published in 2013 (for the 2012 fiscal year) in English, publicly available, and available for download in a PDF format. From this sample of 124 companies, I was able to collect all necessary data for 97 companies. The content elements specified by the <IR> Framework are as follows: (1) organizational overview and external environment; (2) governance; (3) business model; (4) risks and opportunities; (5) strategy and resource allocation; (6) performance; and (7) outlook. In addition to evaluations of each of these seven topics, the Framework also calls for discussion of the company s six important forms of capital, which are identified as financial, manufactured, natural, intellectual, human, and social and relationship. The quantity and quality of the information provided about each of these content elements and kinds of capital are assigned scores that become factors in my analysis. Also reflected in the analysis are scores for the company s adherence to a series of guiding principles that include the following: whether the company identifies material risks (preferably with the help of a Materiality Matrix ), explains how material risks are managed, demonstrates or explains its stakeholder engagement process, and demonstrates or explains the connectivity (or relationship to long-run value) of such information. The scoring process was based on a scale from zero to four, with zero being the lowest and four being the highest number of points awarded for each factor. I constructed three variables that all range from zero to one based on the percentage of total points that are given to each company. The first variable relates to content elements ( Content Elements ), the second to the capitals ( Capitals ), and the third to the guiding principles ( Guiding Principles ). Because all three variables exhibit large positive univariate correlations and the sample is small, a multi-collinearity problem is created when I include all variables together in the model. Therefore, I estimate models with each variable included separately. The average score for Content Elements was 70, with a standard deviation of 25. The average for Capitals was 68, with a standard deviation of 25. The average for Guiding Principles was 57, with a standard deviation of 29. Table 8 reports the results of this analysis. Because of the small number of observations I replace industry with sector fixed effects from the GICS classification. The coefficient on Content Elements was positive but only marginally significant. This suggests that firms that practice IR and include more of the content elements as described in the <IR Framework> often do not have a more long-term oriented investor base (though an alternative explanation for this result is that the scoring procedure used in the study is too noisy). However, the coefficient on Capitals was positive and significant, suggesting that companies that disclose more information about the different forms of capital have a more long-term investor base (and that the scoring procedure is robust enough to provide reliable measures). What s more, the coefficient on Guiding Principles is also positive and even more significant. This finding would seem to suggest that the materiality and connectivity to financial value of information are two key characteristics that drive the association between IR and investor base. These results lend further support to the Journal of Applied Corporate Finance Volume 27 Number 2 Spring

51 argument that specific characteristics of IR (as opposed to some other correlated omitted variable) are associated with the time horizon of a company s investor base. For when using a sample of companies that all issue integrated reports, I find that companies that disclose more information about their different forms of capital and that follow more of the IIRC s guiding principles have investor bases with a longer-term orientation. Conclusion IR is a recent reporting innovation that has gained traction in both the corporate and investor communities. In this article, I present the findings of my study of how the practice of IR affects the investor base of the firm. The main finding of my analysis is that companies that produce integrated reports show a clear tendency to have more long-term, dedicated holders and fewer transient investors. Moreover, through the use of firm-fixed effects and lead-lag analysis, my study provides evidence that suggests a causal relationship between the corporate practice of IR and an investor base with longerterm shareholders. In support of such a causal relationship, my study shows that the relation between IR and investor base is stronger for companies with high growth opportunities, with no (or very limited) ownership by the founding family, for sin companies (those subjected to strong social criticism), and for companies with a consistent IR practice. Moreover, I find that both the presence of a sustainability crisis and investor activism on sustainability issues are associated with increased corporate use of IR, and this increase in IR is in turn positively related to the increased presence of longer-term shareholders in the company s investor base. Although the results I document appear robust to different specifications and variables used, my tests are not designed to address the question of which elements of IR are most effective at attracting long-term investors. As the content of IR becomes more standardized, researchers should be able to distinguish among different kinds of content and perhaps isolate the impact of at least some of them. While I document a matching between companies practicing IR and long-term investors, there is an open question about how these investors change capital allocation decisions based on the specific kinds of information provided by corporate IR. Another question this study does not address is the extent to which the information reported in IR enables longer-term investors to make better investment decisions. It is also important, of course, to remind ourselves that IR is a costly activity and that we are still unable to establish whether the benefits exceed the costs. So even if a company views attraction of long-term investors as a benefit, the costs should not be ignored. Anecdotal evidence and field data suggest that the most important costs involve investments in improving information systems for sustainability data, acquiring skills and expertise to use the data and integrate them in financial reporting, and increasing cross-functional collaboration inside the organization to produce an integrated report. To such costs of IR should also be added any loss of revenue or profit from the disclosure of sensitive competitive information, although there is as yet no evidence to date suggesting that IR increases the costs associated with the disclosure of such proprietary information. George Serafeim is the Jakurski Family Associate Professor of Business Administration at the Harvard Business School. 50 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

52 Appendix Description of Variables Variables LT Investor Dedicated Transient IR Disclosure Quantity Sustainability Report GRI Classified Board Staggered Board Supermajority Vote EESG Score Firm Size Leverage E/P PTB Dividend Yield Sales Growth Beta Volatility Turnover Stock Return Family Firm Sin Firm Sustainability Engagement Sustainability Reporting Engagement Sustainability Engagement After Sustainability Reporting Engagement After Sustainability Crisis Sustainability Crisis After Content Elements Capitals Guiding Principles LT BBG Description % of shares held by dedicated minus transient investors % of shares held by dedicated investors % of shares held by transient investors Measures a company s management commitment and effectiveness towards the creation of an overarching vision and strategy integrating financial and extra-financial aspects. It reflects a company s capacity to convincingly show and communicate that it integrates the economic, social and environmental dimensions into its day-to-day decision-making processes % of quantitative ESG metrics that a firm disclosed for a fiscal year Does the company publish a separate CSR/H&S/Sustainability report? Is the company s CSR report published in accordance with the GRI guidelines? Does the company have a classified board structure? Does the company have a staggered board structure? Does the company have a supermajority vote requirement or qualified majority (for amendments of charters and bylaws or lock-in provisions)? An equal-weighted rating of a company s financial and extra-financial health based on the information in ASSET4 s economic, environmental, social and corporate governance pillars. It reflects a balanced view of a company s performance in these four areas Natural logarithm of firm sales Total debt over total assets EPS over stock price at fiscal year end Stock price over book value per-share Dividends over stock price at fiscal year end One year rate of change in sales Equity beta estimated using CAPM for monthly data over five years Stock return volatility over the fiscal year Dollar volume of trading over the year as a percentage of market value of equity at fiscal year end Stock return over the fiscal year Indicator variable that takes the value of one if the firm is controlled by a family Indicator variable that takes the value of one if the firm is involved in gambling, tobacco, alcohol, firearms, nuclear or military business Indicator variable that takes the value of one if a firm has had a shareholder resolution on environmental and/or social issues in that year Indicator variable that takes the value of one if a firm has had a shareholder resolution on environmental and/or social issues that relate to reporting of data in that year Indicator variable that takes the value of one for all years after a firm has had a shareholder resolution on environmental and/or social issues Indicator variable that takes the value of one for all years after a firm has had a shareholder resolution on environmental and/or social issues that relates to reporting of data Indicator variable that takes the value of one if a firm ranks in the top 20% of number of human rights, employee related, environmental, product, and diversity concerns in the KLD dataset Indicator variable that takes the value of one for years after a firm ranks in the top 20% of number of human rights, employee related, environmental, product, and diversity concerns in the KLD dataset A score ranging from zero to 100 of how much disclosure around the content elements (i.e. Organizational overview and external environment, Governance, Business model, Risks and opportunities, Strategy and resource allocation, Performance, and Outlook) described in the <IR> Framework of the IIRC are included in an integrated report A score ranging from zero to 100 of how much disclosure around the different forms of capital (i.e. natural, human, financial, intellectual, physical, and social) described in the <IR> Framework of the IIRC are included in an integrated report A score ranging from zero to 100 of whether the guiding principles (i.e. connectivity, materiality, stakeholder responsiveness) described in the <IR> Framework of the IIRC are followed in an integrated report % of shares held by pension funds, insurance companies, banks, and government investment vehicles minus hedge funds and investment advisors Journal of Applied Corporate Finance Volume 27 Number 2 Spring

53 An Alignment Proposal: Boosting the Momentum of Sustainability Reporting by Andrew Park and Curtis Ravenel, Bloomberg LP I n an article previously published in this journal, we described the challenges facing the integration of environmental, social, and governance ( ESG ) data into mainstream investment decision-making. We argued that such integration would help markets price in externalized ESG impacts of public companies. Moreover, in making this argument, we reinforced the thesis that high-quality extra-financial data1 was necessary to improve the longer-term efficiency of capital allocation by moving it toward more sustainable uses.2 But, as our article also made clear, there remain multiple challenges to bringing ESG fully into the mainstream. Not only are the integration methodologies still in the relatively early stages (along with the empirical evidence that definitively supports the use of ESG information), the data itself struggles to attain the level of completeness, consistency, and comparability essential to the ready incorporation of ESG into investment decision-making. All of these factors add up to what we described as the process of gaining quantitative legitimacy 3 for ESG data. Bringing a quantitative lens to ESG issues necessarily raises the challenge of measurement. Of course, measurement is already occurring with some scale; and there has even been a proliferation of sustainability metrics with the attendant growth in sustainability data, both collected and reported. Nevertheless, to find entry into the financial system, the data must be standardized to a degree that enables robust comparative analytics across a meaningful universe of companies. After all, few investors examine a single investment opportunity in isolation; what most are seeking to determine is the value of that investment relative to other opportunities. And thus a fractured and inconsistent data set presents a formidable barrier to the integration of ESG, not necessarily for lack of will on the part of investors, but because the data s incompleteness prevents it. Bloomberg LP operates as a neutral intermediary between issuers often those companies that generate the data carried on the Bloomberg Professional Service and the investors who utilize the data to inform their decision-making. 4 We provide news, analytics, and market data without expressing a view of investment choices themselves; our aim is instead to provide information and analytics that help our clients make their own assessments of the relative merits of any given opportunity. It is from this vantage point with issuers and investors as our defining audiences that we offer a system-level perspective on the mechanisms and infrastructure that are making possible ESG s continued maturation into a quantitative discipline. Indeed, part of the mission of Bloomberg s Sustainable Business & Finance Group is to integrate sustainability considerations into mainstream investment decision-making processes. In light of our unique position in the markets, we have cultivated a translational role to build a bridge from theory, which is often forged within the NGO community, to practice (with the help of applied data and tools). Using a combination of our convening power, data platform, and NGO partnerships, we seek opportunities to transform potentially pioneering, but often abstract, ideas on the leading edge of sustainable finance into practically applicable forms. In the specific realm of disclosure metrics and the generation of complete and comparable ESG data, Bloomberg LP works closely with a number of non-profit organizations that are dedicated to developing standardized sustainability reporting frameworks. Two decades ago, this was a novel and largely unexamined area; today the space is populated by a welter of specialized organizations, which signals not only a certain level of maturity, but also perhaps an inflection point in the field s trajectory. In this article, we aim to extend our 1. While this type of information is often described as non-financial, we maintain that this is a misnomer because the data does have financial relevance. Other possible terms include ESG data or sustainability data. 2. Andrew Park & Curtis Ravenel, Integrating Sustainability into Capital Markets: Bloomberg LP and ESG s Quantitative Legitimacy, Journal of Applied Corporate Finance, Vol. 24, No. 3, Summer 2013, available at doi/ /jacf.12030/abstract. 3. Once again, we would like to stress that this is not a wholesale prioritization of quantitative data over qualitative data. The ideal scenario represents a reciprocal dynamic wherein qualitative information meaningfully contextualizes quantitative information, and vice versa. Indeed, neither in isolation is as effective in informing investors (or any other stakeholder for that matter) as when both are integrated within a more meaningful whole. As discussed later in this paper, the integrated reporting movement ( <IR> ) embodies these notions in a structured, principles-based framework. 4. Bloomberg researches 20,000 of the most actively traded public companies in the world, out of which we obtain publicly-disclosed ESG data for over 11,000 companies across 65 countries. While we have observed a 40% year-over-year increase in usage of ESG data by our customers since 2008 when we began providing ESG data on the Bloomberg Professional Service, 2014 revealed a significantly steeper increase of 76% over 2013, climbing to 17,010 customers who are actively using ESG data. See Bloomberg LP s BCause Impact Report, available at 52 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

54 earlier piece by examining the disclosure space, describing our involvement with a specific set of non-profit partners, and pointing to a rapidly emerging challenge to the ready adoption of sustainability reporting: namely, the growing need to rationalize and align reporting frameworks. By so doing, we aim both to address reporting fatigue and to help clarify the relationships within a potentially confusing thicket of acronyms in the space. Reporting Frameworks Organizations Because there are more organizations working to develop various pieces of the reporting machinery than one can reasonably discuss in a short paper, this paper does not aim to provide a comprehensive review of the reporting space, but limits itself to an examination of our partnership universe. Nevertheless, we expect the themes and concerns raised to resonate well beyond this group, with implications for many other proximate actors. Bloomberg supports non-profits working to develop standardized disclosure frameworks for four main reasons: (1) disclosure remains a primary driver of the production of ESG data; (2) standardization is a prerequisite to generating comparable data; (3) standardized disclosures support the continued quantitative maturation of ESG data; and (4) the continuing improvement and spreading use of ESG data will give investors a clearer picture of corporate performance. A rationalized disclosure infrastructure will facilitate market adoption while lending credibility to disclosure processes and the data they generate, both of which are critical elements in the continued advance of sustainable finance. To this end, in our earlier article we highlighted Bloomberg s involvement with the Sustainability Accounting Standards Board (SASB), whose mission is to develop material standardized sustainability disclosures by sector for use by public companies in their annual 10-K reports.5 Guided by a U.S. legal-regulatory definition of materiality, SASB is primarily focused on two key stakeholders: public companies and investors. Beyond SASB, one quickly encounters a preponderance of other organizations with overlapping missions. First and foremost, the Global Reporting Initiative (GRI) represents a much wider and more comprehensive approach to metrics that are responsive to the full spectrum of stakeholders. Whereas SASB is rooted in a U.S.-centric legal/regulatory framework, the GRI is decidedly more international and the most widely used disclosure framework globally.6 The latest iteration of GRI s framework, known as G4, signals a move towards a sector-specific approach with a materiality lens though its concept of materiality is more expansive than the materiality concept espoused by SASB s framework.7 If we view SASB as providing the floor (representing a minimum set of disclosures responsive to investors) to GRI s ceiling (representing a comprehensive catalogue of possible disclosure metrics for multiple stakeholders), the space between can be seen as occupied by other prominent frameworks that take a more theme-specific approach. Consider, for example, CDP, formerly known as the Carbon Disclosure Project. As the original name of the organization suggests, CDP s aim is to increase corporate disclosure of carbon emissions, an undertaking in which they achieved remarkable success.8 But in recent years, the organization s purview has expanded to include disclosure of data on forests and water, with implications for related areas like energy and climate.9 In each of these three areas carbon, forests, water CDP has established itself as a subject authority, constructing calibrated metrics that reflect its focused expertise.10 Similarly, the UN Global Compact, in promulgating its Ten Principles, has succeeded in driving significant company disclosure around not only environmental factors, but also social issues like labor, human rights, and anti-corruption.11 Finally, this brief review of our partner organizations in this space would not be complete without mentioning the International Integrated Reporting Council (IIRC), which has developed the principles of Integrated Reporting ( <IR> ) that inform today s IR movement. Although it has not produced a metrics-driven disclosure framework like those developed by SASB, CDP, and GRI, the efforts of the IIRC, and the IR movement that it has set in motion, are committed to the idea that information is most useful to investors and other corporate stakeholders when presented in context. The principles that underlie the IR framework are accordingly designed to encourage the reporting of traditional financial information alongside other extra-financial information in such a way that readers are fully able to understand what the business is about and how it is performing. In sum, the goal of the IR reporting framework is to provide an integrated understanding of the business as a whole. And as envisioned by the IIRC, the data generated by 5. See Park & Ravenel, According to GRI s database, there are to date over 7,600 organizations issuing almost 19,000 GRI reports. See (last visited 6/2/15). 7. It is beyond the scope of this paper to reconcile different conceptions of materiality, which is a technically complex concept. Moreover, there are other treatments of this topic available, see Eccles, Robert G., and Michael P. Krzus. The Integrated Reporting Movement: Meaning, Momentum Motives, and Materiality. John Wiley & Sons, 2014 (chapters 5 and 6, pages ). 8. Bloomberg Professional Service currently carries CDP data as part of its ESG offering. 9. See cdp.net (last visited 5/26/15). 10. In a similar vein is the Climate Disclosure Standards Board (CDSB), which offers a voluntary reporting framework that aims to help investors understand the implications of climate change on a company s financial performance. CDP is the Secretariat for the CDSB, which is itself a consortium of other acronyms, including the World Business Council for Sustainable Development (WBCSD), World Resources Institute (WRI), and The Climate Registry (TCR). See (last visited 4/23/15). 11. See (last visited 5/26/15). Journal of Applied Corporate Finance Volume 27 Number 2 Spring

55 reporting against metrics developed by GRI, SASB, CDP, and UNGC both quantitative and qualitative are expected to feed seamlessly into an integrated report. In this sense, there is likely a reinforcing dynamic between the success of these reporting frameworks and the integrated reporting movement. To be sure, there are many more concentric and overlapping circles of organizations and frameworks than the ones just mentioned. 12 The need to limit our review serves to bolster the observation that there is a considerable amount of activity underway. We applaud these efforts, many of which are thoughtful and rigorous. Sustainability itself is a capacious term, and each niche within it can (and often does) give rise to a specialized set of disclosure frameworks and metrics that, taken together, would seem to ensure an unprecedented level of market transparency. The proliferation of acronyms and metrics can, however, also cause frustration on the part of reporters struggling to make sense of an ever-expanding and ever-shifting reporting landscape. There is palpable confusion on the part of various stakeholders with particular emphasis on investors for our purposes many of whom are struggling to make sense of the metrics and information being generated. Moreover, some reporting organizations have become sufficiently concerned about the resource requirements of producing in-depth reports that they are beginning to ask what the consequences would be if they didn t produce a report. The question, then, is at what point could the frustration and confusion undermine the continued integration of sustainability reporting as mainstream practice? The Alignment Question We believe we have approached an inflection point in the evolution of the standards and disclosure field. Several decades ago there was a clear dearth of sustainability information and the need for reporting initiatives like GRI, SASB, CDP, and UNGC was only just beginning to be articulated. Today, the picture is decidedly mixed. Sustainability data remains a challenge both in terms of consistency and comparability, though at this point it s not a simple matter of having too little or too much; it s increasingly a matter of sorting out what is useful from what is not. 13 And in an ever more crowded arena of reporting frameworks alongside expanding demand by multiple stakeholders for transparency, the reporters themselves are suffering both fatigue brought on by the sheer scale of the reporting burden, and by uncertainty about how various reporting frameworks relate to one other or fail to do so, as the case may be. Against this backdrop, there are three core challenges motivating the present discussion: 1. From the issuer perspective: What can be done to streamline reporting and relieve some reporting fatigue? 2. From the stakeholder perspective (including that of investors): How can we move towards generating information that is genuinely useful? 3. In general: How can we minimize market confusion around different reporting frameworks and how they are positioned relative to each other? While our early approach in this nascent field was to avoid prematurely picking winners and allowing the field to develop, we now find ourselves pivoting towards an interest in alignment a rationalization of overlapping and interrelated frameworks. On the one hand, this is a sign of continued progress; on the other, it is an acknowledgment of the challenges in preserving the field s momentum through a new growth phase. The choice of wording here alignment, as opposed to harmonization, for instance is conscious and intended to signal what alignment is not. It is not wholesale consolidation or the elevation of a single framework above all others. There are already deeply entrenched systems that present real issues of path dependency and the associated risk of forcing development toward a less-than-optimal outcome. And there will always be too many specialized interests and too much attendant demand for highly refined data to make a single framework feasible. Indeed, harmonization also overstates our aim to the extent that it implies a totally seamless and consistent landscape of reporting frameworks without overlap or conflict. Again, this seems not only infeasible, but an ill-advised response for the multiple users and uses of sustainability information. In sum, alignment implies a workably moderated view of the need for proactive coordination across multiple organizations and reporting frameworks, but as delimited by both feasibility and utility. Alignment in Practice What then does alignment mean in practice? At the outset, it s an acknowledgment that it is permissible for non-profits and NGOs to collude in pursuit of a common interest: making high-quality sustainability reporting a mainstream practice. Alignment therefore implies a need for disclosure frameworks to find just enough agnosticism and flexibility with respect to their specific approaches to make room for active and substantive cooperation. In other words, we see this as a classic collective action problem: organizations that 12. Other organizations considered to be broadly relevant to this area might include (but are certainly not limited to): Global Initiative for Sustainability Ratings (GISR), Ceres, United Nations Principles for Responsible Investment, US SIF (Forum for Sustainable and Responsible Investment), AccountAbility, World Wildlife Fund (WWF), World Resources Institute (WRI). 13. This also tees up the distinction between data (which is raw) and information (contextualized and ready for consumption). 54 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

56 Figure 1 Long-term Orientation of Investor Base Issuer Roundtable Investor Roundtable Common Docs (friction points) Framework A Framework B Framework C Framework D Issuers Investors Framework Orgs Committed Outcomes and Implementation otherwise stand to benefit from subordinating certain of their individual objectives to the collective goal nevertheless tend to pursue their own agendas, thereby preserving a certain territoriality that undermines cooperation. In more concrete terms, we understand alignment to operate on three levels: Organizational: high-level, top-down commitments to coordinate and avoid duplication or conflict; Concepts and Categories: clarification and potential differentiation of common terms that actually have distinct meanings; and Metrics: consolidation of slightly different metrics that ultimately get at the same information. A move towards alignment at this stage could set the reporting framework community on a path toward addressing both of the core challenges discussed earlier. As for the first challenge, sorting through the three levels of alignment could illuminate paths that lead to the streamlining of frameworks that might seem competitive, but on further examination prove to be complementary.14 As for the second, we recognize the predicate need to define an audience in order to then determine what information is deemed useful. For purposes of this argument, the issuer and investor communities are our primary audience, again reflecting Bloomberg s function in the markets. In fact, it is precisely because of Bloomberg s position as a market intermediary at the interface of issuer and investor and reporting entity that we may well be able to help sound the argument for alignment and, under the right circumstances, actively support its implementation. Getting from Here to There Conversations with Bloomberg clients and other market participants about the need for alignment suggests that there is, in fact, more than enough anecdotal evidence to support the exploration of the issue in a structured manner.15 It does not, however, lead us to define a specific form that such alignment ends up taking; indeed, we do not mean to preempt possible outcomes. Our aim is rather to encourage and mediate a dialogue that we hope will reveal and refine what a workable alignment outcome could be at this stage. Moreover, even if an initial attempt of this kind ultimately fails to yield concrete outcomes, an attempt should, at the very least, give rise to constructive self-evaluations by NGOs of their relationships to each other and how they might come closer to coordinating for common benefit. 16 While a detailed blueprint of the process is beyond the scope of this paper, a high-level overview helps ground the foregoing. We envision a process led by a neutral, third-party mediator tasked with conducting background research and interviews, compiling and distilling feedback into a set of common documents, structuring dialogues, and generally running logistics for a multi-stage set of roundtables. Established non-profits with strong relationships in the issuer and investor communities could be tapped to help shape the actual dialogues, clarify objectives, and lend credibility to the proceedings. 14. We note here that Bloomberg LP is itself a reporting entity, and therefore also quite aware of the challenges presented to companies struggling to report against multiple frameworks. As a private company, we are not subject to the same types of reporting requirements as listed companies. Nevertheless, we have made it a point to issue comprehensive sustainability reports not only to meet the standards of transparency we espouse, but also as a point of demonstration of its feasibility. In fact, our latest 2014 sustainability report reflects an early effort to report against both applicable GRI G4 and SASB metrics. See Bloomberg.com/bcause (2014 report). 15. See also Sustainability reporting the time is now, Ernst & Young, Global Reporting Initiative, 2014 ( There is... an increasing number of bodies recognizing that the harmonization and standardization of approaches will be key to increasing a universal acceptance of sustainability reporting, ) available at vwluassets/ey-sustainability-reporting-the-time-is-now/$file/ey-sustainability-reporting-the-time-is-now.pdf (last visited ); Elaine Cohen, The Leadership Battle Among Sustainability Transparency Organizations, TriplePundit, Jan. 22, 2014 ( Creating a harmonized corporate transparency pathway which enables consistent and nonoverlapping disclosure frameworks does not need to be a lost cause, although it looks that way at present, available at (last visited ); Dunston Allison-Hope & Guy Morgan, Navigating the Materiality Muddle, BSR Blog, Aug. 13, 2013 ( The three organizations [IIRC, SASB, and GRI] diverge in their approach [to materiality] based on which stakeholder group they focus their initiative on... Given these potentially mixed messages, what is a company to do? ) available at bsr.org/en/our-insights/blog-view/navigating-the-materiality-muddle (last visited ). 16. Given the live nature of this issue, there is, of course, a need to be coordinative with various other efforts underway (as indicated earlier). Journal of Applied Corporate Finance Volume 27 Number 2 Spring

57 The three core challenges reporting fatigue, curating for useful information, and minimizing market confusion would likely benefit from translation into a pithy set of market messages for the framework organizations. Convening separate roundtables with a representative crosssection of entities from the issuer and investor communities would provide opportunities to speak frankly and constructively about the friction points in the current reporting landscape.17 These views could then be distilled into a set of market messages around which the mediator can structure a final roundtable session focused on the framework organizations themselves. While it would be premature, as already noted, to determine specific outcomes before the interviews, consultations, and roundtables have been convened, it is essential that the process seek to define tangible objectives for an alignment effort of this scale. It would presumably look beyond the necessary initial steps of high-level MOUs (memoranda of understanding) committing the organizations to coordination in principle, and move decisively towards concrete deliverables. In reference to the three-level alignment review, one might expect the outcomes to take one or more of the following forms: a joint statement of intent that definitively signals active coordination; a joint white paper that could explain in greater substance how each disclosure framework is situated vis-àvis the other; an integrated implementation guide that could explain, in a single document, how multiple frameworks could be used together by a reporting entity; a statement clarifying potentially confusing terminology (i.e., materiality, capitals ); 18 and a comprehensive technical review of metrics to bring into alignment units of measure and methodologies around similar KPIs. Once outcomes are agreed upon, a work plan and timeline would guide implementation of the recommendations. The coalescing of key funders to support the effort would not only signal the importance of securing real progress; perhaps more importantly, it would provide a clear indication of a level of seriousness and commitment that should help keep all players accountable. We think this type of considered approach can help to further refine the contours of the challenge while yielding genuinely useful outcomes. The keys to success are likely to lie within the design of the process: there must be a safe space for all parties to speak candidly; there must be a clearly articulated set of market voices representing the friction points issuers and investors currently face; there must be genuine buy-in on the part of the reporting frameworks to own the process and recognize their respective self-interest in a commonly supported outcome. To be sure, Bloomberg is not the only participant in this space to consider the alignment question; nor is there an implied homogeneity of views around the issue. Instead, the current reality is that there are multiple efforts underway, with which any effort of this nature needs to be thoughtfully coordinated. The process should therefore be built to accommodate the possibility of outcomes that depart from what is contemplated above. For example, if through the course of the engagement it becomes clear that the alignment issue is not ripe for full-scale engagement, it should still encourage consideration of interim steps in service of an alignment ideal. Moreover, the program described here is largely U.S.- centric. And for that reason alone, there is an obvious need to coordinate with other efforts in the international realm19 to ensure that a program like this, if and when executed, turns out to be consistent with international alignment processes in whatever form they unfold. In the end, there would be no greater irony than to have to confront a fractured, redundant, or even conflicting set of processes, all in the name of alignment. In Closing The process described here will require patience, focused effort, and real investment of resources. And while other efforts of this kind are underway, we believe this would be the first highly visible and public (that is, outside the realm of behind-thescenes diplomacy) program to bring tangibility to otherwise lofty and as-yet abstract commitments to coordinate in the most general sense. We believe a process like this has the potential to demonstrate the efficacy of a full-scale alignment effort, even if the outcomes end up falling short in some way. We believe that the need for structured discourse among all three communities the framework organizations, the issuers, and the investors is quite real. And under no circumstances do we consider this a definitive move intended to resolve all alignment concerns. We recognize this to be a rapidly evolving issue, and what we offer here is the outline of a program we think could yield potentially significant adjustments in the on-going upward trajectory of sustainability reporting. We believe that it s time to talk about alignment. Not only does it find resonance in the U.S. market, but there 17. It may also present a potentially helpful peer-learning process around sustainability reporting. 18. Both materiality and capitals are enormously complex concepts with venerable histories. We do not imply a complete reworking of these terms, but rather a substantive effort to jointly address where confusion lies in their usages under different frameworks. 19. We limit our discussion to our partner universe partly to enhance the feasibility of an alignment effort. As we see it, a U.S.-centric process can be coordinated and feed into a larger international dialogue with other players already engaging this space, including the IIRC s Corporate Reporting Dialogue (CRD), the World Business Council for Sustainable Development (WBCSD), Sustainable Stock Exchanges, etc. 56 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

58 are multiple other arenas in which alignment could create significant additional value. 20 With a thoughtful, legitimate, and well-resourced process, an alignment effort could present a genuine win-win-win scenario for several important constituencies. It could mean greater usage of the non-profit organizations respective disclosure frameworks. For corporates, it could lead to a meaningful reduction of disclosure burdens through, for example, effective application of rationalized materiality principles. And for investors, the result is likely to be less confusion about the meaning and uses of ESG data. In sum, alignment holds out not only the promise of market transparency achieved through more effective disclosure of higher quality ESG information, but also the chance to align capital with more sustainable uses across the board. This is not a given, but we think the time is right to try. We at Bloomberg stand ready to help. Andrew Park is Head of Sustainable Finance Programs in Bloomberg s Sustainable Business & Finance group, where he develops cross-platform sustainability content and strategy for Bloomberg LP while directing a strategic portfolio of NGO collaborations in Sustainable Finance. He is a member of the Standards Council at the Sustainability Accounting Standards Board (SASB) and is a founding Director of the Finance for Resilience (FiRe) initiative. Prior to his work at Bloomberg LP, he was Special Assistant to the COO of Bloomberg Philanthropies and served as a law clerk to both Judge Robert Katzmann of the Second Circuit Court of Appeals and Judge Jed Rakoff of the Southern District of New York. Andrew holds a D.Phil. from Oxford University in Social Policy as a Rhodes Scholar, and is a graduate of the Yale Law School and Harvard College. Curtis Ravenel is Global Head of Sustainable Business & Finance where he leads Bloomberg s sustainability initiatives within the Chairman s office. The program aggressively integrates sustainability considerations into all firm operations and leverages the Bloomberg Professional Service to evaluate sustainability-related investment risks and opportunities for its 315,000 customers. Curtis has worked for Bloomberg in multiple roles. He was the Financial Controller for Asia managing accounting, tax, treasury and audit services for 23 legal entities with combined annual revenues exceeding $1 billion USD. This was preceded by various roles in the Capital Planning and Financial Analysis Groups. Prior to his work with Bloomberg, Curtis co-managed a small real estate development group, founded a micro-brewery and worked with the Recycling Advisory Council in Washington, DC conducting Full Cost Accounting and Life Cycle Analysis work. He currently serves as a board member at US SIF, The Forum for Sustainable and Responsible Investment, and is an advisor to the Sustainability Accounting Standards Board (SASB) and the Global Initiative for Sustainability Ratings (GISR). Curtis was awarded a David Rockefeller Fellowship with the Partnership for New York City in 2011, and earned an MBA from Columbia Business School and a BA in History from Davidson College. 20. The European Union s move towards mandated non-financial reporting in its recent disclosure directive presents an alignment challenge across 28 member states. There are even alignment questions with respect to the important capacity-building work done by various non-profit/ngo organizations like US SIF, the Global Impact Investor Network (GIIN), and UN Principles for Responsible Investment. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

59 Growing Demand for ESG Information and Standards: Understanding Corporate Opportunities as Well as Risks by Levi S. Stewart, Sustainability Accounting Standards Board (SASB)* I nformation about corporate environmental, social, and governance (ESG) policies and practices has long informed the decisions and strategies of investors. Indeed, the use of ESG information by investors dates at least as far back as the 18th and 19th centuries, when religious organizations screened companies to avoid investments in sin industries, predominantly those involved in slavery, alcohol, and tobacco. 1 While such divestment practices continue to be used, a large and growing number of today s investors have begun to recognize that high-quality corporate ESG disclosure can provide valuable insights into the underlying drivers of corporate financial performance and value. The rising importance of ESG factors to investors can be seen in the record number of shareholder proposals relating to social and environmental issues in Sustainability information has proliferated in recent years. Organizations such as the Sustainability Accounting Standards Board (SASB), the CDP (formerly known as the Carbon Disclosure Project), the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC), CERES, and the UN Principles for Responsible Investment (UNPRI) have all dedicated themselves to improving and increasing the use of sustainability reporting and disclosure. But as investors continue to demand more and better ESG data, the need for standardized disclosures and metrics has also increased. 3 To a greater extent than any of the above organizations, SASB has focused on improving the usefulness and comparability of ESG data for investors. Since its start in 2010, SASB has worked with companies, investors, and third-party organizations to develop sustainability accounting standards for more than 80 industries in 10 major sectors. The standards are designed for disclosure on topics that are likely to constitute material information, 4 in the Management Discussion and Analysis section (MD&A) of SEC filings. The growing investor demand for standardized ESG data begs the question: Why are investors demanding such information and why are corporations willing to disclose it? There is now a large body of academic research that has reported evidence of a positive correlation between a company s commitment to corporate social responsibility (CSR) and a lower cost of capital. 5 (In fact, a 2012 Deutsche Bank review of 19 academic studies found that all of them supported this positive correlation. 6 ) To be sure, the reporting of ESG information alone is unlikely to lower a company s cost of capital. But the reporting of such information implies measurement and measurement informs management. And since a better-informed management is more likely to make valueincreasing investment and operating decisions, a company s commitment to ESG reporting can be seen as reducing the risk of investing in that company, resulting in a lower cost of capital. While ESG data can be used to improve the analysis of risks faced by corporations, 7 this information also has the same potential to provide companies and their investors with an understanding of growth opportunities. These growth opportunities come in large part from innovative products that address social needs without compromising the environment or corporate ethics or governance standards. Reflecting this dual focus on opportunity as well as risk, the United Nations-supported Principles of Responsible Investment (PRI) include the formulation and strong endorsement of a Value Driver Model in which ESG metrics provide investors with valuable information about corporate growth * Acknowledgements: The author would like to thank SASB s staff for their invaluable insight and assistance with this paper: Andrew Collins (Associate Director, Technical Research), Jerome Lavigne-Delville (Chief of Standards Development), and Amanda Medress (Associate Director, Communications). 1. Knoll, Michael, Ethical Screening in Modern Financial Markets; The Conflicting Claims Underlying Socially Responsible Investment. The Business Lawyer 57, no. February 2002 (2002): Accessed December 29, edu/fac/mknoll/ethicalscreening.pdf. 2. Welsh, Heidi, and Michael Passoff, As you Sow: Helping Shareholders Vote Their Values: Proxy Preview Tenth Anniversary Edition, p. 6, accessed December 29, 2014, 3. Eccles, Robert G., Michael P. Krzus, Jean Rogers, and George Serafeim. The Need for Sector-Specific Materiality and Sustainability Reporting Standards, Journal of Applied Corporate Finance 24, no. 2 (2012): The definition of materiality on which SASB has based its work was promulgated by the Supreme Court in the TSC Industries v. Northway, Inc., 426 U.S. 438 (1976) decision and C.F.R (Item 303)(a)(3)(ii). 5. A company s commitment to CSR is measured by its Corporate Social Performance (see footnote below for source), which is defined as a business organization s configuration of principles of social responsibility, processes of social responsiveness, and policies, programs, and observable outcomes as they relate to the firm s societal relationships. Corporate social performance revisited, Wood, Academy of Management Review, 16 (4): , DB Climate Change Advisors, Sustainable Investing: Establishing Long-Term Value and Performance, June 2012, p An Ernst & Young LLP survey of 163 investors, analysts, and portfolio managers found that 77.5 percent of investors frequently or occasionally adjusted their valuations due to a risk identified from ESG performance. Ernst & Young LLP. Tomorrow s investment rules: Global survey of institutional investors on non-financial performance, 2014, p Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

60 and productivity as well as risk management. 8 Much as with traditional financial measures, ESG data are presented in this model on a continuum in which poor performance (relative to competitors ) increases risk while strong relative performance not only reduces risk, but has the potential to contribute to productivity and growth. What s more, as the comparability of ESG information increases, it is reasonable to expect that ESG reporting will provide another arena for competition among the reporting companies. The Case of the Processed Foods Industry The Processed Foods industry offers an illustrative example of how ESG data can uncover key risks and opportunities facing an industry, thereby enriching the analysis of corporate financial performance and values. The industry is now confronting two global trends that provide a backdrop for understanding the importance of ESG data in the investment process: the vulnerability of the water-food-energy nexus to climate change and population growth, 9 and the spread of diet-related non-communicable diseases. 10 Over the next 35 years the world s population is projected to grow to more than nine billion people, and the middle class is expected to grow by more than three billion, creating an increased demand for processed food products that could well be constrained by scarcity. 11 At the same time, a global obesity epidemic, which in the U.S. alone is estimated to cost $52 billion annually, 12 has come to the forefront of consumer attention. As discussed below, both of these social challenges present major business opportunities as well as substantial business risks. The Processed Foods industry has the opportunity to contribute to a higher standard of living for much of the world s population. But achieving this goal presents formidable challenges. The ability of companies to meet increasing demand for foods that address consumer concerns in the presence of growing scarcity could have significant effects, positive as well as negative, on the returns they end up delivering to their shareholders. The promise held by comparable ESG metrics is in the ability to provide companies and the company s investors with a sense of their position on a continuum of ESG performance. For investors, moreover, such performance can be used to assess not only the risk and long-run growth potential of companies, but also the quality of their management teams and the extent of their commitment to the corporate future. In designing its standards, SASB works to develop metrics 8. United Nations Global Compact LEAD and Principles for Responsible Investment. The Value Driver Model: A Tool for Communicating the Business Value of Sustainability, December p. 8, accessed December 29, org/docs/issues_doc/financial_markets/value_driver_model/vdm_report.pdf. 9. The water-food-energy nexus is a term widely used in the sustainable development community, and surely one to be incorporated into greater social lexicon; it demonstrates that the goods of water, food, and energy are inextricably linked. For more information see, Water, Food and Energy Nexus. UN-Water: Diet related non-communicable diseases include, among others, diabetes, cardiovascular disease, and heart disease. For more information see, Food Systems for Better Nutrition. Rome: FAO, that establish this continuum. As an example of one metric for the Processed Foods industry, SASB has proposed that companies track and report the percentage of their advertising devoted to promoting products that satisfy the Children s Food and Beverage Advertising Initiative Uniform Nutrition Criteria. By creating and encouraging the reporting of such a measure, SASB aims to provide a platform on which companies can choose to compete. And many if not most food processing companies will have good reasons to join this competition. For one thing, those companies that focus on promoting nutritional foods to children may benefit from revenue growth that is now being driven largely by increased consumer awareness of diet-related non-communicable diseases. At the same time, companies that continue to promote foods with low nutritional value will not only fail to capture this growing demand, but possibly experience loss of market share caused by a backlash from dissatisfied consumer groups. Such companies also risk the imposition of legislative curbs or requirements, such as the nutritional requirements established by the Healthy Hunger- Free Kids Act for foods served at schools in the United States. Central to this example is the premise that much as investors wouldn t limit their use of financial statements to expenses or liabilities, the use of ESG information shouldn t be limited to the evaluation and management of risk. Indeed, as I will show below, ESG data can provide equally valuable insight into a company s growth and return on capital. The Role of ESG in Understanding Corporate Risk The Processed Foods industry faces significant exposure to climate change and drought. More specifically, the agricultural component of the supply chain presents a clear source of risk one that makes clear the critical importance of the water-food-energy nexus for the industry. The climaterelated risks to this system, which threaten to reduce crop yields and decrease crop quality, could lead to significant increases in input prices as supply becomes constrained in the face of growing demand. In a recent report depicting the risks that climate change and drought pose to the industry, Oxfam estimates that the price of Kellogg s Corn Flakes and General Mill s Kix cereals could rise by up to 44% and 24%, respectively, in the next 15 years, with half of this increase attributable to the effects of climate change. 13 Such risks face competitors across the 11. World Resources Institute, Creating a Sustainable Food Future A menu of solutions to sustainably feed more than 9 billion people by 2050, 2013, p. 12, accessed January 14, 2015, pdf. 12. Allison, D B, R. Zannolli, and K M Narayan, The Direct Health Care Costs of Obesity in The United States. American Journal of Public Health 89, no. 8 (1999): Accessed January 10, PMC /?page= Oxfam, Standing on the Sidelines: Why Food and Beverage Companies Must Do More to Tackle Climate Change, May 20, 2014, p. 2, accessed January 14, 2015, Journal of Applied Corporate Finance Volume 27 Number 2 Spring

61 industry. Those companies that take a proactive stance in addressing these risks will be better positioned to gain market share as the risks materialize. To capture the risk of drought and the effects of climate change, SASB standards recommend that companies disclose the percentage of food ingredients sourced from regions with High or Extremely High Baseline Water Stress. In addition, SASB has encouraged companies to provide a list of priority food ingredients as well as a discussion of sourcing risks arising from environmental and social considerations. Many corporations have recognized and reported on these risks. For example, in its k disclosure, ConAgra states, In the event that such climate change has a negative effect on agricultural productivity, we may be subject to decreased availability or less favorable pricing for certain commodities that are necessary for our products. 14 But if such statements show that companies are recognizing climate change as a potential risk, investors likely want to know what proactive steps a company is taking to mitigate this risk. As we will explore later, there are numerous ways in which companies like ConAgra can and do address the risks arising from climate change. The potential loss of value from supply chain exposure to the effects of drought and climate change which ESG data can be used to estimate is not just hypothetical. Such information has moved markets in recent years. In response to a 2010 ban on Russian wheat exports, the shares of General Mills and RalCorp Holdings (since acquired by ConAgra) experienced losses of 2.2% and 3.9%. 15 The ban, which was prompted by a prolonged drought in Russia s major wheat growing regions, affected a variety of participants in addition to General Mills and RalCorp across the Processed Food industry, including 16, 17 Unilever, Nestle, and Mondelez, among others. Companies that track their exposures to drought and other effects of climate change use various strategies and techniques to manage exposure. For instance in its 2014 Corporate Citizenship Report, ConAgra states that climate change poses the risk of potentially threatening our water supply and fundamentally altering growing regions as we now know them. 18 The company further notes that its strategy includes goals for reducing greenhouse gas emissions within our own operations and throughout our supply chain as a way to mitigate these risks and build a business that is resilient to climate change. 19 While such discussion is admirable, the decision-usefulness to investors would be bolstered through quantification of supply chain exposure to drought and pointed discussion on the environmental risks associated with priority crops, as called for in SASB s standards. In addition to the tools ConAgra describes, companies have numerous tools and strategies to address risks related to climate change. Over a short- to medium-term time horizon, proactive companies may use futures contracts to hedge the risk of changes in raw materials price, or diversify the regions from which they source raw materials so as to reduce the likelihood and degree of any supply shortages or price increases. But over the longer term, some far-sighted companies will manage these risks most effectively by developing products that are less likely to be affected by drought and other climate change-related events. In this sense, effective risk management has the potential to promote growth and provide industry leaders with the opportunity to pass cost savings to consumers, enhance profitability, and gain market share. And to the extent ESG information that supports such new products is made available to and processed by long-term fundamental investors, corporate disclosure of such information is likely to encourage more accurate and sophisticated analysis and valuation by the capital markets and generate higher values for companies with environmentally sustainable practices. ESG Data Indicates Growth and Productivity As a result of changing demographics and greater understanding of the water-food-energy nexus, processed foods companies are seeing growing demand for products that are developed in ways that do not degrade the environment. 20 As participants in this industry compete to gain share of this growing market segment, standardized metrics will provide investors with the information necessary to make better-informed decisions. To address this need, SASB standards recommend that companies in the industry measure and report the percentage of food ingredients sourced that are certified to a third-party environmental and/or social standard. The organizations recognized as providing such certification include the Roundtable on Sustainable Palm Oil, Rainforest Alliance, Fair Trade International, and USDA Organic. In a recent publication, the United Nation s Food and Agriculture Organization (FAO) notes that global retail sales of organic-labeled foods were estimated at $46 billion, a four-fold increase from 1997, and that sales of Fairtrade Certified foods reached nearly $3.5 billion, with a 40% annual growth rate between 1997 and Whereas total U.S. food sales grew by 4.5% in 2011, the U.S. organic market grew by 9.5%; and the average rate of growth for 2013 to 2018 is projected to reach 14. ConAgra Foods, Inc. FY13 Form 10-k for the period ending May 26, 2013 (filed Jul. 19, 2013), p Pleven, Liam, Gregory Zuckerman, and Scott Kilman, Russian Export Ban Raises Global Food Fears. Wall Street Journal, August 5, Accessed January 2, Belton, Catherine, Jack Farchy, and Javier Blas, Russia grain export ban sparks price fears Financial Times, August 5, Accessed May 4, com/cms/s/0/485c93ae-a06f-11df-a feabdc0.html#axzz3zbeouucl. 17. Mondelez International, Inc. FY 2010 Form 10-k for the period ending December 31, 2013 (filed Feb. 28, 2011), p ConAgra Foods, Inc., 2014 Corporate Citizenship Report, 2014, p Ibid. 20. PWC, Retail & Consumer A subsector focus on megatrends Packaged food and beverages ( F&B ). May 2014, accessed December 30, 2014, user_content/editor/files/ind_retail/megatrends_fb.pdf. 21. Liu, Pascal. Voluntary Environmental and Social Labels in the Food Sector. In Innovations in Food Labelling. Rome: Food and Agriculture Organization of the United Nations, Accessed December 30, i0576e08.pdf. 60 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

62 Table 1 Metric Risk Opportunity Global Food Safety Initiative audit conformance: (1) major non-conformance rate and associated corrective action rate, and (2) minor non-conformances rate and associated corrective action rate Notice of food safety violations received; percentage corrected 30 High major non-conformance rates and low corrective action rates could indicate risks to food safety, which could lead to recalls, lost contracts, and remediation costs. Major non-conformances may indicate systemic governance risks, which could affect risk premiums. Minor non-conformances may expose findings that if not corrected could turn into major non-conformances that present higher-magnitude repercussions. Violations are a direct expense to registrants in the form of time and resources needed to correct any notices received and fines that may be levied if such notices are not addressed. Notices of violations speak to management s ability to comply with self- and industry-imposed best practices, as well as government regulations. Minimizing or eliminating non-conformances and maximizing corrective action rates indicate that management is properly managing food safety issues, which could in turn provide a strategic rationale for expanding the core business, as resources that may otherwise be focused on establishing compliance can be leveraged to promote growth. N/A 14% annually between 2013 and , 23 In sum, increased demand for products certified to third-party environmental or social standards appear to represent a sizable opportunity for processed foods companies. A review of corporate earnings calls further supports the expectation of significant growth for products certified to thirdparty standards. Speaking to the importance of growth from certified-organic food sales on its July 7, 2014 Investor Day, representatives from Campbell s Soup claimed that: within Soup, we believe there is substantial upside in two distinct areas, indulgents and organic as it [organic] currently accounts for $190 million in sales each year and is growing at nearly 9 percent. 24 Campbell s is also expanding into the organic baby food and beverage markets through its purchases of Plum Organics and expansions of its Bolthouse Farms portfolio. 25 Along with Campbell s, consider also the case of Hain Celestial. Although no giant by Processed Food industry standards, the company, which had $2.15 billion in fiscal year 2014 sales, 26 reported in its second quarter FY 15 earnings call that over 50% of its products are certified organic, and that adjusted operating income is up 11% year on year citing consumer demand for organic foods as a key driver of growth. 27 In line with these trends in consumer demand, General Mills has established a goal of building our Natural and Organic Food business to $1 billion in sales by fiscal Reaffirming this commitment, the company noted that sales from this business segment totaled more than $160 million in the third quarter, up 60% versus last year, including the addition of Annie s. 28 Besides opening new markets, another way companies can grow return on capital is through increases in productivity. In 22. Scott-Thomas, Caroline. US Organic Market Continues to Outpace Conventional Food Sales Growth. FoodNavigator-USA.com. April 24, Accessed January 14, Daniells, Stephen. US Organic Food Market to Grow 14% from Food- Navigator-USA.com. January 3, Accessed January 14, Campbell Soup Company. CPB.US Investor Day: Shareholder Meeting Call, July 21, Accessed through Bloomberg LP on January 6, Campbell Soup Company. CPB.US Q Earnings Call, February 25, Accessed through Bloomberg LP on May 6, the Processed Foods industry, managing the packaging life cycle presents a major opportunity for cost savings. Nestlé, for example, saved more than $170 million by reducing the amount of packaging it used in With resource constraints likely to grow, companies that reduce packaging weight and transition to renewable materials may reduce transportation costs and reduce price volatility for packaging produced from fossil fuel stocks. To capture corporate performance in this area, SASB has encouraged companies to measure and report the following indicators of packaging efficiency: total weight of packaging; percentage made from recycled or renewable materials; [and] percentage that is recyclable or compostable. Such metrics, or others designed to reflect packaging used or CO 2 emitted, can be normalized on a revenue (or other) basis to provide investors with details on the efficiency of a company s operations and its effect on corporate productivity. Standardized ESG Metrics to Inform Investor Analysis In addition to the measures already mentioned, SASB recommends that companies in the Processed Foods industry disclose information on food safety and sourcing of certified products. While some of SASB s standards address the risks and opportunities associated with global mega trends, others bear more directly on a company s operating efficiency and performance. SASB has proposed three metrics for evaluating companies performance on food safety that are presented, along with associated risks and opportunities, in Table 1: While investors may be able to glean useful information from any one of these three metrics, viewing them together 26. Hain Celestial Group, Inc., FY 2014 Form 10-k for the period ending June 30, 2014 (filed Aug. 27, 2014), p Hain Celestial Group, Inc. HAIN.US Q Earnings Call, February 4, 2015, Accessed through Bloomberg LP on May 6, General Mills. GIS.US Q Earnings Call, March 18, 2015, Accessed through Bloomberg LP on May 6, Nestle, Nestle in Society: Creating Shared Value and Meeting Our Commitments, 2013, p Note disclosure shall include a description of notable recalls such as those that affected a significant amount of product or those related to serious illness or fatality. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

63 Table 2 Metric Risk Opportunity Revenue from products labeled and marketed to promote health and nutrition attributes Revenue from products that meet Smart Snacks in School criteria or foreign equivalent Description of process to identify and manage products and ingredients of consumer concern Disclosure on this topic points to the risks associated with regulation and public outcry relating to the products that do not promote health and nutrition attributes. The Healthy Hunger-Free Kids Act was passed in 2010, products that meet the standards proposed by this act are allowed for sale in schools whereas products that do not are forbidden from such sales. This metric gives investors information on the risk that a firm s products may be excluded from certain markets. Processed foods contain certain ingredients about which public health concerns exist. This metric allows registrants to discuss its efforts to address such ingredients and the potential risk that its ingredients may come under further scrutiny or even regulation. Companies that do not realize the change in consumer demand and increased regulatory scrutiny may be at risk of losing market share as demand and regulations push the industry to recognize health concerns. There has been substantial growth in demand for products that promote health and wellness. This metric gives investors information as to how companies are positioned to gain market share of this growing segment. The public has become hyper-aware of the affects that energy-dense, nutrient-poor foods have on children. This awareness has driven demand for foods of higher nutritional value. Disclosure will provide insight into which product segments are better performing and whether the registrant is taking advantage of such market trends. Companies taking a proactive stance on limiting ingredients of consumer concern will be better positioned to gain market share as demand for such products continues to grow. Additionally, Companies that have developed strategies to address health concerns about processed foods will maintain brand value and be better suited to increase market share. provides insight into the size and regularity of the total costs that result from recalls and, perhaps even more importantly, into management s approach to and effectiveness in limiting future recalls. Low recall rates, when combined with effective preventive measures, are also likely to serve investors as reliable indicators of how management allocates resources to more productive capacities as well. Moreover, this kind of ESG data, to the extent it provides outsiders with a reassuring view of the firm s risk management processes, may well end up reducing its cost of capital, and so increase its value (for a given level of earnings and cash flow). Such data also has the potential to provide investors and managements alike with a deeper understanding into what is driving (or diminishing) the companies long-run average return on capital. In sum, the metrics on food safety presented in Table 1 reflect a company s risk management capabilities while providing insight into its potential to leverage competitive advantage achieved through superior performance to enhance or drive growth. But, as we have seen, SASB has also proposed standards for the Processed Foods industry that provide information that can shed light on a company s growth opportunities (though such opportunities, if sufficiently neglected, are liable to become sources of risk). One area that presents opportunities for this industry is provided by SASB standards on Health & Nutrition that are presented in Table 2: In a clear sign that some food companies recognize the opportunity presented by health and wellness, representatives of ConAgra directed attention in a recent earnings call to the company s recently launched Healthy Choice Simply Steamers product line, noting that it s really on trend with the desire from consumers of minimally processed foods and we re off to a very good start. 31 Another well-known food company, Snyder-Lance Inc., announced in its November 4, 2014 earnings call the creation of a Better for You division that will allow us to drive our long-term growth and begin to reshape not only that new division but [the] overall company. 32 Whether it be through organically growing health and wellness products and brands or through mergers and acquisitions, companies in the Processed Foods industry are making concerted efforts to capture this increasing demand. While addressing an analyst s concern over scaling health and wellness-oriented brands, Mondelez s (formerly Kraft Foods Inc.) CEO Irene Rosenfeld stated without a doubt, betterfor-you snacking is on trend. It s resonating well with our consumers around the world, and therefore, it will continue to be an important focus area for us I think you should expect to continue to see us building on our better-for-you snacks, both organically and through M&A. 33 And it s not just companies that are recognizing the opportunities presented by demand for health and wellness products. Mainstream investors have begun to recognize and 31. ConAgra Food, Inc. CAG.US Q Earnings Call, December 18, Accessed through Bloomberg LP on January 6, Snyder Lance, Inc. LNCE.US Q Earnings Call, November 04, Accessed through Bloomberg LP on January 6, Mondelez International, Inc. MDLZ.US Q Earnings Call, April 29, Accessed through Bloomberg LP on May 6, Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

64 focus on the value of incorporating these attributes into the product mix. As just one example, a recent Morgan Stanley research paper on integrating ESG into corporate valuation concludes that [i]n terms of opportunities, companies with more exposure to healthy products in their portfolio can benefit by leveraging this key trend, which has been driving growth across food categories. 34 In addition to suggesting that health and wellness products are likely to affect valuations through revenue risk and opportunity, the paper suggests that investors pose questions to management on such topics as, the proportion of the company s product portfolio that is exposed to less healthy foods as well as the company s efforts to leverage the consumer trends towards healthy eating. 35 Consistent with the message and issues raised by Morgan Stanley, SASB metrics presented in Table 2 seek to address growing demand for standardized ESG disclosure while limiting the potential for information asymmetry and investor uncertainty that could arise from less standardized disclosure. But investors and analysts want more than narrative to support decisions on how they allocate capital they want corresponding data. While information on a company-bycompany basis is disaggregated and lacks comparability, a 2013 Hudson Institute study of 15 leading Processed Foods companies found that, although foods determined to be better-for-you (BFY) constituted only 38.6% of sales between 2007 and 2011, these same foods contributed to 71.8% of growth over the same time period. The study also notes that those companies with above-average BFY portfolio sales had an average operating profit margin of 15.3% and an average operating profit growth of 49.6%, as compared to 9.5% and 14.3% respectively for those with below-average BFY portfolio sales. 36 Such findings lend further credence to the previously cited statements by industry executives (in conference calls) that consumer demand for BFY food is driving growth in both sales and (more importantly) profits. While this research would suggest the health and wellness attributes of a company s product portfolio have implications for financial performance, there remains a lack of comparable information that investors can incorporate into their analysis and decision-making. Many companies in the Processed Foods industry now report some form of metric that reflects the health and nutri- tion attributes of their products. However, the metrics lack comparability across the industry. Whereas Nestle provides information on products meeting or exceeding Nestlé Nutritional Foundation profiling criteria, 37 Mondelez highlights the percent[age] of our revenue from our Better Choices products, 38 and General Mills reports the percentage of its 2014 U.S. retail sales volume comprised of products that have been nutritionally improved since While the disclosure of such metrics should be applauded, the lack of comparability reduces their usefulness to analysts and investors. Standardized metrics on health and nutrition can give investors meaningful insight into, among other things, a company s ability to capture demand and increase market share in this growing market. And this type of ESG information may well prove pivotal by further informing investors expectations about the company s future returns on capital and long-run value. In Summary Investors have largely incorporated ESG data into their research, mainly as a way of assessing risk. A recent PwC survey of 40 institutions with $7.6 trillion worth of assets under management found that 73% of investors considered risk mitigation as a primary driver compelling them to use ESG information. Nevertheless, enhanced performance and impact on overall capacity to create value were close behind, cited by 52% and 30% of investors, respectively, as supporting these aspects as primary drivers for consideration of ESG information. 40 In the past, much of the discussion on corporate sustainability has focused on the ability of corporations to minimize the liabilities of poor environmental stewardship and the harm of mismanaged social practices. In the future, the use of ESG information will expand to incorporate growth and productivity opportunities associated with strong ESG performance. As companies use SASB standards to disclose ESG information in ways that prove useful for investors, the case for using ESG data to evaluate corporate productivity and growth, as well as risk, will only grow stronger. Levi. S. Stewart, CPA, is a Technical Research Analyst at the Sustainability Accounting Standards Board. 34. Morgan Stanley Research, Embedding Sustainability into Valuation, January 27, 2015, p Ibid, p Hudson Institute, Better-For-You Foods: An Opportunity To Improve Public Health And Increase Food Industry Profits, March 2013, p Nestle, Nestle in Society: Creating Shared Value and Meeting Our Commitments, 2013, p Mondelez International, Inc., The Call for Well-being: 2013 Progress Report, 2013, p General Mills, Inc., Global Responsibility: 2015, 2015, p The question presented for which this data relates asked, Why are investors considering sustainability issues? The possible responses included, were primary driver, somewhat of a drive, not at all a driver. For more information on this study see: PWC, Sustainability goes mainstream: Insight into investor views, May 2014, p. 6, accessed January 6, 2015, Journal of Applied Corporate Finance Volume 27 Number 2 Spring

65 ESG Integration in Corporate Fixed Income by Robert Fernandez and Nicholas Elfner, Breckinridge Capital Advisors B reckinridge is a separate-account, high-grade fixed-income manager whose primary goal is to preserve capital while building a reliable source of income and opportunistically improving total return for our clients. Much of our work in research accordingly involves the evaluation of credit risk and a search for ways to limit such risk. As part of this effort, we made the decision in 2011 to integrate an analysis of environmental, social, and governance (ESG) issues into our fundamental credit-research process. We have found that taking such an integrated approach to investment research provides a more comprehensive and forward-looking evaluation of a borrower s ability to repay. In addition, ESG integration helps us to better identify and price risk, which are key factors in valuing fixed-income investment. In this article, we review the merits of ESG analysis as well as the use of such analysis in our credit evaluation process.1 While so doing, we also discuss what we think we have gained by incorporating this non-financial analysis into credit research. Finally, we summarize a number of corporate sustainability trends as well as the most important findings of our 2014 ESG engagement project with the corporate issuers whose bonds we have chosen to buy. What is ESG? Environmental, social, and governance issues represent risks and opportunities that can be assessed in the context of corporate behavior and performance. Because they are non-financial in nature and typically affect a company s performance over the medium to long term, 2 ESG issues are generally analyzed by evaluating numerous related key indicators or metrics. For example, the methodology used by Sustainalytics to evaluate the ESG performance of a company draws from a universe of more than 100 indicators, with 70 to 90 indicators used for a given industry peer group. 3 A sample of ESG issues and underlying indicators that can be used to evaluate these potential credit risks is provided in Table This commentary on the value of ESG in corporate-credit analysis provides an update to our previous white papers, including The Investment Merits of Sustainability in Fixed Income, published in February 2013, and Breckinridge s Corporate Credit Principles: A Sustainable Approach, published in September CFA Institute Inc., Environmental, Social and Governance Factors at Listed Companies, a Manual for Investors, Table 1 Environmental Issue Toxic emissions and waste Water management in manufacturing Social Issue Product safety and quality Labor management Governance Issue Example of ESG Issues and Indicators Board structure and independence Business ethics and competitive behavior Indicator Percentage of waste diverted from landfills Total water withdrawn, percentage recycled Indicator Number, frequency or cost of product recalls Employee satisfaction and turnover Indicator Percentage of independent directors Amount of fines due to anti-competitive practices Source: Sustainability Accounting Standards Board, MSCI, Breckinridge. ESG-research providers like Sustainalytics have long gathered company-specific ESG information by searching news articles as well as reports from governmental and non-governmental agencies. During the last few years, however, there has been a significant increase in ESG reporting by companies as a response, in part, to requests for greater transparency from various stakeholders. According to the Governance & Accountability Institute, 72% of the companies that make up the S&P 500 produced some form of sustainability, responsibility, or citizenship report in 2013, up significantly from 20% in KPMG also saw greater adoption of ESG reporting in its annual survey: 71% of the 4,100 companies queried in 2013 published a sustainability report, as compared to 64% in In addition to outside pressure, a growing number of companies are pursuing sustainability initiatives that, together with periodic reports of their accomplishments, reflect management s belief in their strategic value. In McKinsey & Company s 2014 global online sustainability survey of corporate executives, 43% of the respondents said that their companies seek to align sustainability with their overall business goals, mission or values, as compared to 21% in Further, 63% of the 3. Sustainalytics, Sustainalytics Global Platform Manual. Version 1.0, March Governance & Accountability Institute, Inc. Flash Report: 72 percent of S&P 500 Companies Now Publishing Sustainability/Responsibility Reports, June 3, KPMG International, The KPMG Survey of Corporate Responsibility Reporting 2013, pg Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

66 CEOs surveyed by the UN Global Compact and Accenture in their 2013 study on sustainability said they expect sustainability to transform their industry within five years. 7 Finally, companies are collaborating with the recently formed Sustainability Accounting Standards Board (SASB) in the development of material, sector-specific ESG reporting standards. ESG Risks and Opportunities There have been notable periods when insufficient management of ESG risks had significant negative consequences for companies and their investors. For example, the technology and telecom meltdown of , which saw a wave of corporate governance failures, resulted in massive losses of both stockholder and bondholder value. 8 During the U.S. financial crisis ( ), bondholders experienced extraordinary losses on investments in brokerage houses that have been attributed to inadequate oversight of the risks inherent in their financial products and investments. 9 More recently, the costs associated with environmental (2011) and mortgage litigation ( ) have significantly reduced the expected profitability and values of corporate issuers in the energy and banking sector. But at the same time, we now have suggestive evidence that effective ESG risk management pays off. For example, one recent academic study has reported finding that companies that have engaged in corporate social responsibility activities have reduced their systematic risk and increased their values. 12 This finding is consistent, moreover, with an earlier study showing that corporate issuers with proactive environmental practices have a lower cost of debt, which typically correlates with stronger creditworthiness. 13 Still, quantifying the positive effects of sustainability initiatives on financial returns can be challenging for companies. As one example, the cost savings from energy, waste, and water efficiency have proven to be significant, and have demonstrated their ability to drive margin expansion and produce other quantifiable benefits. But of the 25 companies we contacted and communicated with during our last summer s corporate engagement project, only one, Praxair Corporation, had been able to calculate the total dollars saved 6. McKinsey and Company, Sustainability s strategic worth: McKinsey Global Survey, This annual survey collected responses from 3,344 corporate executives from February 11 to February 21, See The UN Global Compact-Accenture CEO Study on Sustainability 2013, pg Monks, R.A.G. & Minow, N., Corporate Governance, March 2012, pg. xxi. The authors note how inadequate corporate governance practices contributed to fraud and significant stakeholder losses in Larcker, D. and Tayan, B., A Real Look at Real World Corporate Governance, July 2013, pgs The authors refer to Lehman Brothers as an example of how ineffective board oversight contributed to the brokerage firm s demise. The board lacked qualified directors as none of the members had financial services expertise, among other issues. 10. Bakhsh, Nidaa, BP Maintains Gulf of Mexico Oil Spill Cost at $43 billion, Bloomberg Businessweek. The article mentions that a US judge determined that BP PLC acted with gross negligence in drilling the Macondo well of the Louisiana coast in September With this finding, BP is exposed to more than $18.0 billion in fines, in addition to the $28.0 billion post-spill clean-up costs. 11. See US Department of Justice press release, Bank of America to Pay $16.65 Billion in Historic Justice Department Settlement for Financial Fraud Leading up to and During the Financial Crisis. The settlement is related to its mortgage origination and residential mortgage backed security and collateralized debt obligation activities. by its sustainability projects. After developing its Sustainable Development Management System to gather environmental and social information about its business, Praxair used that system to show that its sustainability productivity improvements yielded savings of $112 million in 2012, and as much as $500 million in total. 14 Moreover, an understanding of ESG can help companies identify revenue-enhancing opportunities, such as new product offerings that help customers become more sustainable. The Home Depot Inc., the home improvement retailer, now offers more than 7,700 Eco Option products, such as LED light bulbs and tankless water heaters. In addition to saving customers money through lower utility bills, these products generated 7.5% of the company s total sales in 2011 and are growing more quickly than the rest of the business. 15 Johnson Controls, Inc. supplies energy efficiency equipment to help commercial property owners reduce energy consumption and emissions, and provides advanced battery systems and light-weight automotive interiors components that boost fuel efficiency in cars. For example, the company estimates that its Start- Stop automotive battery technology is saving over 380 million gallons of fuel per year on the 20 million cars where it has been installed. 16 Finally, under its Sustainable Living Plan, Unilever PLC, the multinational consumer goods company, is integrating social, environmental, and economic impacts into product design. Brands that have gone through this assessment, including Lifebuoy and Dove, grew by double digits in 2014, which is well above the company average. 17 Why We Use ESG Breckinridge employs a bottom-up credit-research approach to investing in corporate bonds. This emphasis on fundamental analysis supports our primary investment mandate of preserving capital and building sustainable sources of income while seeking opportunities to increase total return. As a result, our credit analysts are particularly sensitive to the goal of mitigating credit risk. Our process begins with an assessment of a company s capital sources and operating trends. Our review of capital 12. Albuquerque, R., Durnev, A. & Koskinen, Y., Corporate Social Responsibility and Firm Risk: Theory and Empirical Evidence, Boston University and University of Iowa, June Bauer, R. and D. Hann, Corporate Environmental Management and Credit Risk, Maastricht University, European Centre for Corporate Engagement (ECCE), December The figure of $112 million in 2012 savings from sustainability productivity came up during our call with Praxair s investor relations and sustainability professionals. The cumulative $500 million in savings has been disclosed in its investor presentations: See: Reports%20Papers%20Case%20Studies%20and%20Presentations/Investors/Investor%20Presentations/2014/PraxairGoldmanSachsConferece pdf. 15. From our call with investor relations at The Home Depot Inc. 16. See The Johnson Controls Way, 2014 Business and Sustainability Report available here: 17. See Journal of Applied Corporate Finance Volume 27 Number 2 Spring

67 Examples of Credit and ESG Characteristics Risks stemming from the impact of management s operational decisions on the environment. A company with operations that rely on natural resources is better placed to safeguard its reputation, reduce future costs and avoid a ratings downgrade by remaining committed to environmental protection in both word and action. E S G Statoil ASA is a Norwegian integrated oil and gas company. From a credit perspective, Statoil s financial leverage is among the lowest in the integrated peer group. Its net debt to total capitalization ratio of 10 percent and net debt to earnings before interest, taxes, depreciation and amortization (EBITDA) ratio of 0.2 times provide significant flexibility. Its liquidity is also strong with $18 billion in cash and short-term investments at its most recent quarter-end. Environmentally, Statoil is an industry leader in carbon intensity, spill prevention, emissions and environmental safety. It demonstrates a strong track record in developing alternative technologies, particularly offshore wind energy generation. Risks derived from a company s relationships with employees, customers, suppliers and the community. Management who carefully weigh the costs and benefits associated with these relationships can help mitigate controversy risks. BHP Billiton Plc (BHP) is the largest mining company in the world. Through commodity price cycles, it has demonstrated a consistent ability to maintain strong free cash flow and moderate financial leverage. Trailing 12-month free cash flow after capital expenditures was a sizeable $8.4 billion and net debt to EBITDA was a moderate 0.9 times at its most recent quarter-end. BHP has also been actively managing its material social risks and opportunities. BHP health and safety practices are industry-leading with its total recordable injury rates at a record low in Although the company has been involved in labor controversies, it is recognized for its strong human rights policy, and comprehensive community development and engagement programs. Risks that originate from a company s corporate governance policies and procedures. Corporations with effective and independent board leadership promote transparency and institute guidelines and incentives to align managerial behavior with the interests of stakeholders. Toronto-Dominion Bank (TD) is the second-largest depository institution in Canada, and is active in wealth management, insurance and capital markets. TD s solid profitability and steady asset quality are key credit strengths. For instance, it reported a 15 percent return on equity in the most recent quarter and credit losses are near a five-year low at 0.31 percent. We view TD as an outlier versus its banking peers in managing its material governance and reputational risks and opportunities. TD has a strong governance structure with a diverse, independent board and a corporate-governance committee that oversees sustainability issues. The chairman and CEO position are split and five women sit on its 15-member board. The bank s risk management framework is considered strong. Source: Breckinridge, Company Reports. Figure 1 High ESG Performers Exhibit Lower Earnings Volatility 100% 50% 0% -50% -100% -150% -200% -250% -300% Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q S&P 500 Top ESG Performers* *Represents 100 Top Q214 ESG performers vs. peer group. Source: Bloomberg, Breckinridge. Risk Mitigation & Lower Earnings Volatility Our emphasis on risk mitigation coupled with a long-standing commitment to fundamental credit research made the decision to integrate ESG into our investment process a natural one for Breckinridge. Our decision to move forward with ESG integration in 2011 was also driven by the evolution in corporate sustainability reporting. Armed with more, and better, material ESG information on our corporate borrowsources focuses on an assessment of key leverage and liquidity metrics, which are among the most important indicators of default probability and credit health. Our review of operating trends consists primarily of an in-depth analysis of margins and free cash flow. We also assess the strength of a company s business profile, market position, brand, and reputation. Our analyses are then summarized in an internal credit rating that is assigned to each corporate credit by our analysts. 66 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

68 Figure 2 S&P Market Value Shifted Towards Intangible Assets Table 2 ESG Ratings Provide Added Information Value 83% 68% 32% 20% 20% Corporates Correlation All Sectors 0.34 Industrial 0.10 Financial 0.22 Utility 0.30 Source: MSCI Ratings Analysis as of October % 32% 68% 80% 80% Intangible Market Value 1995 Tangible Book Value 2005 Source: Ocean Tomo, LLC Annual Study of Intangible Asset Market Value ers, we were now able to evaluate a broader array of risks, which in turn puts our analysts in a better position to evaluate a company s creditworthiness. Since then, we have seen how the integration of material ESG factors into our research process provides us with a more complete understanding of our borrowers, including the quality and character of management. A company s environmental footprint, policies, and risk management approach are shaped by its senior executive team. At the same time, the firm s supply chain and labor relations are social issues that are within the scope of management s responsibility. Finally, the composition of the board and its subcommittees reflect management s priorities and the values embedded in the corporate culture. To better understand how ESG integration may add value from a risk mitigation perspective (see Figure 1), we compared the net income volatility of two groups: (1) the 100 companies in the S&P 500 that received our top ESG ratings, and (2) all the companies that make up the S&P 500. We found that our subset of higher-rated ESG corporate credits had less variability in their earnings than the broader S&P 500 universe. Stability of both earnings and margins are key credit fundamentals that we monitor when managing investment-grade bond portfolios. 18 Furthermore, a 2012 meta-study by Deutsche Bank Climate Change Advisors concluded that relevant academic studies are virtually unanimous in their support of the possibility that companies with strong ESG ratings relative to peers have a lower weighted-average cost of capital. A lower cost of capital, besides providing companies with higher valuations for a given level of operating earnings, also strengthens companies ability to invest in their businesses and generate sustainable returns above their weighted-average cost of capital Analysis prepared by Breckinridge Capital Advisors Inc. using data from The Bloomberg, Top 100 Q214 ESG performers vs. peer group, See DB Climate Change Advisors, Sustainable Investing: Establishing Long-Term Value and Performance, June See Deliotte IAS Plus, IAS 38 Intangible assets, available here iasplus.com/en/standards/ias/ias38. An Intangibles Economy ESG analysis is also useful when evaluating a company s stewardship of its intangible assets. The International Accounting Standards Board defines an intangible asset as an identifiable non-monetary asset without physical substance. 20 Examples of intangible assets include trademarks, patented technology, and computer software. The value of certain intangible assets, such as goodwill, is accounted for on a balance sheet. For others, like customer lists and supplier relationships, it can be argued that their value is captured only in a company s equity market capitalization. In 2010, an estimated 80% of the S&P 500 s equity market valuation was based on intangible assets, up from 17% in 1975, as shown in Figure The starting point in 1975 reflects a U.S. economy more heavily concentrated in manufacturing, when valuations were largely based on hard assets like equipment and facilities. Today, our economy is knowledge-driven and consumer-driven with investors placing a greater premium on intellectual capital and patents. Traditional accounting is an effective tool for tracking key financial figures such as revenue and earnings. But it falls short when reporting on non-financial risks that may affect a company s reputation with its customers or the communities in which it operates. 22 ESG integration plays an important role in the analysis of such non-financial risks and opportunities. A company with limited understanding or oversight of its ESG risks is vulnerable to situations that could tarnish its brand and competitive position. Ultimately, and in some cases immediately, this may lead to a loss in its equity market valuation and, of greatest concern to Breckinridge, affect the performance and value of its bonds. Additive with a Low Correlation to Moody s Ratings In a study published in 2012, MSCI reported finding a low positive correlation between its ESG ratings and Moody s credit ratings. In the analysis, whose findings are summarized in Table 2, MSCI calculated a correlation between their ESG ratings 21. See Ocean Tomo, LLC, Intangible Asset Market Value Study, Ocean Tomo calculates intangible assets by subtracting the tangible book value from the market capitalization of a given company or index. 22. Rogers, J. and Herz R., Corporate Disclosure of Material Information: The Evolution And the Need to Evolve Again, Journal of Applied Corporate Finance, Summer 2013, pg. 53. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

69 Figure 3 A Historical Comparison of Monthly Gross Total Returns Source: Breckinridge, Barclays. 2.5% 2.0% 1.5% 1.0% 0.5% 0% -0.5% -1.0% -1.5% -2.0% Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Breckinridge Intermediate Term Taxable Barclays Government/Credit Index and Moody s ratings of comparable corporate issuers of only To be sure, a high ESG rating provides no guarantee of a company s ability and willingness to service debt; but this finding nonetheless suggests that the ESG factors may provide useful non-financial indications of companies vulnerability to risk that, however relevant in evaluating creditworthiness, may not be fully considered by Moody s. Moody s states that when assigning a rating, its analysts are looking through the next economic cycle or longer. 24 The average length of an economic cycle, according to the National Bureau of Economic Research (NBER), has been 56.4 months, or a little less than five years. 25 While some ESG risks, such as governance issues, may be relevant for that time frame, agencies may not consider other longer-term horizon risks. 26 Since Breckinridge invests in corporate bonds with up to 20-year maturities, a broader assessment of risk, including ESG, may prove a valuable complement to if not indeed a kind of check or second opinion on a Moody s rating. Although the management of certain ESG issues may not have a material impact on the credit profile of the company during the short term, these risks can affect the company s ability to repay its debt over longer periods of time. Therefore, our longer-term investment perspective, coupled with the low positive correlation between ESG and credit ratings, supports our belief that ESG analysis offers additional informational value. Comparable Returns, but with Potentially Lower Volatility We expect the returns and volatility of ESG fixed-income strategies to be at least comparable to those of traditional fixed-income strategies in the near term while having the potential to outperform over the long term. Although truly long-term performance data is lacking, both our experience at Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Dec-14 Breckinridge Intermediate Term Taxable Sustainable Figure 4 Barclays MSCI Comparison of Total Returns and Standard Deviation 8.0% 6.0% 4.0% 2.0% 0.0% 6.8% 6.7% 5% Barclays MSCI US Corporate Sustainability Index (12/31/07-12/31/14) Barclays US Corporate Investment Grade Bond Index (12/31/07-12/31/14) Mean Total Return 12 Month (%) Standard Deviation (%) Inception for Sustainability Index: 1/01/2007. Source: Barclays Live. 7.7% Breckinridge over a three-year period and the findings of an MSCI analysis over seven years demonstrate that an investment in ESG fixed-income strategies delivers comparable returns to an investment in traditional fixed-income, but with potentially lower volatility. The returns and standard deviation of the Breckinridge Intermediate Term Taxable strategy are consistent with the same measures for the comparable Breckinridge Intermediate Term Taxable Sustainable strategy. For the first eight months after its launch in July 2011, there was a modest difference in returns, as can be seen in Figure 3. This was attributed to the smaller size of the Taxable Sustainable composite, which made it more sensitive to trading activity and bond maturities, among other factors. As the number of accounts in the composite has grown, 23. In a study prepared by MSCI, See Moody s Ratings Policy & Approach available here: com/pages/amr aspx. 25. See the National Bureau of Economic Research (NBER) available here: The 56.4 month cycle measures peak to peak for 33 cycles from 1854 to See Moody s Investors Service, Global Manufacturing Companies Rating Methodology, July Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

70 Figure 5 An Example: a Hypothetical Beverage Company and its ESG Risks and Opportunities Supply Chain (Upstream) Company Operations (Manufacturing) Use and Disposal (Downstream) E Development and use of an extensive water management plan can help the company manage through periods of water scarcity, a business risk that can lead to reduced crop yields, higher input costs and lower profits. Lack of clear goals and timetables to cut or eliminate waste and emissions from production facilities demonstrates a missed opportunity to benefit from efficiency projects that can reduce operating expenses and boost profits. Efforts to reducing packaging materials and postconsumer waste can benefit the company through lower shipping costs, increased awareness and support from consumers for its products. S Weak human rights and supplier code of conduct policies demonstrate inadequate oversight of working conditions at suppliers, which can leave the company susceptible to a controversy that damages its brand. Comprehensive health, safety and wellness programs for employees help to reduce workplace injuries, foster morale, and increase retention and productivity. Responding to consumer preferences for healthier products by introducing new low- or no-calorie beverage options and by reducing sodium and sugar content in existing products can boost demand and sales, and help counteract new legislation aimed at curbing soda sales. 27 G Strong bribery and corruption policies help govern the interaction of employees with suppliers. Evidence of a bribe, kickback or inappropriate gift can contribute to higher costs in the form of litigation, fines and increased regulation. A board-level committee on sustainability may be indicative of a serious, corporate-wide commitment to driving accountability and innovation in the management of ESG issues. 28 A corporate culture characterized by poor transparency including inadequate ESG reporting and spotty stakeholder engagement can cause ill will among customers and may impair the company s license to operate. 29 Source: Breckinridge, Corporate Sustainability Reports, KPMG, 30 MSCI, Sustainalytics. the returns of the two strategies have converged. This convergence is also evident when year-to-date returns through November 2014 are compared to annualized returns since inception of the Taxable Sustainable Strategy. Furthermore, the volatility of the two strategies, as measured by the standard deviation of returns, is also comparable from July 2011 through November Additionally, in 2013 Barclays and MSCI introduced a new group of fixed-income indices that incorporate ESG ratings from MSCI (see Figure 4). These new indices share the same eligibility standards as the Barclays fixed-income indices, such as the minimum debt issue size of $250 million and investment-grade issuers only. MSCI looked at back-tested returns for the Barclays MSCI U.S. Corporate Bond Sustainability Index, which includes Best-in-Class ESG corporate issuers. Barclays and MSCI have found that total returns were comparable and volatility measures were slightly lower for the Barclays MSCI ESG U.S. Corporate 27. Nagourney, Adam, Berkeley Officials Outspent but Optimistic in Battle over Soda Tax, New York Times, Oct. 7, Paine, Lynn S., Sustainability in the Boardroom, Harvard Business Review, July Eccles, R. and Serafeim, G., Innovating for a Sustainable Strategy, Harvard Business Review, May The writers note that the license to operate is granted by society and represents a continuum of permission to do business. Customers have to be willing to buy the firm s products, suppliers to provide the materials the company needs Bond Sustainability Index than the relevant Barclays U.S. Corporate Bond IG Index since the inception of the Barclays MSCI ESG indices in January Know Your Borrower We believe that ESG integration offers a more comprehensive assessment of our borrowers. In Figure 5, we use the case of a beverage company to illustrate how the management of material ESG issues can affect, for good or ill, a company s operating and financial performance. How We Integrate ESG To integrate ESG issues into our investment process, we created a framework that aggregates ESG metrics and information from ESG-research providers as well as other third-party sources. As part of their fundamental credit research, our corporate analysts review a company s ESG policies and targets, which in many cases are outlined in its corporate sustainability report. This to make them, and people to go to work there. Changing social expectations, such as those about firms responsibility for the environment and for their communities, can threaten the company s license. 30. See KPMG International, A New Vision of Value, Connecting Corporate and Societal Value Creation, More information about the Barclays MSCI ESG indices can be found here: Journal of Applied Corporate Finance Volume 27 Number 2 Spring

71 Figure 6 Credit with ESG is used to Analyze Companies for Investment FUNDAMENTAL CREDIT RESEARCH ESG ANALYSIS & ENGAGEMENT PROPRIETARY SCORES, RATINGS & VALUATION SECURITY SELECTION qualitative assessment, along with data and information from third parties, is weighted and scored; and the score is translated into a sustainability rating as shown in Figure 6. Then, using a process that is illustrated in Figure 7, this measure of a credit s ESG risk profile can then affect the analyst s internal rating on a company. The analyst can raise the internal rating to reflect a corporation s low ESG risks, or downgrade the rating if ESG risks are considered high or poorly managed. The final internal rating may drive valuation and trading decisions. Our Engagement Efforts Our knowledge of our corporate borrowers is also enhanced through engagement calls. Breckinridge believes that engagement enables us to leverage our voice as a stakeholder to bring greater focus on management s stewardship of ESG issues, in accordance with the Principles for Responsible Investment. 32 Bondholders play a key role in the capital structure; but unlike shareowners, we have no formal venue such as proxy voting where our voice can be heard systematically. To accomplish this, we use our engagement efforts to facilitate ongoing private dialogues with management. From these discussions, we gain a better understanding of the credit and ESG profiles of borrowers and the material issues, opportunities, and risks they face. At the same time, we encourage transparent reporting on material ESG issues and the management of those risks, especially when disclosure falls below best practices. In the summer of 2014, we had engagement calls with our 25 largest investment-grade corporate holdings in the following six sectors: chemicals, food and beverage, media and telecommunications, real estate investment trusts, retailers, and rail and transportation. We began the engagement process by conducting thorough ESG research on each company. We used third-party ESG sources such as MSCI and Sustainalytics, as well as publicly available documents such as corporate social responsibility reports and proxy statements. This in-depth research helped us create customized questionnaires for each corporation on material ESG risks Figure 7 Example: Credit Upgrade/Downgrade for ESG Risks Internal Rating BBB+ A A Company A: ESG Upgrade LOW ESG RISKS Company B ESG Downgrade HIGH ESG RISKS and opportunities. To introduce our prepared questions in our conversations with management, we explained how we look at ESG issues as part of our credit research. Following calls, notes were recorded and archived for future use by the credit-research team. Analysts used key insights from the calls to modify their qualitative ESG assessments and scores for specific companies. In some cases, these adjustments led to changes in both their sustainability and internal ratings. Trends in Corporate Sustainability The round of engagement calls during the summer of 2014 highlighted three trends in corporate sustainability, one positive and two that indicate there is room for improvement. Setting Environmental Targets All of the companies we spoke with said that they plan to reduce their environmental externalities in some way. In 32. Breckinridge became a signatory to the Principles for Responsible Investment in Signatories commit to six principles that call for ESG integration and engagement Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

72 other words, management teams have become increasingly convinced that their business activity can be harmful to the environment. And they are showing increased willingness to devote corporate resources to managing both regulatory and reputational risks by setting and working to achieve targets to limit their environmental impact. We found that the most common goal among the companies we contacted is to cut greenhouse gas (GHG) emissions. Third-party ESG research cites carbon emissions as a material concern for all of the industries we targeted for calls. 33 And consistent with this finding, 87% of the companies we contacted have set this as a target and 83% responded to the most recent CDP survey. 34 What s more, the average CDP disclosure score, which measures transparency of the response, for our sample of the companies we invest in was a remarkably high 92.3 out of 100 (as compared to the global CDP average of 56). 35 In sum, management teams at a number of companies we invest in have identified GHG emissions as a risk for their businesses, are reporting on it, and are working to mitigate it. Other areas related to environmental impact are water and waste reduction goals. The materiality of these two areas, unlike GHGs, is not consistent across all sectors. For example, water is a material ESG issue for food and beverage companies, but not for the rail transportation sector. For the companies where water is deemed a material concern, 75% have goals to reduce their water consumption. We observed a similar trend in the area of non-hazardous and hazardous waste. Waste reduction is a material concern for about half of the companies we surveyed; 71% of this group said they have goals to reduce waste. Sustainability Oversight by the Board In addition to company-specific questionnaires, we prepared a few questions that we asked in all of our conversations. One pertained to board-level oversight of sustainability initiatives. We asked if the company s board of directors had a standalone sustainability committee or if board members were engaged in some way with ESG issues. We found that none of the companies in our sample had a standalone sustainability committee at the board. Lynn Paine, Harvard Business School professor, mentions in a recent article that such a committee could be a useful addition to many if not most boards by serving as a source of knowledge and a driver of change. 36 The article also states that no more than 10% of U.S. public companies have dedicated sustainability committees. 37 Although sustainability committees are rare, we did learn that over half (56%) of the companies in our sample have board members with some responsibility for ESG governance. In a recent study, the Investor Responsibility Research Center Institute (IRRCI) reached a similar finding that 55.4% of the S&P 500 companies had board oversight of sustainability issues. 38 According to the IRRCI survey, oversight of environmental and social issues is usually given to the corporate governance and nominating committee. 39 In general, we observe that the most sustainabilityminded companies enact ESG initiatives from the top down. As stakeholders continue to demand accountability for ESG issues and as management s understanding of these risks builds, corporate boards are likely to take on more ESG governance responsibilities. ESG and Executive Compensation Despite the growing interest in sustainability, few of the companies we spoke with have tied ESG performance to executive compensation. A 2014 McKinsey survey highlights as a possible explanation the conflict between short-term earnings pressure and the long-term nature of sustainability initiatives. 40 But the McKinsey survey also suggests growing executive concern about the disconnect between ESG and executive compensation. Of the executives who responded, 34% say too few people at their companies are accountable for sustainability, a notable increase from 23% in In their Roadmap for Sustainability, Ceres found that 39, and thus only seven percent, of the 600 companies evaluated in their study formally link ESG goals to executive compensation. 42 In cases where compensation incentives are tied in some way to ESG issues among our sample of companies, the most common area was health and safety. This was typically seen in businesses with large labor forces and complex and industrialized operations, such as in the food and beverage, and rail transportation sectors. Nevertheless, Ceres says that investors are beginning to ask for compensation and ESG alignment, and that they expect this development to grow due to the compelling business case for sustainability. 43 We agree with investors about this, 33. Sustainalytics evaluated GHG Reduction Programs in determining overall ESG performance for all 25 companies in our sample. 34. CDP, formerly known as the Carbon Disclosure Project, surveys companies on their climate change risks. It assigns a Disclosure score, for the quality and breadth of its reporting, and a Performance score, for its actions that related to climate change mitigation and adaptation. 35. The Carbon Disclosure Project (CDP) Paine, Lynn S., Sustainability in the Boardroom, Harvard Business Review, July Paine, Lynn S., Sustainability in the Boardroom, Harvard Business Review, July See DeSimone, Peter, Board Oversight of Sustainability Issues, Sustainable Investments Institute and the Investor Responsibility Research Center Institute (IRRCI) See DeSimone, Peter, Board Oversight of Sustainability Issues, Sustainable Investments Institute and Investor Responsibility Research Center Institute (IRRCI), McKinsey and Company, Sustainability s strategic worth: McKinsey Global Survey, McKinsey and Company, Sustainability s strategic worth: McKinsey Global Survey, See The Ceres Roadmap for Sustainability: A strategic vision and practical framework for sustainable corporations in the 21st century economy, Ceres, Information on executive compensation tied to ESG performance can be found here: org/roadmap-assessment/company-performance/governance-for-sustainability/copy_of_executive-compensation-tied-to-esg-performance#performance. Ceres is a non-profit based in Boston that advocates for sustainable business practices and for a sustainable economy. 43. See The Ceres Roadmap for Sustainability. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

73 and believe that companies that add financial incentives for reaching ESG goals are more likely to be successful in fully integrating sustainability into their operations. In Support of Standardized ESG Disclosure As mentioned above, company disclosure of ESG data and metrics has improved over the last several years. However, disclosures are not standardized across sectors or even within sectors and are also not integrated into regulatory filings like the SEC s 10-K report. The emergence of the Sustainable Accounting Standards Board (SASB) in 2011 represents a major step forward. With an ultimate goal of incorporating material, sector-specific ESG factors into a corporation s regulatory filings for the benefit of investors, SASB s more immediate mission is to cultivate and circulate sustainability accounting standards that can be used to guide public corporations in voluntary disclosures of material ESG information. This is undertaken through an extensive process that includes fact-based research and participation by all varieties of corporate stakeholders, 44 including a number of corporate partners. For example, we at Breckinridge support SASB s efforts to integrate sustainability reporting with financial reporting by serving on its Advisory Council and participating in sector-specific SASB working groups. Conclusion ESG analysis has been a valuable addition to our creditresearch process. It has assisted us in identifying and pricing risk. ESG issues and the evolution of corporate ESG reporting also reflect the growing appreciation that many companies may benefit by investing more heavily in their non-investor stakeholders, including their suppliers and employees as well as their customers. In recent times, there has been a singular focus on the concerns of shareholders, or what is called shareholder value maximization. In many cases, this focus appears to have led to short-term thinking (reflected, for example, in excessive share buybacks) at the expense of long-term investment. 45 A fiduciary duty exists when a person or management has responsibility or discretion over assets of the shareowner. 46 But considering other stakeholders in the management or board decision-making process need not have negative effects on shareholders; and if done in a strategically effective way, it can end up adding significant value. Managing stakeholders interests presents risks and opportunities for companies and their boards. We believe that when such stakeholder relationships are well managed that is, when companies devote the right amount of capital and resources, neither too much nor too little, to building and maintaining them companies will be better positioned to reduce their cost of capital, protect their brands, and compete effectively into the future. And for this reason alone, companies that make significant investments in all their important stakeholders are likely to be more stable credits and better investments for our clients. Robert Fernandez is Director of ESG Research at Breckinridge Capital Advisors. Nicholas Elfner is Director of Corporate Research at Breckinridge Capital Advisors. Disclaimer: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk including loss of principal. An investor should consult with an investment professional before making any investment decisions. Factual material is believed to be accurate, taken directly from sources believed to be reliable, including but not limited to, Federal and various state & local government documents, official financial reports, academic articles, and other public materials. However, none of the information should be relied on without independent verification. 44. Sustainable Accounting Standards Board is an independent 501(c) 3 non-profit. Content is from SASB s website. 45. Montier, J., The World s Dumbest Idea, GMO White Paper, December See website Institute for The Fiduciary Standard website for interview with Tamar Frankel, Ph.D, Professor of Law, Boston University School of Law, Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

74 The Science and Art of High Quality Investing by Dan Hanson and Rohan Dhanuka, Jarislowsky Fraser Global Investment Management* Life is not an exact science, it is an art. Samuel Butler * The authors would like to thank Don Chew for invaluable editorial guidance, and thanks to our colleagues at Jarislowsky, Fraser Limited, and Columbia University for helpful comments. here is a long tradition of investing in quality T companies, one whose best-known modern practitioner is Warren Buffett, but which dates back to Benjamin Graham in the 1930s. But despite the length of its pedigree, and the respect commanded by its most successful practitioners, neither the academic literature nor investors have reached agreement on a clear definition of quality. Definitions are wide-ranging and, in some cases, even contradictory. In this paper we explore the concept of high quality investing. First, we review the science of approaching quality via financial statement and market performance measures. We review some widely known measures. We note that many of those widely known measures have been studied from an academic rather than practitioner perspective. Secondly, we further examine those widely used measures from the perspective of the long-term investor in today s market. We test for the persistence, and long-term performance implications, of these scientific measures. Thirdly, we review the art of approaching quality via qualitative measures including culture and ESG metrics. Finally, we propose that a combination of science and art is a promising approach for practitioners and researchers alike. The traditional Blue Chip quality investment practitioner tends to recognize quality in the form of high ROEs, low debt, and stable earnings. This framework is consistent with the view that quality is the opposite of junk, which is characterized by cyclical profitability, highly leveraged balance sheets, and erratic earnings streams. Another take on quality one that came into vogue after the TMT bubble of 2000 is the view that quality is the opposite of aggressive growth. In contrast to aggressive growth firms, quality companies generate large and fairly predictable free cash flow that is to say, far more cash than they reinvest in the business and are known to have disciplined capital allocation, management, and governance structures. In addition to these traditional indicators of quality, academics in finance and accounting have produced research during the past two decades that has provided the basis for accounting measures of quality that attempt to classify companies according to the quality of their earnings. But whereas traditional versions of high quality tend to emphasize stable earnings, the more recent accounting research and the investment strategies that have come out of it begin with the recognition that the illusion of earnings stability can be created through practices known as earnings management. The underlying premise of these studies and investment approaches is that high quality managements care more about producing operating cash flow and economic earnings than reported accounting earnings; and to the extent this is so, more volatile or lumpy reported earnings can actually be a reliable indicator of corporate integrity and a management culture committed to transparency. Financial statement measures of quality are by their nature backward-looking. The S&P Quality scores have been published since 1956, and award high scores to companies with low earnings volatility and consistent, non-cyclical earnings and dividend growth. Studies have shown favorable returns to high (but not the very highest) quality buckets. 1 Take a business like Philip Morris, which satisfies the S&P high quality criteria and which Jim Collins identified as great in his business bestseller Good to Great. On financial statement criteria, Philip Morris with strong brands supporting predictable, non-cyclical earnings and stable dividend payouts is a poster-child for many models of high quality. However, for many investors, the negative health implications of cigarettes, the company s violation of the public trust (which culminated in the $206 billion industry settlement in the U.S. in 1998), and the negative volume trends of the underlying business, stand in stark contradiction to a notion of high quality. Some investors look explicitly to ESG criteria to identify high quality businesses. By incorporating environmental, social, and governance practices into business analysis, investors are incorporating a forward looking perspective that includes a view on future customer relevance. As an example, David Swensen, Yale s chief investment officer, recently wrote to Yale s external managers that consideration of the risks associated with climate change should produce higher-quality 1. Frederick L. Muller and Bruce D. Fielitz, Standard & Poor s Quality Rankings Revisited, The Journal of Portfolio Management, Spring 1987, Vol. 13, No. 3. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

75 portfolios. 2 This concept of higher-quality is fundamentally driven, and quite distinct from the economic cyclical and financial statement approach discussed above. Yet another approach to quality investing is to define investments according to stock price technicals rather than fundamentals. In this version, low-quality stocks are characterized by high volatility, and high betas and high quality stocks are distinguished by low volatility and betas. 3 In terms of portfolio construction, since the 2008 financial crisis, minimum-variance or low beta portfolios have been marketed as high quality portfolios. In our view, however, such an approach (if viewed as a form of quality ) risks being based on a flawed logic: while it s true that low-beta portfolios are likely to have many of the same characteristics as those valued by traditional fundamental analysis, there is no compelling reason to expect the companies identified by such a process to outperform the market over a long period of time. 4 This approach is based on a kind of data mining that has no persuasive theoretical or practical justification even though billions of investor dollars are pursuing these so-called quality strategies. 5 In sum, there are many contradictory yet plausible ways to think about quality as an attribute of a company or a security. As practitioners of high quality fundamental investing, we will assert that quality has very little to do with short- or mediumterm financial or technical descriptors like beta or reported earnings volatility. We believe that the most reliable approach to identifying a high quality fundamental investment is to look for a durable business franchise with a sound business model and a conservative capital structure. A quality company is one with sustainable competitive advantages sources of value that can be maintained or become even more pronounced in the future, increasing the relevance of its products and services to its customers and markets. For long-term equity investors like us, assessing quality is in large part a matter of understanding reinvestment risk ; that is, we want to know whether the management team is committed to paying out excess capital after prudently investing to maintain and grow the firm s core franchises, and identifying and pursuing the firm s positive- NPV (or strategically prudent) investment opportunities. Our goal is to find quality companies with durable franchises and supportive governance, management, and cultural characteristics companies where there is a high probability of maintaining long-term sustainable competitive advantages. 2. As cited in David Swensen on the Fossil Fuel Divestment Debate, Editors Corner, Financial Analysts Journal, Volume 71 No. 3. See also and%20hyperlinks/ccir%20statement%20(2014).pdf. 3. An engaging summary discussion of both the academic and practitioner history of low volatility investing by Eric Falkenstein: history-of-low-volatility-investing.html. 4. Steve Johnson, Minimum variance bandwagon worries Union Investment, Financial Times, April 5, 2015, More than a third of Union s equity assets, about 20bn, are managed in minimum variance and minimum volatility strategies But Schindler fears that booming demand for minimum variance approaches means the uncorrelated stocks central to the strategy are now becoming more and more correlated, destroying its rationale. 5. Kalsenik Kose (2014) makes a provocative point around academic research on the To be sure, the earnings quality analysis developed by academics what we will refer to as the science of financial metrics can help in identifying today s high quality businesses. But for long-term investors, the most valuable skill is likely to be the art of exercising forward-looking judgment about the durability of the franchise, the stewardship of management, and the effectiveness of the governance structure that will outlive the current management team. It is these characteristics that are likely to provide the most reliable guides to high quality investments those that have the potential to be what have become known colloquially as compounders. What s more, in addition to the research on financial metrics, there is also a relatively new body of research on non-financial indicators of quality that we believe provides support for our business value approach to identifying quality companies. Such research looks for an association between soft variables like indicators of culture and sustainability as opposed to financial performance as measured by returns on capital or stock returns. The findings of this research, which is now in a preliminary phase, has shown some promise in informing the search by business value investors for quality. Because these variables generally don t lend themselves to quantification, their use by investors relies heavily on subjective judgment. And in this sense, their application to value investing can be described as more art than science. In the pages that follow, we will review the science and art of high quality investing from a fundamental practitioner perspective. We believe there is promise in this new work that attempts to make connections between the science of financial statement metrics and the qualitative and quantitative nonfinancial aspects of KPI s which frame cultural and forward-looking issues that are collectively important to the art of business value investing. One last point about quality investing: Because high quality stocks tend to be large, mature companies with in some cases robust yet bounded growth potential (people call them blue chip, but they often mean boring ), they don t attract egregious overvaluation. 6 For this reason, longterm investors often find these assets to be underpriced in light of their low default risk and therefore limited risk of permanent impairment of capital. But that said, high quality investing is not a mechanical process of buying low beta or minimum variance portfolios; on the contrary high quality topic of quality investing, and the obvious incentives pushing academics to ferret out investment strategies with anomalous returns lead to what John Cochrane (2011) memorably characterized as a zoo of factors. They mention that out of 40 quality factors examined by them, only 25 yielded positive results, of which 6 were statistically different from zero. Comparing this to published factors, they found them indistinguishable from random occurrences, though there is a bias to publish those with positive returns. Regarding factor publications, they mention that With statistical instability like this, one catches a whiff of data-snooping. Published as a Research Associates piece: Quality_Investing_pdf.pdf. 6. Chuck Joyce and Kimball Mayer, Profits for the Long Run: Affirming the Case for Quality, GMO White Paper, June 2012, gmo.com. 74 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

76 investing means thinking about the long-term drivers of business success, the fundamentals, not the short-term market technicals. To the extent that factors like low trading volumes, stock price volatility, and hedge fund ownership provide clues to stocks that are underappreciated, we would encourage fundamental investors to pay attention to them. But we would also caution such investors against assuming a causal relationship between such indicators and stock returns, or that such variables alone provide insights with predictive power. And finally, because our goal is to invest and generate returns, valuation matters. While we may not yet be in agreement with how to define or measure quality, we very much agree with the practical concept of QARP (Quality at a Reasonable Price) as a framework for incorporating quality into investment portfolios. 7 Examining the Performance of Financial Signals in Today s Data-oriented Markets As we noted earlier, an extensive literature on the area of quality investing, as detected through an examination of corporate financial statements, has been produced by academic finance and accounting in the past two decades. At the same time, a more recent, but rapidly growing body of work is now being produced on the area of non-financial corporate reporting, which includes efforts to evaluate corporate culture, reputation, and corporate performance on a host of issues that are collectively known as ESG (environmental, social, and governance). As practitioners of high quality fundamental investing, we believe that the use of a combination of quantitative and qualitative information is critical to identifying companies likely to sustain high quality attributes. Relying on financial data alone, which is by its nature backward-looking, is the equivalent of driving while looking through the rear-view mirror. And thus the most effective fundamental investment process is bound to be a combination of art and science forward-looking and backward-looking, qualitative and quantitative analysis. Our objective as high quality investors is to identify attractively valued equity securities of companies that we believe have and most importantly will continue to have high quality characteristics. For that reason, the persistence of key characteristics and indicators is of real relevance to the investment outcome in a way that is not true of many factor based or mean-reversion approaches to investing. (For example, in the case of low P/E or low P/B approaches, because investment success is driven by mean reversion, both the investing windows of opportunity and the optimal holding periods are relatively short.) In a study we conducted for this article, we began by evaluating the more recent performance of a number of widely used financial measures of earnings quality. But our results were mixed: although earlier academic studies have generally supported the predictive power of these indicators, our findings suggest that almost all of them have lost their power to generate abnormal stock returns during the last decade or so. The extraordinary growth in investors use of data analytics capabilities, along with the huge amounts of capital chasing these strategies, appears to have sharply limited the effectiveness of these approaches. In the second part of our study, we analyzed the persistence of these financial indicators and the effect of such persistence on stock returns. We believe persistence is highly relevant for long-term investors with multi-year holding periods. At the same time, the academic literature may well exaggerate the profitability of short-term investment strategies by ignoring implementation frictions, such as the constant rebalancing needed for short portfolios and the trading costs associated with high turnover. There has been much discussion of short termism influencing and corrupting market behavior, by investors and management teams alike. 8 For long-term investors (which we define as 2+ year holding periods), much of the traditional finance literature misses the mark insofar as factor models typically incorporate monthly, quarterly, or annual rebalancing. Mean reverting factor based approaches typically lose effectiveness at 1+ year holding periods, and so we examine the return implications to various quality models at time horizons of one, two, three, four, and five years. As practitioners of long-term, high quality investing, our objective is to identify a priori companies that are high quality, and that we believe are likely to sustain high quality status while generating strong returns over a 3+ year time horizon. Moreover, with regard to the science of quality investing, both the literature and the investment analysis appear to have been too ready to simply follow the data. In the last decade or so, an explosion of both computing power and readily downloadable accounting financial data has contributed to an increase in data mining practices that have been summed up by a cartoon of a boy digging through a pile of horse dung saying, there s got to be a pony in there somewhere. This is not to say that data mining which means identifying patterns and relationships over long periods of time can t 7. Asness et al. (2014) explores the valuation of quality (and invokes the QARP concept) in detail and finds that high quality stocks do have higher prices on average, but not by a very large margin. As such, they find that high quality stocks have high riskadjusted returns. While this work is compelling, we do note that their definition of quality includes technical, non-fundamental factors like beta and volatility. As such it is not surprising to note that this measure of quality is strongly counter-cyclical (low quality sharply outperforms after market lows, in a risk-on environment). We believe that the QARP concept can be most robustly implemented by incorporating forward-looking fundamental and qualitative considerations. Asness, Clifford S. and Frazzini, Andrea and Pedersen, Lasse Heje, Quality Minus Junk (June 19, 2014). Available at SSRN: ssrn.com/abstract= Harford, Jarrad and Kecskes, Ambrus and Mansi, Sattar, Do Long-Term Investors Improve Corporate Decision Making? (April 18, 2015). Finance Down Under 2015 Building on the Best from the Cellars of Finance Paper; Asian Finance Association 2015 Conference Paper. Available at SSRN: or doi.org/ /ssrn Journal of Applied Corporate Finance Volume 27 Number 2 Spring

77 produce results, at least for a while. Take, for example, the minimum variance and low beta strategies. These black box approaches were discovered by back-fitting the data in a way that produced an observed alpha. We would argue that such min-var and low beta strategies amount to fighting the last war, as they dramatically outperformed many widely followed factor approaches such as book value or momentum strategies during the credit crisis (and also August 2007 quant crisis ). In any event, the common thread of these approaches is a realization that quality (whether measured with financial or non-financial indicators or judgments) can provide important incremental information to equity investors. Where assessments of quality become especially important is in the evaluation of corporate reinvestment, or capital redeployment, risk the risk that management will waste corporate free cash flow on overpriced acquisitions or value-destroying attempts to preserve market share. Whether financial or nonfinancial, our objective is to explore how this information about quality can be useful to long-term fundamental investors. So, for example, whereas gross profits or ROIC may be effective proxies for profitability, indicators of board independence or effective governance disclosure practices may turn out to be effective proxies for ESG characteristics. Revisiting the Financial Quality Indicators: Methods and Findings In deciding which financial signals to examine, we decided to recreate and extend the findings of a working paper by University of Rochester professor Robert Novy-Marx 9 by focusing on a subset of his financial metrics. We examined the following financial quality metrics: Gross profitability: Revenue minus COGS scaled by total book assets. This is a useful measure of profitability due to its simplicity. ROIC: EBIT-to-tangible capital, where tangible capital is property, plant and equipment plus working capital. The very definition of financial quality is high and sustained profits relative to capital employed, so this measure has economic appeal. Sloan s Accrual: Measured as the year-over-year change in current assets excluding cash and short term liabilities, minus the change in long term liabilities excluding debt in current liabilities and income taxes payable, minus the depreciation and amortization. As specified in an article published in 1996, accruals are scaled by the average of total assets and total assets lagged one year. 10 Historically, as Sloan s work has demonstrated, companies with lower accruals tend to have higher quality earnings, as reflected in their lower risk of later negative earnings events (such as earnings restatements) and higher stock price returns. Piotroski s F score: Constructed as the sum of nine binary variables that take the value zero (indicating weakness) or one (indicating strength), the F-score assigns one point for each of four profitability signals (positive earnings before extraordinary items, positive cash flows from operations, increasing returns on-assets (IB/AT that exceeds that of the previous year), and negative accruals); one point for each of three liquidity signals (decreasing debt, increasing current ratio, and no equity issuance); and one point for each of two efficiency signals (increasing gross margins (revenues minus cost of goods sold scaled by revenues) and increasing asset turnover (revenues scaled by assets)). Grantham s quality score: Average ranks of returns-onequity, asset-to-book equity, and the inverse of ROE volatility. ROE is net income-to-book equity. ROE volatility is the standard deviation of ROE over the preceding five years. In addition to the above quality metrics, for context we included an analysis of two traditional value factors, P/E and P/B: Earnings to Price: Net income divided by market equity. Book to price: Book equity scaled to market equity We recreated the returns on an annual basis using both CAPM and Fama/French three factor models. The data methodology we used was as follows: We identified the largest 1,036 U.S. Equity stocks (by market cap as of 2015) and analyzed their results 11 during the 14-year period from 2000 through the end of Replicating a retail investor approach, we used annual data and rebalanced portfolios on an annual basis. We formed a long only portfolio based on the top 30 percentile of companies in terms of the quality metric ranking of all the companies We analyzed the portfolio results based on two approaches: standard CAPM Alpha 12 vs. market as defined by our complete dataset as well as the three factor alpha. For the three factor approach, we used Fama/French s annual factors for U.S. equities and regressed 13 the portfolio returns vs. the published factors to generate the model alpha. The main differences in our treatment of data from the research summarized by the Novy-Marx paper were in our 9. Robert Novy-Marx, Quality Investing (working paper), December 2012, significantly revised May 2014, Richard Sloan, Do Stock Prices Reflect Information in Accruals and Cash Flows About Future Earnings?, The Accounting Review, 71, The results were based on total stock return (including dividends) over the calendar year immediately after the year that financial results are evaluated. For e.g., if we look at a company s financial results in 2001 and select it for our portfolio, we would buy it around January 1, 2002 and sell it around January 1, 2003 with slight adjustments based on market closures. Its total stock return over this period is reflected in the results of our portfolio. 12. E(R i ) = R f + β i (E(R m ) R f ) For the market return we are using the market as defined by our complete data set rather than the Fama French market factor. 13. r it r ft = a 1 + β im (r mt - r ft ) + β is SMB t + β ih HML t + ε it The factors were downloaded from their website data_library.html. 76 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

78 Table 1 Alphas Generated by Financial Quality and Value Factor Portfolios14 Three factor model results Sort Variable E[re] Alpha CAPM Alpha Beta market Beta SML Beta HML Financial quality factors Gross profitability 4.9% 0.8% 1.7% (0.08) p values ROIC 4.9% 0.8% 1.9% 0.83 (0.15) 0.03 p values Sloan's accrual 6.4% 1.3% 1.7% p values Piotroski's score 5.6% 1.6% 2.2% 0.80 (0.09) 0.08 p values Value Factors Grantham's score 6.8% -0.2% 0.5% 0.77 (0.29) 0.23 p values Earnings to price 7.4% 3.6% 3.4% 0.74 (0.30) 0.39 p values Book to price 6.3% 1.9% 0.7% 0.84 (0.16) 0.45 p values time period (we use 2000 onwards compared to his 1967 onward analysis), as well as our annual (vs. their quarterly) rebalancing, and our use of long-only portfolios (his focus is on a long-short strategy). We also did not correct for any potential industry biases (he corrected for financial industry biases). While our data set is more limited, we believe it is more reflective of the market opportunity today. Statistical findings Within a CAPM framework, we find that none of these strategies generate positive alphas (at a statistically significant level of 0.05 p value), with the exception of the value factor Earnings to Price. It is noteworthy that P/E but not P/B was effective in the sample period , potentially due to the adverse returns to P/B strategies during the financial crisis. Using a Fama/French three-factor model framework, our tests show that again the P/E value factor is effective, but among the financial quality factors only ROIC generates statistically significant alphas. The most plausible explanation of these findings is that the explanatory value of financial quality metrics as a returns strategy has been arbitraged away 14. We look for significance of alpha generated through the p values. Statistical significance is usually assumed at 0.05 p values. In our results, we find that the only truly statistically significant alpha is generated by the Price to Earnings factor. However, we also find ROIC to be somewhat significant with a borderline line p value of All of the other metrics are not found to be significant. in the current data heavy environment of financial markets. These results are significantly different from those of the Novy-Marx study, in which the measure of gross profitability had a significant alpha and most strategies generated significant alphas when using a three-factor framework. Our hypothesis on statistical findings The recent advent of easy to download data from Factset, Capital IQ, Bloomberg, and other sources has made financial metric analysis a trivial exercise for most practitioners. Also, there has been a lot of popular literature published on the metrics discussed above, which has led to widespread awareness, and, prior to the quant crisis of August 2007, to an extended period of (arguably illusory) high returns by quant factor strategies enabling them to attract significant capital. Our best guess is that all the attention paid to these various factors has largely arbitraged away the alphas associated with these strategies. Although the P/E factor still appears significant in our analysis, P/B fails to outperform during in the sample period, potentially because of the low (and perverse) returns to P/B strategies during the financial crisis There is no sense in which our findings contradict or disprove those reported by Novy-Marx since both our time period and methodology are different. Although we generally agree that more is better from a standpoint of sample size, we also believe that our approach does reflect long-term investors current opportunity set for returns in today s data intensive era. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

79 Understanding the Role of Persistence in Delivering High Quality Returns In finance there are differences between theory and practice that can have major consequences. For investors, actual realized returns returns that you can eat are what matters. The taxes, transaction costs, and impact costs associated with carrying out trading strategies (which arguably should include the ability to stick with the strategy through all kinds of markets) should all be taken account of when assessing the allegedly high returns promised by such trading rules. Also potentially important is acknowledgment of the behavioral impediments and agency problems in the investment industry that are reflected in, if not actually caused by institutional shorttermism. The problem can be summed up simply by pointing to the institutional reality that pension and endowment funds with multi-decade liability horizons use asset managers with average holding periods of less than 18 months. 16 This observation supports our belief that time arbitrage the ability to take a long-term view can be a sustainable competitive advantage for investors in public equity securities. For investors with a long time horizon, there is enormous upside optionality to being aligned with high quality management with a demonstrated ability and commitment to the effective redeployment of capital. As already suggested, for the long-term equity holders of most large, well-established companies, the returns from future capital redeployment actions are likely to be the single most important determinant of their total investment returns. This dynamic of reinvestment by compounders is reflected in Warren Buffett s much-repeated statement, Far better to buy a wonderful company at a fair price than a fair company at a wonderful price. As already noted, Buffett s approach is the polar opposite of the quantitatively driven investment and factor approaches that are based on the implicit (if not explicit) principle that all values (including the quality aspects of corporate performance) revert to a mean. And such mean reversion, which appears to assume the impermanence of all aspects of corporate performance, calls for an annual, or even quarterly, rebalancing approach to investing. By taking such an approach, investors effectively forgo the meaningful potential upside from identifying and then holding exceptionally well-run companies. 17 Reflecting our perspective as long-term investors, we have given a new twist to the Novy-Marx quality analysis by examining the persistence of the financial indicators of quality that he examined, and then attempting to determine whether such persistence has any incremental effect on stock returns. We set out to answer the question: Are there any additional incremental returns associated with investing in companies whose earnings are rated as high quality for not just one year, but for two, three, four, and five consecutive years? In other words, does the data support our contention as fundamental investors that there are rewards to investors for identifying companies that are not only high quality today, but are likely to remain high quality? And are such persistent financial indicators of quality likely to be associated with consistently higher returns? To examine the impact of persistence, we looked at each of our examined financial metrics and created portfolios of companies showing persistence in that measure of one, two, three, four, and five years. For the one-year cohort, we select all companies that were above the 30% threshold for that particular year. For the other cohorts, we select companies that fall exactly into that cohort. For example, our threeyear persistence sample for a given financial metric consists of a portfolio of companies 18 that have been rated in the top 30 percentile of that metric for each of the last three years 19 (and not the last two or the last four or the last five). We now discuss the persistence of each of the metrics and its association with stock returns Gross profitability. As can be seen in Table 2, we find that persistence in maintaining higher than average levels of gross profitability does not add value in any of the cohorts. (The closest to statistical significant alpha generation is the three-year persistence cohort.) What explanation do we offer for this finding? Since the initial signal itself also failed to produce alpha during our more recent ( ) sample period, we don t find it surprising that the persistence of this signal does not add alphas across cohorts. Although gross profit may be an effective proxy for profits more generally, in a reasonably efficient market such profits and their persistence are likely to be reflected into current valuations. ROIC. We find that ROIC is close to statistical significance in its performance. However, the significance and the 16. Average pension manager portfolio turnover is 67.2% (implying holding periods of <18 months). Chakrabarty, B., Moulton, P. C., & Trzcinka, C. (2013, March). Institutional holding periods [Electronic version]. Paper presented at the annual Finance Down Under conference, Melbourne, Australia. Retrieved June 2015, from Cornell University, SHA School site: A few other thoughts on time horizons: stated very simply, for a 20x PE stock, 19/20 (95%) of the value in the stock reflects earnings beyond the current year. Clearly future earnings, future earnings growth as a consequence of capital redeployment decisions, and future payouts will dominate near term results as value drivers. In defining long-term, longer is better insofar as the benefits of deferring tax events, and the negatives of frictional impact costs, compound to greater effect with greater time horizons. Using the language of options, one might attribute the positive alpha in high quality equities to underpricing of the long-term time horizon or theta (time value) for compounded upside, since the marginal investor does not have a long-term time horizon. 18. In creating these samples, we also use the market as a control signal note that we do not have a beta of 1.0 with the market in the 3 factor model, due to differences in portfolio construction vs. Fama/French (for example, our universe of the 1,036 largest stocks has a large cap bias relative to using a broader universe). 19. We use rolling periods of 5 years starting from 1996 to Since we have to have minimum 5 years of data to form 1 to 5 year cohorts, we create cohorts from 2000 to This gives us 14 data points for each cohort. For e.g., for the 4 year cohort, we have 14 such cohorts starting from The 2000 cohorts would include data from 1997 to Also, the 2 to 5 year cohorts are based on exact persistence of signal i.e. a 4 year cohort means that company signal has persisted for exactly 4 years, not less or more. Only in the case of the 1 year cohort do we take all companies that exhibited the metric i.e., it encompasses the 1,2,3,4 and 5 year cohorts. 78 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

80 Table 2 Persistence of Gross Profitability Cohorts20 Gross profitability Avg. no in cohort E[r] Alpha Rm-rf SMB HML Alpha(CAPM) Complete market 1036 Factor 4.5% 0% 0.88 (0.11) 0.13 NA P-Value NA 1 year at least persistence 310 Factor 4.9% 1.7% (0.08) 0.8% P-Value year exact persistence 23 Factor 4.8% 1.8% (0.09) 0.8% P-Value year exact persistence 18 Factor 4.9% 1.9% (0.08) 1.0% P-Value year exact persistence 15 Factor 4.6% 1.7% (0.08) 0.8% P-Value year exact persistence 221 Factor 4.3% 1.3% (0.08) 0.5% P-Value Table 3 Persistence of ROIC Cohorts21 ROIC Avg. no in cohort E[r] Alpha Rm-rf SMB HML Alpha(CAPM) Complete market 1036 Factor 4.5% 0% 0.88 (0.11) 0.13 NA P-Value NA 1 year at least persistence 310 Factor 4.9% 1.9% 0.83 (0.15) % P-Value year exact persistence 35 Factor 4.4% 1.7% 0.83 (0.16) % P-Value year exact persistence 26 Factor 4.9% 2.2% 0.80 (0.21) % P-Value year exact persistence 21 Factor 4.3% 1.7% 0.79 (0.21) % P-Value year exact persistence 175 Factor 4.0% 1.4% 0.77 (0.19) % P-Value absolute alpha value seems to diminish almost monotonically (with the exception of the two year cohort) as we increase the persistence of the signal. 20. For gross profitability, we find that none of the cohorts come close to statistical significance (p value of 0.05). The closest significant alpha is in the 3 year cohort with a p value of 0.18, indicating 82% certainty of significance. 21. For this metric, we find that the first 3 years are very close to statistically significant, especially the first and third year cohorts. The first year has a p value of 0.08 and Given that ROIC is a simple proxy for operating performance, it would indicate that high performing companies initially return higher value. However, given the steady drop the third year has a p value of 0.10, both of which fall within 90% certainty of significance. Even the 2 year cohort with a 0.16 p value is not far off from significance. The results are made more relevant by the fact that the alpha s generated in all three years are quite large, i.e. in the 1.7% to 2.2% range. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

81 Table 4 Persistence of Sloan s accrual cohorts22 Sloan s accrual Avg. no in cohort E[r] Alpha Rm-rf SMB HML Alpha(CAPM) Complete market 1036 Factor 4.5% 0% 0.88 (0.11) 0.13 NA P-Value NA 1 year at least persistence 307 Factor 6.4% 1.7% % P-Value year exact persistence 62 Factor 9.3% 3.8% (0.20) 3.3% P-Value year exact persistence 20 Factor 11.8% 2.7% (0.29) 5.2% P-Value year exact persistence 6 Factor 19.5% 10.5% (0.37) 12.1% P-Value year exact persistence 4 Factor 35.3% 7.8% (1.31) 21.2% P-Value Table 5 Persistence of Piotroski s score cohorts23 Piotriski s score Avg. no in cohort E[r] Alpha Rm-rf SMB HML Alpha(CAPM) Complete market 1036 Factor 4.5% 0% 0.88 (0.11) 0.13 NA P-Value NA 1 year at least persistence 201 Factor 5.6% 2.2% 0.80 (0.09) % P-Value year exact persistence 36 Factor 1.7% -0.9% 0.87 (0.15) (0.05) -2.7% P-Value year exact persistence 10 Factor 4.4% 0.9% 0.95 (0.19) % P-Value year exact persistence 3 Factor 4.6% 1.4% 1.00 (0.46) % P-Value year exact persistence 1 Factor 1.3% -1.0% 0.47 (0.25) % P-Value that we tested. Sloan s Accruals. Our findings provide strong evidence that Sloan s accrual signal appears to have been completely arbitraged away, with almost no persistence. Prior to publiin persistence portfolios, we would assume that high quality operating companies start to get priced in for quality, and so the expected returns drop. Nonetheless, ROIC stands out as showing the strongest persistence among the quality metrics 22. For this metric we find that none of the cohorts seem to be significant. The closest cohort to significance is the first year with a 0.19 p value but it deteriorates after that across all cohorts. 23. For this metric we find that none of the cohorts seem to be significant. The closest cohort to significance is the first year with a 0.16 p value, but it deteriorates after that across all cohorts. 80 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

82 Table 6 Persistence of Grantham s score cohorts24 Granthams s Avg. n in cohort E[r] Alpha Rm-rf SMB HML Alpha(CAPM) Complete market 1035 Factor 8.1% 0% 0.90 (0.12) 0.11 NA P-Value NA 1 year at least persistence 310 Factor 6.8% 0.5% 0.77 (0.29) % P-Value year exact persistence 54 Factor 6.1% -0.2% 0.80 (0.40) % P-Value year exact persistence 38 Factor 6.3% -0.2% 0.79 (0.34) % P-Value year exact persistence 31 Factor 5.8% -0.8% 0.80 (0.29) % P-Value year exact persistence 122 Factor 5.4% -1.0% 0.79 (0.34) % P-Value cation in 1996 and widespread adoption in the 2000 s, the Sloan s accrual signal generated significant alpha. However, our analysis of the period shows no statistical significance. Furthermore, given the self-correcting nature of the accruals signal, we are not surprised to see increasingly noisy results with longer periods of persistence. The nature of the accrual signal is such that it identifies companies with aggressive (or conservative) earnings. For example, if management is boosting sales by extending lenient credit terms to unworthy customers, and then receivables balloon, the accruals signal will identify low quality earnings. Later the company is likely to hit a wall, finds it cannot sustain sales growth, and takes the inevitable write-down. But as already noted, the success and widespread adoption of this strategy by market participants appears to have caused it to lose its predictive power, and the historical effectiveness of the accruals signal has been arbitraged away. Piotroski s F-Score. This measure seems to generate no significant alpha over our time period. And the more persistent the signal, the lower the stock returns. While the immediate 1-year portfolio does hold some information (albeit at a 84% confidence level), at high persistence there is not statistical significance. One explanation, as we suggested earlier with the case of gross profitability, is that the high quality signaled by a high Piotroski score effectively gets priced into the stock early. Another explanation, however, is that given the large number of variables that form this metric, it could be a case of too many variables driving uncorrelated final signals. The nature of a highly-fitted multifactor approach, which includes mean reverting measures (which require periodic rebalancing to exploit), is such that a sustained alpha is unlikely and so this signal is not likely to be useful for multi-year holding periods. Grantham s score. Our findings show that this signal does not generate any significant alpha at any time, and thus it does not seem to have any informative value. Our finding is consistent with Novy-Marx s findings in his paper. Moreover, in some sense the earnings (ROE) volatility measure is arguably upside down, in the sense that low earnings variability may indicate smoothing of reported results via earnings management. Earnings to Price. This stalwart value factor was the highest alpha generated in our data set and it was found to be statistically significant. This finding suggests that trading on the basis of low PE multiples would have generated significant profits over the last 13 years (and as it would during almost any period). Nevertheless, we also find, as can be seen in Table 7, that the significance of the metric falls as the persistence of 24. For this metric we find that none of the cohorts seem to be significant. Note that the complete market is slightly different in this metric measurement as we have data only from 2004 instead of 2000 for the others. This was due to the fact that it requires a 10 year s signal as one of its components. We note there will be significant industry bias in this metric. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

83 Table 7 Persistence of Earnings to price cohorts25 Earnings to price Complete market year at least persistence year exact persistence 62 3 year exact persistence 38 4 year exact persistence 26 5 year exact persistence 74 Table 8 Avg. n in cohort Persistence of Book to price cohorts26 E[r] Alpha Rm-rf SMB HML Alpha(CAPM) Factor 4.5% 0% 0.88 (0.11) 0.13 NA P-Value NA Factor 7.4% 3.4% 0.74 (0.30) % P-Value Factor 8.3% 4.1% 0.69 (0.25) % P-Value Factor 9.0% 5.5% 0.69 (0.36) % P-Value Factor 8.1% 4.9% 0.67 (0.38) % P-Value Factor 6.6% 2.3% 0.62 (0.29) % P-Value Book to price Avg. n in cohort E[r] Alpha Rm-rf SMB HML Alpha(CAPM) Complete market 1036 Factor 4.5% 0% 0.88 (0.11) 0.13 NA P-Value NA 1 year at least persistence 310 Factor 6.3% 0.7% 0.84 (0.16) % P-Value year exact persistence 37 Factor 8.6% 2.9% 0.78 (0.32) % P-Value year exact persistence 28 Factor 9.3% 3.8% 0.78 (0.43) % P-Value year exact persistence 23 Factor 9.8% 4.6% 0.77 (0.47) % P-Value year exact persistence 162 Factor 9.0% 4.5% 0.78 (0.50) % P-Value the metric increases beyond 3 years, which makes sense given that the mean reversion dynamic drives a large proportion of the alpha. Our findings would indicate that a low PE strategy can 25. For this metric, most of the cohorts seem to be highly statistically significant with p values below 0.05 for the 1-3 year cohorts and 0.07 for the four year. Only the 5 year cohort is not significant with a p value far exceeding acceptable limits. be effective in a multiyear portfolio, however alpha is most reliably generated in the early years of portfolio formation. Also, the decreasing alpha generated of the signal in the case of persistently low PE stocks in the five year cohort suggests 26. For this metric, most of the significant cohorts lie at the longer durations. The 3,4 and 5 year cohorts are close to significance with p values from However, the earlier two cohorts do not appear to exhibit significance. 82 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

84 that persistently low PE multiples are probably priced in by the market for, and could be considered a potential red flag (the classic value trap ), by investors. Book to Price. Surprisingly, the Book to Price variable shows no statistical significance in predicting stock returns for the current year or for year two, but the measure becomes significant for the three-, four-, and five-year portfolios. In fact, the year four and five portfolios generate significant alphas in the range of 4.5%. This is an intriguing result, as it suggests that a basket of confirmed value traps has outperformed recently de-rated companies. It would indicate that over a five-year period, most low P/B companies will revert towards market mean leading to significant alpha generation for investors. A caveat is that these results likely relate to the particular experience of overleveraged firms in the 2008 financial crisis. The one- and two-year persistence cohorts included numerous crash and burn companies which, after absorbing significant losses, were re-rated by the market to low P/B status in 2008, and subsequently in 2008 & 2009 suffered permanent losses as a result of bankruptcy, mergers, and dilutive capital raises. By contrast, the 3/4/5 year persistence cohorts, ex post, were (in general) the companies which survived the financial crisis. While these persistently cheap companies may include some value traps, in general companies that were cheap in the cyclical peak of 2006 did not go bankrupt in Using Signals of Quality and Culture to Complement Financial Metrics In the first two sections, we focused on financial metrics as predictors of market-based success. We reported finding that very few financial quality metrics appear to generate significant alpha. The main exception was ROIC, the use of which has created alpha consistently over a long period of time. Furthermore, the persistence analysis shows that for investors capable of identifying a priori high ROIC companies that will maintain their high ROIC attributes for multiple years, the alpha will continue as the gift that keeps giving. This is nirvana for the long-term investor who seeks to identify and build a portfolio of multi-year holdings, which thereby have the potential to compound alpha. In recent years a wide literature of academics and practitioners has been developed which supports the proposition that high ESG characteristics are associated with lower costs of capital and higher quality profitability including high ROIC. Several meta studies illustrate the do well by doing good premise that corporate responsibility as proxied for by ESG is consistent with stronger firm performance. 27 As we observe across these multiple studies, there seems to be clear evidence that companies with high non-financial indicators of quality seem to perform significantly better on market and accounting-based metrics. What we examine specifically is whether non-financial indicators of quality such as corporate culture, ESG or sustainability practices can be used to predict either superior operating or market performance. That is to say, can ESG and other factors be used together with financial quality metrics to help analysts identify a priori those high ROIC companies that are likely to maintain their high ROIC attributes? We processed our data set of operating financial quality metrics versus a broad set of non-financial metrics to determine if we can identify these high quality cohorts using non-financial metrics. We focused on operating rather than market performance because we believe that, at least over the relatively short period examined by our study, quality is defined more reliably by operating performance than by stock market performance. Within accounting metrics, we selected ROIC as the key variable given our earlier findings of its materiality to market performance and high quality stock selection. The non-financial metrics are regressed versus the observed ROICs. The key non-financial metrics we examined are as follows: Environment and efficiency Sustainalytics environment score Bloomberg Environment disclosure score Social and stakeholder management Sustainalytics social score Fortune best places to work CR magazine s top 100 corporate citizens list Bloomberg social disclosure score Governance Sustainalytics governance score Bloomberg disclosure score % of women on board Board attendance meeting % % of independent directors Miscellaneous and Third party indices (constituents or not) 27. The existing literature is increasingly prolific and includes work by practitioners. Fulton & Kahn s (Sustainable Investing: Establishing Long-Term Value and Performance, Deutsche Bank, 2012) is a meta study published in June 2012 which summarizes a number of studies as below with ESG acting as a proxy for non-financial indicators of quality and found that 15 out of 18 studies on ESG vs. correlation to higher market based performance indicated positive results. Another meta study by Arabesque partners ( From the Stock Holder to the Stakeholder, Clark Feiner Viehs in September 2014) found that 88% of studies show that solid ESG practices are associated with better operating performance, and that 90% of the studies of cost of capital show that sound sustainability standards lower the cost of capital of the firm. An academic study that focuses on strong corporate ESG as a predictor of market based performance compares performance of the responsible portfolio (150 companies derived from the KLD) with the S&P 500 and found that it had slightly superior average returns and only marginally more risk despite having 70% less stocks. See Investing for Change: Profit from Sustainable Investment, Landier, Augustin Nair, Oxford University Press Finally, Serafeim et al. (2015) find that firms with good performance on material sustainability issues significantly outperform firms with poor performance on these issues, suggesting that investment in material sustainability issues are shareholder value enhancing. He uses SASB s materiality map to determine relevant KPI s by industry. See Corporate Sustainability: First evidence of materiality, Serafeim Khan Yoon, March Journal of Applied Corporate Finance Volume 27 Number 2 Spring

85 Table 9 Regression on non-financial metrics vs. ROIC 28 E S G Misc. Coefficients Standard Error t Stat P-value Intercept (0.59) 0.49 (1.20) 23% Sustainalytics E (2.16) 1.34 (1.61) 11% Bloomberg Env Disc Sc (0.36) 0.46 (0.78) 44% Sustainalytics S % Fortune best places to work (1.81) 1.22 (1.48) 14% CR citizen (0.37) 0.83 (0.45) 66% Bloomberg Soc Disc Sc (0.13) 0.47 (0.28) 78% Sustainalytics G (0.96) 1.31 (0.73) 47% Bloomberg Gov Disc Sc % % Women on Bd:Y (0.14) 0.39 (0.35) 73% % Indep Directors:Y % ISS (0.73) 0.52 (1.42) 16% Index or not (0.13) 0.57 (0.22) 83% ISS score MSCI KLD FTSE sustainable companies Dow Jones sustainable companies Such non-financial metrics are released at different times during the year, starting from February and ending in November. We used data from 2014, and regressed them against year- end 2014 ROIC. Our analysis indicated there are two variables with statistically significant correlations with ROIC at the 10% or better confidence level, and two more at the 15% level. As we can be seen in Table 9, the key variables appear to be the Bloomberg governance disclosure scores, and the Percentage (%) of Independent Directors on Board. Both of these values appear to add significant coefficients to the predicted ROICs. This result is consistent with previous studies that have shown that (1) performance on governance issues is associated with strong firm performance, and (2) that strong corporate governance is often an effective proxy for performance on a broader set of ESG issues. 29 At the same time, and surprisingly, both the Sustainalytics Environment Score and the Fortune Best Places to Work survey appear to be associated with lower ROICs and thus reduced corporate value (albeit with confidence <90%). In summary, the most significant variable the one that stands out is the Bloomberg governance disclosure score, which appears in this analysis to be the most significant of the non-financial metrics in predicting ROIC, and, as a result potentially generating alpha over time. In sum, we found that our initial findings have received strong support from prior academic research. Having identified governance as the key proxy of non-financial quality metrics, we now conclude this section with a discussion of the art of investing. How can long-term investors identify, a priori, those companies which are likely to maintain their high quality status? As fundamental investors, we believe that the answer is in the culture and leadership of the business. These areas have not in the past readily lent themselves to traditional finance theory. They are low frequency observations (annual rather than daily, weekly, monthly, or quarterly), with a higher degree of qualitative and subjective content than the toolkit of quantitative finance is suited for. However, with the computing power and ability to analyze narrative data, and the explosion of qualitative KPIs describing business practices, the traditional art of high quality business analysis is increasingly addressable by the framework of the science of academic finance. 28. We find that the Bloomberg governance score and the % of independent directors are the most significant metrics given the low p values. From a statistical significance perspective, the Bloomberg governance score is the most relevant with 99% certainty of significance. It also has the highest coefficient in the model. The Bloomberg governance disclosure score is a proprietary score assigned, calculated by Bloomberg based on their assessment of the governance metrics reported by individual companies. 29. A number of academic studies demonstrate the link between governance and accounting-based financial performance, including: Corporate governance, corporate social responsibility and corporate performance Huang, Journal of Management and Organization, 2010, which explores the relationship between corporate governance, CSR, financial performance (as measured by ROA) and CSP. He found that a governance model which includes independent outside directors and which has specific ownership characteristics has a significant positive impact on financial performance and CSP. Corporate governance and Firm performance, Bhagat Bolton, Journal of Corporate Finance, 2008, finds a significant positive correlation of stock ownership by board members, along with CEO-Chairman separation to positive operating performance; Governance mechanisms and equity prices, Cremers Martin Nair, Journal of Finance (2005), , found that external and internal governing mechanisms are strong complements that are associated with long-term abnormal returns and accounting measures of profitability; Corporate governance and firm value: International evidence Ammann Oesch Schmid, Journal of Empirical Finance, 2010 and Bauer et al. (2009), find a positive relationship between good corporate governance and accounting based performance (or firm value), in addition to market performance; Governance and stock market performance Hooper Sim Uppal, Elsevier 2009, demonstrated a significant positive association between stock market performance measures and the quality of the institutional environment. These findings suggest countries with better-developed governance systems have stock markets with higher returns on equity and lower levels of risk. 84 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

86 Figure 1 No. of companies in each persistence cohort for ROIC in 2014 Figure 2 No. of companies in each persistence cohort for Governance in 2014 Sample of Companies Google Inc., Johnson & Johnson, Facebook, The Procter & Gamble Company, Pfizer Inc., The Walt Disney Company, Comcast Corporation, Intel Corporation, Gilead Sciences Inc., Visa Inc., Merck & Co. Inc., International Business Machines Corporation 2014 ROIC Persistence % % 235 Sample of Companies Google Inc., Johnson & Johnson, The Procter & Gamble Company, Pfizer Inc., The Coca-Cola Company, Visa Inc., International Business Machines Corporation, Gilead Sciences Inc., Pepsico, Inc., Amgen Inc. Philip Morris International, Inc. -12% 207-9% Governance Persistence Sample of Companies 3M Company, Abbott Laboratories, Agilent Technologies Inc., Colgate-Palmolive Co., Comerica Incorporated, ConocoPhillips, U.S. Bancorp, Wells Fargo & Company, Weyerhaeuser Co % 91-7% 85 Sample of Companies 3M Company, Abbott Laboratories, Agilent Technologies Inc., Biogen Inc., Campbell Soup Company, Chevron Corporation, Texas Instruments Inc., Tiffany & Co., Tyson Foods, Inc., Union Pacific Corporation -15% 0% Year 2 Year 3 Year 4 Year 5 Year 1 Year 2 Year 3 Year 4 Year 5 Year The Intersection of Financial and Non-Financial Metric Persistence Long-term investors buy stocks they intend to hold for years. Hence, the Holy Grail for long-term fundamental investors is to identify companies that are high quality both in terms of financial and non-financial metrics, and thus, likely to continue delivering high quality performance. In the previous sections, we have identified the most relevant metric for each type of metric. For financial metrics, we suggest using ROIC and for non-financial metrics we suggest using Governance (in our case proxied by the Bloomberg Governance score). We examine the persistence trend for both and attempt to identify companies that generate positive alpha as well as show persistent high governance scores. For the ROIC metrics, 30 we used our dataset of the 1,000 or so largest companies in the US with a top 30 percentile threshold to generate a persistence trend for In this case, we use a definition of at least x years persistence to define cohorts; for example, if x is 3, a company with three-year persistence will make the one-, two-, and three-year cohorts. One clear finding of our analysis is a steady decrease in number of companies by about 12% across each cohort. We also note that the number of companies starts to reach similar levels as we increase the time period of the cohorts. We hypothesize that high ROIC companies in the final cohorts will tend to remain the same as our financial results suggests. And since we also find that the higher persistent cohorts do not add significant alpha, the sweet spot for long-term investors would seem to be in identifying the three-year cohorts, with the potential expectation that they will outperform during the next two or more years. Similarly, we looked at the non-financial metric for corporate governance, as proxied for by the Bloomberg Governance score. (In this case, we used the same 30 percentile threshold but used the S&P 500 as our database given data constraints.) As can be seen in Figure 2, the numbers of companies in the four- and five-year cohorts stay the same, indicating that high quality companies tend to remain high quality. And so in the case of this metric, the sweet spot appears to be after the fourth year, since we can reasonably expect those companies to keep their high governance scores. This finding may also reflect the evolving (and sometimes suspect) quality of the data in the arena of ESG. Our aim here is just to illustrate how non-financial metrics can be helpful to complement financial data in identifying potential persistently high quality businesses. Finally, we combined the two lists in terms of their most relevant datasets that is, the three-year persistence cohort for ROIC and the four-year persistence cohort for governance. In so doing, we found 14 companies that meet both criteria (and are listed in Table 10). 31 We think of this list, or filtering an investment universe by a similar process, as providing a useful starting point for the search for quality companies. That said, there appears to be a clear bias in our methods toward non-cyclical industries, with approximately one third of companies in the health care sector and another one third in the consumer staples sector (approximately two times and three times the respective market weights). While it s easy 30. For this exhibit, we form cohorts differently from section 2. In section 2, our cohorts (with the exception of the 1 year) were exact cohorts, i.e. 4 year meant 4 year persistence exactly. For this analysis, we create inclusive cohorts, i.e. the 4 year cohort includes the 4 and 5 year cohorts. Each cohort thus includes all the stocks of the cohorts that come after it. The reason for this methodology change is to illustrate the rate at which companies lose persistence. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

87 Table 10 Companies matching both criteria Johnson & Johnson Pfizer Inc. The Coca-Cola Company Pepsico, Inc. Amgen, Inc. CVS Health Corporation 3M Company Biogen Inc. Starbucks Corporation Hewlett-Packard Company Northrop Grumman Corporation Dr Pepper Snapple Group, Inc. The Clorox Company Wyndham Worldwide Corporation to see a potential industry or business model bias, as fundamental investors we would argue that this simply reflects the reality that certain business models are more attractive to long-term fundamental investors because the sustainable competitive advantages that drive high ROICs are more prevalent in businesses that are more reliant on the intangibles of brands and patents. 32 Conclusion Quality investing has been an area of increasing interest by academics. But the definitions of quality in most finance studies have been incomplete, limited by the science of ad hoc and sometimes conflicting financial metrics. At the same time, the art of making judgments on corporate culture, and intangibles more broadly due in part to the challenges of measurement has been underappreciated by academic finance. 33 Nevertheless, practitioners of fundamental investing understand that the quality of culture and leadership matters, and the science of measurement can be brought to this art. For example, a recent (2010) study by Alex Edmans showed that buying the Fortune 100 Best Firms to Work For has outperformed (while those which fall off the list underperform) market averages. 34 In the 1990s John Kotter s Corporate Culture and Performance, in the 2000s Jim Collins s Good to Great, and in the 2010s Laura Rittenhouse s Investing Between the Lines all attempt to put an empirical framework around the subjective and forward-looking aspects of culture and leadership. Given the general acceptance of quality investment approaches, how is it that widely admired high quality companies continue to outperform? Why is quality not fully valued by the market? The short answer is that those investors with a relatively short-term focus tend to undervalue intangible assets the kind that don t show up on corporate balance sheets, such as the payoffs from corporate R&D spending, advertising, and patent citations. History in the form of consistently high returns by business value investors has shown that investors (and managers) who take a long-term view have an opportunity to identify opportunities missed or underpriced by a world focused on a shorter time horizon. For this reason, we are encouraged that the developing area of ESG reporting will prove to be a useful tool for fundamental investors seeking a more robust assessment of quality. At the same time, we are confident that the art of high quality analysis will benefit from an expanded palette of data and, in so doing, reinforce the predictive power of the science of systematic analysis. Dan Hanson, CFA, is a Partner and member of the Investment Strategy Committee with Jarislowsky Fraser Global Investment Management. Mr. Hanson has more than 20 years of experience in U.S. and global equities, and U.S. credit and mortgage securities. Mr. Hanson is a member of the board of directors of the Sustainability Accounting Standards Board (SASB), and is involved in a number of initiatives in the area of governance, corporate reporting, and sustainable investing. He earned a BA degree, cum laude, in economics and French from Middlebury College, and an MBA in analytical finance and accounting from the University of Chicago. Rohan Dhanuka was formerly a Research Assistant with Jarislowsky Fraser Global Investment Management. Previously, Mr. Dhanuka has worked for McKinsey & Company as a Business Analyst. Prior to that, he worked in risk analytics at Nomura. He earned an MBA from Columbia University, a MSc. in Financial Engineering from Nanyang Technological University, Singapore and a B.E. degree, first class, from VTU, India. 31. Note this is for 2014 only and is limited by the S&P 500 dataset used for governance. 32. Hanson, Dan, ESG Investing in Graham & Doddsville (Summer 2013). Journal of Applied Corporate Finance, Vol. 25, Issue 3, pp , Available at SSRN: 33.Zingales et. al. (2013) note that the finance literature has ignored the role corporate culture can play, despite the incomplete contract framework (Grossman and Hart, 1986) which posits that values can play a role in ameliorating the inefficiencies created by the incompleteness in the contractual environment [and] a company s financial choices have consequences on the corporate culture. This naturally links to the implications of ESG & CSR (corporate social responsibility) activities. Guiso, Luigi, Sapienza, Paola and Zingales, Luigi, The Value of Corporate Culture (September 1, 2013). Chicago Booth Research Paper No ; Fama-Miller Working Paper. Available at SSRN: Edmans, Alex, Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices (January 20, 2010). Journal of Financial Economics 101(3), , September Available at SSRN: 86 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

88 Intangibles and Sustainability: Holistic Approaches to Measuring and Managing Value Creation by Mary Adams, Smarter-Companies BT he intangible capital (IC) and sustainability movements have been developing in parallel but are increasingly understood as inter-related threads of the search for prosperity in the postindustrial world. Both are trying to bring longer-term thinking to decisions about how business and society use resources. Both bring a broader view of the organization, recognizing the importance of resources that don t fit the traditional accounting definition of assets. Both face challenges in trying to connect their ideas to mainstream business practices. And both see an opportunity to use measurement as a lever to make that connection. Yet, in spite of all these shared interests, the two movements have not had a lot of interaction. This is slowly changing thanks, at least in part, to the integrated reporting movement. This article uses theory and practice from the intangibles movement to suggest integrated approaches that include both intangibles and sustainability. It lays out the differing frameworks, addresses how they interact to provide a more complete view of value creation, and outlines alternatives for measuring value and value creation. The temptation for many is to start with the value question. I hope to make the case that the determination of value depends on the degree to which all corporate and market participants involved understand the underlying value creation system. Resource Frameworks The best way to understand the relationship between these two movements is to see their conceptual frameworks side by side. Figure 1 summarizes the basics of these related frameworks. Because the makeup of the frameworks tends to vary in practice, this exhibit should be viewed as a general overview, not a detailed summary of these varied approaches. Intangible Capital. The first family of frameworks is commonly called Intellectual Capital or Intangible Capital. These frameworks were developed by scholars and practitioners with an interest in the growing role of intangibles and knowledge in business. These practitioners come from a variety of backgrounds, ranging from accounting to knowledge management, strategy, and innovation. They focus on the intangible assets that have taken on greater importance as the economy has shifted from the industrial era to what is often referred to as the knowledge era. Sustainability. The second family of frameworks is often referred to as the sustainability movement. There is considerable variation in the frameworks used in practice, which include Corporate Citizenship, Corporate Responsibility, Corporate Social Responsibility, ESG, and Triple Bottom Line. The essence of these movements is the attention they pay to social, environmental, and governance concerns. Integrated Framework. At the center of the figure is the Figure 1 Framework Model Integrated Reporting Framework Financial Capital (cash, debt, equity, grants) Manufactured Capital (buildings, equipment, infrastructure) Natural Capital (air, water, land, minerals, forests, biodiversity, eco-system health) Intellectual Capital (intellectual property, organization capital such as knowledge, systems, procedures, protocols) Human Capital (competencies, capabilities, experience, motivations) Social/Relationship Capital (shared norms, key relationships, brand and reputations) Intangible Capital Framework Strategic Capital (purpose, business model, governance, culture) Sustainability Framework Journal of Applied Corporate Finance Volume 27 Number 2 Spring

89 Figure 2 <IR> Value Creation Diagram Integrated Reporting (<IR>) Framework. This framework was developed by a task force organized by the International Integrated Reporting Council (IIRC). The aim of this task force is to represent and combine elements of both the intangibility and sustainability movements and, as the figure suggests, to connect these two kinds of resources with traditional tangible and financial resources. The Integrated Reporting Framework attempts to make it easier to talk holistically about how value creation using corporate knowledge resources and social challenges (such as preserving and restoring natural and human capital) is connected with a corporation s tangible and financial resources and how the system as a whole drives financial results and capital formation. Seeing these three frameworks side by side helps highlight overlapping and complementary resources in each and, in so doing, makes clear the value of the integrated model. Nevertheless, it s important to keep in mind that these frameworks are not ends in themselves. While they are good for drawing attention to resources that don t fit the traditional accounting and industrial management definitions, they don t explain how these resources are connected to traditional measures such as revenues, profits and valuation. The challenge here is to advance the thinking behind the frameworks and show how the resources are put to work, and how they create value for a business, its shareholders as well as its stakeholders. Value Creation Models Traditional tools for understanding value creation tend to ignore intangibles and sustainability. Michael Porter s famous Value Chain, for example, is designed like a factory with inputs on the left being transformed into finished products on the right. Financial statements are great at reporting this kind of linear value creation, beginning with investments in plant, equipment, and raw material, and the transformation of work-in-process into finished goods and product sales. The underlying assumption here is that value is created by delivering products. Yet this industrial view fails to capture the full value creation of today s businesses, even those in manufacturing. This is because it ignores the intangible competencies, systems, data, processes and networks that fuel innovation and performance. It also ignores the external effects of the organization on its community and the physical environment. The <IR> movement has provided a generic value creation model in its most recent report 1 that is presented graphically in Figure 2. At the same time, many of the companies that now publish integrated reports are coming up with unique visualizations of their own value creation stories. 2 For example, a growing number of companies have adopted the downloadable worksheet shown in Figure 3 that enables a company to create a customized value creation model. 3 The goal is to create a single sheet that summarizes 1. International <IR> Framework available from the IIRC at: international-ir-framework/. 2. <IR> Examples site available from the IIRC at: 3. IC Canvas available from Smarter-Companies: com/forum/topics/icounts-open-source-hub Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

90 Figure 3 The Value Creation Process Value Creation System PARTNERS Relational Capital PURPOSE Strategic Capital PROPERTY Structural Capital PEOPLE Human Capital PLANET Natural Capital CUSTOMERS VALUE PROPOSITION PROCESSES COMPETENCIES RESOURCES Resources SUPPLIERS BUSINESS MODEL DATA/IP MANAGEMENT LAND Management STAKEHOLDERS CULTURE BUILDINGS/EQPMT ADVISORS/BOARD WASTE Branding, Marketing, CRM, Sales Strategy, Governance, Communications Finance, IT, Operations, Innovation Hiring, Training, Employee engagement, Work/life balance Sustainability management Qualitative Measures Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Δ Quantitative Measures KPI s KPI s KPI s KPI s KPI s Financial Measures Revenue Profits, Prosperity Op Costs + Tangible + Intangible Capital Expenditures Market Validation Reputation and Valuation all the tangible and intangible resources that the company uses to create value for its customers and stakeholders. The resource boxes are meant to be filled in with an inventory of all the important processes and competencies the company uses to support its value proposition. The measure boxes can be used to plot out ways that these resources can be measured. The market validation box along the bottom serves as a reminder that reputation and valuation are measures of the health and performance of the full value creation system. This kind of approach can be helpful in moving these concepts of sustainability and intangible value from the theoretical to the practical. It is much easier to engage a businessperson if you are talking about his or her specific processes and designs rather than structural capital or about specific competencies rather than human capital. The immediate goal of such an approach, as noted earlier, is to make clear the links between sustainability, intangible values, and traditional financial and management metrics. But there s an even more important reason for thinking this way. The new world in which intangibles and sustainability continue to grow in importance is a world where value is increasingly co-created with stakeholders. Most intangible resources are attracted to, but not owned, by companies. This means that value creation is a two-way street. Employees who are engaged and believe in the mission of a business are more likely to make significant contributions to innovation and performance. Customers who trust the business are more loyal. Natural resources are no longer considered free goods; companies have to be able to earn and attract resources in order to earn a profit. Ultimately, this kind of mapping or modelling of value creation is an important foundation for strategic planning and for performance measurement and evaluation. Now let s consider the limitations of what existing measures are able to tell us about future growth opportunities, and how we might develop new measures that help us recognize and make the most of such opportunities. Macro Measures What happens when corporate value creation systems intersect with traditional economic and financial measures? The macro data tell an interesting story. The best data available has been developed using an Intangible Capital approach called the CHS method (for its original authors, Corrado, Hulten and Sichel, who are economists associated with The Conference Board). The intent was to gather macroeconomic data about the rise of the intangibles economy. This framework has been in use for nearly a decade, and is now used to measure the knowledge economies of many countries. The OECD also uses this methodology for its member countries using the label knowledge-based capital (or KBC ) in place of the more commonly used intangible capital. Figure 4 shows spending on intangibles by U.S. corporations as a percentage of non-farm business output when using the CHS method. As these data show, U.S. corporate investment in intangibles has risen steadily since the end of World War II. What s more, it has been more than 20 years since the level of such investment first surpassed the level of U.S. corporate investment in tangibles. As the CHS data make clear, U.S. companies have changed how they are investing their money. The expectation is that these investments in intangibles create systems, processes, designs, data and capabilities that have lasting value. Work is still underway by a number of academics to Journal of Applied Corporate Finance Volume 27 Number 2 Spring

91 Figure 4 U.S. Corporate Investments in Intangibles Percent of NFB Output Tangible Intangible Data from The Conference Board 4 figure out how to measure the amount of and the return on this value. One of the limitations here is that there is no accounting data to measure the amount or the value of this spending because traditional accounting does not treat expenditures on intangibles as investments that can be capitalized. The reason is that most intangibles do not meet minimum accounting tests as assets : they are often not owned, can be hard to identify separately (such as automated systems that include data, software and designs), and are often created internally rather than through arms-length transactions. Think about a company like Federal Express. Fedex owns the largest private fleet of aircraft in the world, countless trucks, and all manner of sorting equipment. But these tangible assets are not the longest-lived assets they own and they don t even really give the company competitive advantage. The company s longest-lived resources are the processes that have been developed over decades to optimize the pickup, routing, and delivery of packages. Related assets include databases and networks that help Fedex get packages through customs in 220 countries around the world. But, again, because the costs incurred to build, maintain, and improve these long-lived resources are not capitalized as assets, the value of resources remains invisible in traditional financial reporting. Think about what would happen if Fedex lost all of its tangible assets, and then think about the consequences of losing its intangibles? The loss of all its planes and trucks would be a devastating blow. But Fedex could probably recover most of its value if it still had all its systems and data. In contrast, what would happen if Fedex lost all its intangibles? The essence of the company would be gone. But now let s consider how the market views Fedex. At the end of its fiscal year (May 30) 2014, Fedex had a tangible net worth of $11.4 billion, which amounted to just 28% of its market equity capitalization of $40.3 billion. And this percentage is actually higher than the average for public companies in the United States. As can be seen in Figure 4, the percentage of corporate value represented by tangible net worth in the S&P 500 has plummeted from 83% in 1975 to about 16% today. One of the most notable changes during this period, which has experienced a general shift of the economy away from industrial manufacturing, has been the sharp rise in the use of computing technologies. Although large mainframes were in use prior to 1975, the rapid adoption of personal computers in the 1980s prompted an increase in the intangible knowledge components of work. The next great shift came with the rise of the Internet in the 1990s, which connected personal computers and super-charged this intangible, knowledge-based capital. But if these numbers provide a clear illustration of the shift in value from the tangible to intangible, it is important to recognize that this is not really a measurement of intangibles but, rather, of an intangible information gap. In other words, the market isn t explicitly valuing a company s investment in intangibles; instead it is assigning a value to the future earnings and cash flow that such investment is expected to produce. Think about a company like Amazon, which is famous for investing for the long term with remarkably little attention to quarterly EPS. How much is Amazon investing to maintain its core digital infrastructure? How much of the spending in a given year is related to short-term operations versus longterm projects? Do these projects create assets with lasting 4. Data and graph available from The Conference Board at: 90 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

92 Figure 5 Intangibles Information Gap 100% 80% 60% 40% 20% 0% 83% 17% 32% Data compiled by Ocean Tomo 5 68% 32% 20% 16% Tangible Assets 68% 80% Intangible Assets 84% value? What kind of capabilities are they creating? What is the return on this spending? The GAAP requirement to expense (instead of capitalizing) most of its long-term investments means that Amazon s intangible infrastructure remains invisible except in the form of revenues and profits. Analysts and investors are left to formulate their own answers without the data hidden in the financials that could answer many of these questions. This phenomenon can also be seen in acquisition accounting. An acquisition is the one moment when accountants have to capitalize the intangible value in a company. As reported in Figure 6, during the past three years, roughly 72% of the value of companies acquired in U.S. M&A transactions was booked as intangibles. Some of this value was assigned to specific intangibles such as customer lists and trade names. But the majority of it, roughly 40%, was booked as goodwill. As with the S&P calculation above, this goodwill is an intangible information gap, a plug number between the total value and the portion that is identified on the balance sheet. With such a large portion of acquisitions left undefined, it is not surprising that many mergers fail to deliver on initial expectations. One famous example of intangibles in M&A was Google s acquisition of Motorola Mobility in Google accounted for the total purchase price of $12.5 billion as follows: $2.9 billion was cash acquired; $5.5 billion was attributed to patents and developed technology; $2.6 billion to goodwill; $730 million to customer relationships; and $670 million to other net assets acquired. This transaction actually had less goodwill than average (21% versus an average of 40%) because of the large value allocated to the patents. What was especially striking was that, as is the common practice, Mobility s portfolio of some 17,000 patents was not on Motorola s books prior to the acquisition; the $5.5 billion value assigned to the portfolio appeared in the market for the first time when it was included on Google s books after the transaction. This is just one example of the intangibles that represent a significant information gap in most every company. They hint at another level to the story told by the macro measures of investment and corporate value. Unfortunately, these macro measures are the best available today. Once you get down to the corporate level, the picture gets much fuzzier. Micro Measures While we can clearly see the intangibles trend at a macro level, it is much harder to see at the micro or firm level. This is not to say that there is no data on intangibles (or sustainability) at the corporate level. There are actually enormous amounts of data for example, on human resources, customers, and processes but it is usually scattered. What kind of measures are available? There are basically three kinds: Financial revenue, costs, investment and valuation Quantitative counting things that can be counted or measured Qualitative analysis or ratings No one measure is satisfactory. But using the three kinds of measures together enables a kind of triangulation that is, a way of estimating the health and outlook of intangibles by combining all three kinds of measurement in a single view. Most of the information that can be used in this triangulation process is actually buried in the narrative of business plans, strategic reports and annual review. Take Federal Express s employees. The company s 2014 annual report states: Along with a strong reputation among customers and the general public, FedEx is widely acknowledged as a great place to work. For instance, for the past three years, since its inaugural release, FedEx Express was named as one of the top global companies to work for by The Great Place to Work Institute in its ranking of the World s Best Multinational Workplaces. In order to even be considered for this honor, a company must appear on at least five national Great Place to Work lists and have at least 5,000 employees worldwide. It is our people our greatest asset that give us our strong reputation. In addition to superior physical and information networks, FedEx has an exemplary human network, with more than 300,000 team members who are absolutely, positively focused on safety, the highest ethical and professional standards, and the needs of their customers and communities. Through our internal Purple Promise and Humanitarian Award programs, we recognize and reward employees who enhance customer service and promote human welfare. For additional information on our people-first philosophy and workplace initiatives, see 5. Graph available from Ocean Tomo at: Journal of Applied Corporate Finance Volume 27 Number 2 Spring

93 Figure 6 Intangibles in M&A Figure 7 Triangulation Qualitative Tangible, 28% Earnings Potential Goodwill, 40% Financial Corporate Intangibles Intangible, 32% Quantitative Averages , Data from Houlihan Lokey 6 Elsewhere in the report, one can find specific data on their human capital. The following is for their largest segment, Fedex Express: Financial: $9.9 billion salaries and benefits, plus pension and severance charges. The company also reported that merit increases had been delayed or eliminated for that year. Quantitative: 112,000 full-time and 50,000 permanent part-time employees. The narrative also reported that the employees were not unionized except for their pilots. Qualitative: The narrative cites risk arising from lawsuits from the owner-operator model they use for many of their drivers. This is a pretty limited amount of data for a 162-page report. Their CSR site also describes programs but provides little additional data. This is not a critique of Fedex; its approach is representative of the common practice in corporate reporting of presenting financial statements together with significant narrative that describes what s behind the numbers. Intangibles get lip service but not that much hard data. In the reports of companies experimenting with <IR>, different categories of capital are often featured on separate pages or sections with graphical triangulation data mixed with focused narrative. This can be seen in some of the presentations that companies are beginning to make in their integrated reports where they use graphic layouts to display key financial, quantitative, and qualitative data. Consider, for example, the kind of reporting provided by the Brazilian company Itau Unibanco Holding SA that is shown in Figure 8. 7 This is more information than is typically included in an annual report and begins to give a better flavor of how this company manages its human capital. Why would a company want to expand from the traditional to the integrated model? Because it believes that greater transparency and better information makes it a more attractive employer, partner, and investment and that, by so doing, it ends up creating more value for all its stakeholders, including its shareholders. Valuation How does information on intangibles relate back to the valuation issue suggested in the macro-level measures seen above? The macro data make it clear that money is being spent on intangibles. But, as already noted, there is no clear information about how much is being spent on what, and how much this investment is contributing to increased corporate value. This is not to say that intangibles are not and cannot be valued. This kind of valuation takes place all the time for acquisition and tax transactions, especially for purposes of transfer pricing for example, when accounting for inter-company use of intangibles like patents and trademarks. But this kind of valuation is still far more art than science. In fact, during one recent experiment, a European chemicals company gave the same information on a patent portfolio to two different valuation firms to value the portfolios for transfer pricing purposes. The company received two very different answers: one valued the portfolio at $100 million, the other at $260 million. How did this happen? The answer provides an important lesson about value and valuation in today s economy. Valuation is a complex process subject to many regulations and practices. Valuations reflect market conditions but 6. Calculations based on data from Houlihan Lokey Purchase Price Allocation Study available here: 7. From Itau Unibanco example on the IIRC Examples site: org/fragment/ Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

94 Figure 8 Itau Unibanco Integrated Report Example Human capital R$10,667MM salaries, charges and ( 7.6% ) compared to 2012 Age (%) Above 50 years 7 Between 30 and 49 years 56 Around 2 MM hours invested in training in ,587 merits and promotions in 2013 (14.2% of employees) Learn more 36 Below 30 years 36 Learn more Learn more Learn more also rely heavily on the analysis of the cash flow of the underlying asset or business. At its essence, valuation is a calculation of the present value of the future cash flows associated with an asset or a company. There are many variations on this process but the fundamental steps are straightforward: Financial statements Projections Discount factor Net present value Objective Subjective Subjective R$2,560 MM Gender (%) 40.4 PLR) 11% R$2,850 MM Itaú Business School R$185 MM in training 59.6 Objective Because the input (financial statements) and output (a monetary value) are numerical, the process feels objective and reliable. However, the steps in between of developing and discounting the financial projections can be highly subjective. The subjectivity comes in the significant number of assumptions that must be made about the company s intangibles. These include, for example, assumptions about the capability and engagement of managers and employees ( human capital ), the scalability of the systems and processes ( structural capital ), the strength of customer relationships and the reliability of the company s partners ( relationship Male Learn more Female capital ), and its use of natural resources ( natural capital ). There are no objective measures that inform these assumptions. This is why the valuation process remains the province of trained experts who bring their professional judgment to bear on the process. One can imagine that the better the triangulated data available to a valuation professional or a business or equity analyst for that matter the more accurate their findings. Where was the difference in the two valuations received by the chemicals company? The projections were reportedly pretty similar. But the discount rates used by the two valuation firms were quite different. The discount factor is generally calculated taking into account market as well as company specific risk. This case reflected two defensible but nonetheless subjective assessments of the risk inherent in the projections and the underlying portfolio. But whatever the explanation, this is essentially what is happening in equity markets: different investors and analysts draw very different conclusions in the face of the same data. There will always be some variation in perceived value in markets. Buyers have different perspectives and information is never perfect. But the size of the intangible information gap remains too large. Information asymmetries create opportunity but they also create risk. The 80% (or greater) gap between net book value and corporate value creates both. Stakeholder Value There is one other alternative for measurement of value that bears examination. It s related to the empowerment of citizens and consumers through new technologies. Social media give a voice to anyone with an opinion to share. Companies spend an increasing amount of time listening to and managing these conversations. A lot of this feedback comes through streams in social media such as Facebook and Twitter. There are also rating sites that rate products or companies. This approach is already well-established in consumerfacing companies. Books and consumer products are rated on sites like Amazon. The experience of staying at a hotel is rated this way on Expedia. The experience of working for a company is rated this way on Glassdoor. These ratings are, in a sense, crowd-sourced measures of intangibles. They provide a special power because they are prepared from the outside in, rather from the inside out, as is the case with triangulated reporting. These data tell the company s story in an authentic, (sometimes) painfully honest way. They can also be a powerful source of learning about what stakeholders really think of you. This kind of data is helpful for making better decisions and also for telling your story to the marketplace. As explained above, the importance of stakeholder feedback has increased as value creation has become ever more dependent on intangibles. Employees, customers, partners, and communities are critical to a company s ability to create Journal of Applied Corporate Finance Volume 27 Number 2 Spring

95 Figure 9 Sample Stakeholder Rating of Human Capital TRAINING TURNOVER TALENT ACQUISITION [PLATFORM SOFTWARE] EXPERIENCE HEALTHCARE EXPERIENCE INTEROPERABILITY STANDARDS PROGRAMMING (.NET) INTEGRATION SOLUTIONS value, generate profits and build its valuation. The importance of this relationship between value creation and attraction suggests that companies should move beyond the traditional measures discussed above. If stakeholders are important to a company s future then why not solicit their opinion of the company? Figure 9 shows an excerpt from the stakeholder ratings of a software company by its stakeholders. The data was gathered through interviews of internal and external stakeholders by a third party in which they were asked to evaluate (on a scale from 1-5) the strength of key elements of the company s intangible capital. The ratings shown here cover the key employee competencies and the effectiveness of human capital management in attracting, training, and retaining talent. The competency scores were all in a healthy range of 3-4 out of 5. But training received a score just over 2 out of 5. Such data, though admittedly qualitative, paint a much richer picture of the contribution of the company s human capital to its overall value creation. These stakeholder data were used internally to make changes that fueled a growth spurt of 27% over the next two years. The data were also included in a business plan that helped the company win its first ever bank line. The power of stakeholder feedback is that it can cut through the noise of diverse sources of data about intangibles. It s likely that this form of data will become more and more common in the future. Conclusion: Value and Value Creation The intangibles and sustainability movements are each making contributions to management thinking, bringing a broader and more holistic point of view. Understanding how the basic frameworks fit together is a good first step. But to connect with the everyday work of mainstream businesspeople, we need to join these frameworks to concepts of value creation, measurement and valuation. Intangibles and sustainability are already being measured every day but not very accurately. The task falls to our twin movements to improve the flow of information, fill in the intangible information gap and demonstrate the value of holistic, integrated business management. Mary Adams is the founder of Smarter-Companies, a company that provides tools to measure, manage and optimize value creation. The company has trained partners in Europe, Africa, Asia, and South and North America. She is also the co-author of Intangible Capital: Putting Knowledge to Work in the 21st Century Organization. Previously, she spent 14 years as the founder of Trek Consulting and 14 years as a high-risk lender at Citicorp and Sanwa Business Credit. She received a BA Political Science from Rice University and a Master of International Management from the Thunderbird School (now part of Arizona State). 94 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

96 Tracking Real-time Corporate Sustainability Signals Using Cognitive Computing by Greg Bala and Hendrik Bartel, TruValue Labs, and James P. Hawley and Yung-Jae Lee, Saint Mary s College of California* BT he last decade saw extraordinary growth in the number of companies and analysts measuring and reporting on corporate sustainability performance. Thanks to the efforts of large corporations such as MSCI, Bloomberg, Thompson-Reuters, and nongovernmental organizations such as the Climate Disclosure Standards Board, sustainability reporting and measurement have responded to perceived needs of investors, consumers, and other stakeholders for ESG/sustainability indicators. But, as one observer has commented, all this activity and growth has created considerable confusion: There are a dizzying number and variety of external ratings, rankings, indices and awards that seek to measure corporate sustainability performance. Stakeholders of all kinds investors, consumers, employees, etc. are increasingly relying on these ratings to help inform their decisions (to invest, purchase, work, etc.). Companies also rely on such ratings to gauge and validate their own sustainability efforts, with some even linking management performance evaluation and compensation to external ratings. These ratings, therefore, must be robust, accurate and credible. 1 To the words robust, accurate and credible, the author of this statement might also have added tracking changes in real-time. The reason it did not is that, until recently, no rating or ranking firm has tracked sustainability/esg data in real-time using big data analytics, which is now widely used in other arenas such as marketing and consumer understanding, business informatics and analytics, and internet search and recommendations. The aim of this article is to discuss the promise of big data sustainability analytics or, more specifically, the applications to ESG of a set of technologies known as cognitive computing. More specifically, we present a model and initial data analysis of a computer-based application that we call Sustainability Trend Analysis, or STA. The main output of STA is real-time, big data-based dynamic sustainability signals, or DSS. DSS are forward-looking indicators of the quantity and quality of sustainability initiatives and investments by public companies and other large organizations. As discussed by a number of other articles in this issue, such corporate investment can be designed to address environmental, social, and governance problems while also furthering the goals of the organizations, including value maximization. As we also suggest in this article, the DSS produced by cognitive computing can be viewed as analogous to the stock price signals provided by equity markets about future corporate financial performance. The volatility of such equity market signals reflects both differences, as well as continuous change, in market participants views of the discounted value of future cash flows based on their perceived degree of risk. Using a similar process, DSS provides insight in the different and continuously changing views of all kinds of corporate stakeholders investors as well as customers and employees, representatives of the general public, thought leaders and subject matter experts about a company s reputation as a corporate citizen. As discussed in the pages that follow, the data gathered and analyzed by cognitive computing can serve both to measure and to shape future expectations about sustainability performance by corporations. And as we also suggest, the use of such data has the potential to improve equity analysis by identifying both risks and opportunities that tend to be overlooked by more conventional approaches. We define sustainability in terms of environmental, social, and corporate governance (ESG) factors that companies and investors increasingly focus on as a core element of value creation. (And, indeed, ESG is used interchangeably with sustainability and responsible investment. 2 ) The goal of STA is to use the power of big data technologies and analytics, natural language processing (computational linguistics), and machine learning known collectively as cognitive computing to provide real-time trend analytics along a number of ESG dimensions without the need for human analysts or, alternatively, to provide more frequent data to human analysts to facilitate an enhanced * An earlier and quite different version of this paper was presented at the Principals for Responsible Investment Academic Network meetings, Montreal, PQ, Canada, September The authors wish to thank Don Chew, Bob Eccles, Jon Lukomnik, Doug Park, and Nada Villermain-Lécolier for their comments and criticism accessed 01/08/15 2. This is similar in usage by, for example, BlackRock ( corporate/en-us/about-us/responsible-investment); Context reporting ( the Carbon Disclosure Project ( Scoring-Methodology.pdf) Journal of Applied Corporate Finance Volume 27 Number 2 Spring

97 research process. Like other technological developments, cognitive computing is a scalable and disruptive technology that brings the ability to observe, measure, analyze, and compare sustainability signals producing real-time trends. Traditional, human-based analysis produces infrequent reports that are typically updated on a yearly or quarterly schedule (the ESG industry standard until recently), which is too infrequent to provide meaningful and actionable analytic (quantitative) results. STA offers a host of new avenues for evaluating corporate sustainable value creation (and risk detection and mitigation). The same is true on the investment side, where DSS and STA enable extra financial value indicators to be taken into account. 3 We argue that adoption of such technologies is a game changer: it can provide more comprehensive analysis of corporate risks and opportunities, and of projected growth prospects as well as returns on capital. 4 For this reason, DSS and STA are likely to prove useful to investors as well as to corporations wanting to monitor their ESG profiles and reputation. In their recently published book on global integrated reporting developments, Bob Eccles, Mike Krusz, and Sydney Ribot conclude with a call for greater use of information technology more specifically, big data, analytics, cloud computing, and social media in the sustainability space. They argue that IT [can] dramatically improve the process and quality of integrated reporting to the benefit of both the company and its audience, it can improve both parties integrated thinking. 5 Eccles et al. identify four kinds of big data analytics: descriptive, diagnostic, predictive, and prescriptive. 6 At present ESG/sustainability research uses human labor-intensive work to cover descriptive tasks, while consultants do diagnostics and some elements of the prescriptive. In the way such tasks are now performed analysts have limited ability to identify meaningful descriptive trends because there are too few data points (that are generally too far apart) to discover either short-term or longer-term trends, or even to use past trends to predict how certain events might be perceived. But with the help of cognitive computing s probabilistic event analysis, functions such as description, diagnosis, prescription, and some elements of prediction become possible in the ESG arena. Indeed, they can be expected to operate according to much the same logic that produces the shopping or film suggestions offered by Amazon and Netflix. 3. What is extra-financial at one time period may well become financial in the next, as the valuation of corporate governance indicates. In the early 1990s the market did not perceive governance as material, yet by the turn of the century it was so valued and therefore financial. Indeed, the larger issue is how the market values intangibles, which some have estimated currently to account for up to 80% of value of many if not most large firms. 4. Specifically these technologies can conform to what GISR (Global Initiative for Sustainability Ratings) lists as key process requirements for reporting and analysis: transparency, impartiality, continuous improvement, inclusiveness and assurability ( ratesustainability.org/wp-content/uploads/2013/10/gisr-principles-map.pdf). 5. Robert G. Eccles, Michael P. Krzus and Syndey Bibot, The Integrated Reporting Movement (Workiva on-line, 2014, np. chapter 9). They add, paper based reports Access to real-time sustainability information enables both investors and corporates to respond to the growing demand for sustainable processes, products, and investment vehicles. On the investment side, portfolio managers and analysts can stay on top of current information more easily, and can track, quantify, and report on larger amounts of information. Investment product creators can assemble investment indexes, ETFs, and other vehicles to take better account of DSS changes in the composition and weightings of those products. Long-term investors can both track portfolio sustainability movements, and scan the investment horizon for future sustainable investment prospects. Corporate governance monitors can similarly follow real-time events more easily, including both ongoing engagements and potential future engagement prospects. On the corporate side, individual firms can track both their own sustainability profiles and reputations, and those of their competitors, both within sectors and across sectors. How to Meet the Growing Demand for ESG/ Sustainability Information As we noted at the outset, the last decade witnessed extraordinary growth in the number of companies and analysts measuring and reporting corporate sustainability performance. But the massive and steadily growing volume of such information presents a challenge for companies, investors, analysts, regulators, and other interested parties. Reading and analyzing these ever-growing sources is extremely costly when using primarily human analysts. Big data technologies and analytics offer a scalable complement or perhaps an alternative. 7 Additionally, human analysts inevitably bring a subjective point of view to their undertaking while the basis for and methodology of the analysis and recommendations typically lack transparency. 8 This situation can be addressed by emerging technologies that are able to improve the quality, quantity, and timeliness of ESG data. These technologies, which are together referred to as cognitive computing, consist mainly of the following three: the ability to automatically data-mine all web-based material. the use of natural language processing (NLP, also called computational linguistics ) to summarize and analyze text ( unstructured data ) in the way the human [which include pdf files] have severe inherent limitations [while] corporate reporting websites of the largest 500 companies in the world today only scratch the surface when it comes to using currently available IT. 6. Eccles et al, Ibid, 2014, chapter 9, np. 7. We define analytics as making meaning from patterns in data, a quantitative undertaking. Analysis is broader, usually defined as making meaning by disaggregating a larger problem into its component parts, which can be quantitative but also qualitative. 8. The recently formed organization, Global Initiative for Sustainability Ratings ( ratesustainability.org), makes this abundantly clear. See especially their comparison mapping: Map.pdf (accessed ). 96 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

98 mind would. It can also assign consistent quantitative ratings from a text, making for consistency over time not subject to human subjectivity. In a more advanced form when combined with elements of artificial intelligence, the software can be trained to answer complex queries like the following: how does company x compare to company y on carbon emissions, water use efficiency or supply chain conditions and supply chain management? the use machine learning (ML) analytics (a form of artificial intelligence) to continuously enhance the above two technological functions. When used in combination, these three technologies open the possibility of not only making intangibles like ESG data tangible, thereby making possible assessments of their materiality, but doing so on a broader, deeper, and more accurate basis than what currently exists. In sum, cognitive computing makes possible the detection of dynamic sustainability signals. 9 Natural language processing (NLP) is a field of computer science in which large amounts of unstructured content are read by computers at extremely rapid speeds and transformed into structured data outputs. In addition to summarizing long documents, NLP can be used for topic segmentation and recognition and also for a function called relationship extraction, which uses algorithms to identify entities and relationships amongst entities within unstructured content. Finally, after the meaning of a text has been identified in this way, sentiment analysis can be used to determine the polarity of the topic and the intensity of language used about a specific object or subject within a body of text. Most modern NLP sentiment techniques use stochastic, probabilistic, and other statistical methods to derive actual meaning from text. Machine learning (ML) is the use of computers to process new data in ways that reflect what it has learned from past processing of similar data. Because ML does not follow explicit programmed instructions, this learning can happen in different ways, in some cases supervised, in others unsupervised. An example of supervised learning involves the classification of content by a human analyst to aid the learning process. In unsupervised learning, the computer uses large amounts of input to start creating clusters of meaning and significance. The following section presents analysis of early-stage dynamic sustainability data produced by NLP and ML processes. 10 Initial Data Analysis In this section we start by presenting DSS trends for twelve companies during the six-month period (July 4, 2014 January 7, 2015) with respect to the companies initiatives to strengthen employee engagement. Then we present the results of a volatility analysis of that DSS data by NLP and ML technology operations (July 19, 2014 January 21, 2015). The NLP and other programs parse tens of thousands of content pieces daily and automatically from a growing set of web and electronic sources available on the Internet. Most of that material is not germane to sustainability and is discarded. The remainder is sorted into six meta-categories of sustainability information. 11 Figure 1 shows the trends regarding employee engagement (what is called compounded TruValue, which is defined in the technical appendix, exhibit 1) over about a six-month period for 12 companies. (Compounded TV is a sustainability-compounded score.) Costco and Exxon Mobil are, respectively, the best and worst cases in this period. With all companies beginning at a zero point, perceptions of Costco improve by 52% during the time period analyzed, while the standing of Exxon Mobil deteriorates by 44%. Costco s trend, for example, can be attributed to a number of dynamic sustainability signals (data points) that include the following: (1) recognition as best place to work without a college degree; (2) lower turnover than comparable firms, resulting in high service quality and customer satisfaction; (3) a higher level of employer paid health coverage and higher salaries than comparable firms. In addition, Costco also (4) hires the great majority of its managers from a group who began working behind the register, and (5) it even managed to raise (modestly) wages during the recession with no layoffs, striking a good balance among employees, shareowners, customers, and other stakeholders. NLP interprets these stories and their sentiments, assigning them a point-intime rating for each piece of information, thereby creating the basis for establishing a trend. 9. Other financial sectors are beginning to use the new technology. For example, seekingalpha.com (08/21/14) points out that...a performance-tracking dashboard includes tabs for creating/previewing ads, tracking ad impressions/reach, and monitoring user engagement. Facebook has been taking a go-it-slow approach to monetizing Instagram s 200M+ users, even as many top brands gain huge followings on the photo/videosharing platform. Similar technology can be used to mine ESG related information. 10. From TruValue Labs data, July 19, 2014 January 19, These are defined as follows: Leadership/governance: relation with stockowners and stakeholders, integrity, strategy/vision and implementation, interaction with regulators, pending governmental actions, major lawsuit potential liabilities, executive compensation, supply chain monitoring (also in workplace as appropriate), political lobbying and contributions. Product integrity and innovation: services and products that are cutting edge, revolutionary, competitive; high safety and high quality, and delight customers; state-of-the-art minimal negative environmental impact; respect for privacy and data protection. Environment: using clean state-of-the art technology; sustainable (including through full life cycle of product); accounting for negative externalities (e.g. on water, fuel consumption, biodiversity, clean up costs). Workplace: properly motivate, compensate and respect employees; enhance diversity; focus on safety and health of employees; employee engagement; training and education opportunities; adequate benefits and retirement systems; monitoring supply chain for basic rights (e.g. health/safety, child and forced labor). Social impact: attempts to benefit society; treat stakeholders fairly and ethically along with, stockowners, suppliers, vendors, contract workers; good community relations and, where relevant, meaningful philanthropy; customer satisfaction. Economic sustainability: strong business/financial model and outlook; loyal customer base; positive return to shareowners (not necessarily short term); long-term focus. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

99 Figure 1 Compounded TruValue for Employee Engagement (7 month duration) Bank of America Costco Wholesale Coca-Cola Comcast Berkshire Hathaway Apple Darden Restaurants Halliburton Cisco Systems Chevron Eli Lilly Exxon Mobil 58% Apple 56% 54% 52% Bank of America 50% 48% 46% Berkshire Hathaway 44% 42% Chevron 40% 38% 36% Cisco Systems 34% 32% 30% Coca-Cola 28% 26% 24% Comcast 22% 20% Costco Wholesale 18% 16% 14% Darden Restaurants 12% 10% 8% Eli Lilly 6% 4% Exxon Mobil 2% 0% -2% Halliburton -4% -6% -8% -10% -12% -14% -16% -18% -20% -22% -24% -26% -28% -30% -32% -34% -36% -38% -40% -42% -44% -46% -48% -50% Jun Jun Jun Jun Jul Jul Jul Jul Jul Aug Aug Aug Aug Sep Sep Sep Sep Oct Oct Oct Oct Oct Nov Nov Nov Nov Dec Dec Dec Dec Dec Jan Volatility From this look at trends we move to a more detailed analysis that examines volatility within the trend (in aggregate and in each of the six meta categories listed above). We broadly define volatility as a measure of the dispersion of time series values over a particular interval. We analyze volatility for two reasons. First is the widely held belief by ESG rating agencies and others that changes in the ESG performance occur slowly and only over the long term. We have found this not to be the case. For example, the case of Petrobras shown in Figure 2 is one of many examples in which short-term variability is clear. The kind of short-term variability revealed in Figure 2 is typically masked by most, if not all, conventional ESG measures that provide summary information spanning long time intervals. The second reason to examine volatility is that when it is significantly statistically correlated with a relevant variable, it can provide real-time indicators of investment risk or opportunity from DSS signals that can be used for portfolio construction and monitoring as well as for tracking corporate reputation. To our knowledge, no such analysis has been previously undertaken, since this level of granular ESG data has simply not been available. There is mounting evidence that markets are coming to realize and accept ESG factors as potentially material, and that at least some ESG factors will be seen as material not just in the long run, but also in the nearer term as well. Our analysis of volatility proceeds as follows. From the database of the S&P 500, we found robust data across all six meta categories for 58 companies. 12 For those companies, we correlated volatility with compounded TruValue (CTV), as defined in Appendix 1. Such compounded value is the accumulation over time periods of ESG value, as gathered 12. A more technical working paper detailing methods and data can be found at: ver%203.1%20smc%20website%20submit%20version.pdf. Also at SSRN: 98 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

100 Figure 2 Petrobras The x-axis on the left is the aggregate metric, while the y-axis is the timeline, in this case a six-month period. The dotted line is the metric trend line over a 30-day period. from dynamic sustainability signals. We found that the variability (defined as coefficient of variation) of CTV was statistically significant for the E and S, and, to a lesser extent, the G categories. 13 In addition to computing CTV for the aggregated six meta categories and each meta category separately, we also calculated the coefficient of variation (CV) over the real-time series of core ratings as a measure of their volatility. 14 We found that for two of the meta categories (environmental and social), there was statistical significance at lower than a 5% p-value level (0.02 and 0.01, respectively). In the meta category of leadership and governance, there was a potentially important, but not a statistically significant result (0.08). 15 Our findings are graphically presented in Exhibit 2 in the appendix for E and S factors. Both such factors have a more dispersed distribution pattern than for the other meta categories, indicating greater volatility. 16 What is the significance of volatility for ESG factors? We suggest that volatility has potential materiality and value implications, somewhat parallel to a company s beta as a measure of financial risk and associated return. From the samples studied, we found statistically significant evidence, in the social and environment meta categories, that compound TV increases as TV volatility decreases. 17 In other words, the more positively the ESG/sustainability values accumulate, the lesser the degree of volatility. 13. The coefficient of variation volatility is calculated by dividing standard deviation of the time series by the average of time series over a chosen time period. 14. The coefficient of variation was selected as a primary measure of volatility because, unlike standard deviation, it is calculated by dividing standard deviation of index by the average of TV index over a time period, and it is a relative measure. For example, CV of 0 means no variation relative to the mean and 1 means standard deviation is equal to the mean. The findings (graphs 3 and 4) are displayed graphically for economic and social categories in exhibition 3 in the Appendix, along with the correlation, R squared and p values. 15. We hypothesize that this is due to the as yet developing data sources which feed the governance metric. Thus, in the future we expect this will also be statistically significant. A fuller, more definitive examination of these initial correlations awaits additional study with more data as well as focusing on event analysis among other approaches. 16. We believe this is, as stated, an artifact of news feed inputs and generally reflects that good news tends to impact firms more and more intensely in product and economic stability areas. Why workplace also fits this pattern is not clear and will be investigated in a future study. 17. It is worthwhile to note that the more volatile the time series, the less it contributes to the ongoing accumulation because volatility usually involves both upward and downward movements. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

101 What is likely happening with the E and S meta categories is that they show a reasonable relationship across the companies selected. The consistent effect of volatility was to erode companies ratings. In other words, the more a signal bounces around, the less it will sustain a value, thus compounding less. Recall that a high compound value shows greater ESG value. (Alternatively, such volatility could be interpreted as the direct effect of negative E and S, which in turn reduces ESG compounded value.) In either case, there are clear indicators of short-term variation. From these shortterm movements we establish trends and can evaluate their statistical significance. Conclusion and Future Analysis We have presented an overview of the potential for cognitive computing in the ESG arena using NLP, machine learning, and other artificial intelligence techniques. These technologies can draw on and analyze real-time developments that were previously a limiting factor in ESG analysis. Together they produce not merely data, but data analytics. The output of these technologies is what we call dynamic sustainability signals, or DSS. At the moment, we do not have strong evidence that DSS is a significant explanatory variable in predicting corporate stock price performance. But we expect that with the use of these new technological and analytical tools, DSS may over time affect various measures of corporate performance (not only stock price, but measures of operating performance such as ROA, ROIC, and EVA). We see promising indications that markets increasingly take into account ESG/sustainability factors. Our analysis implies that DSS volatility measures provide another way that markets can react to ESG factors that investors or other important corporate stakeholders see as material. Our initial analysis suggests that there are statistically significant short term volatility variations when correlated against compounded sustainability signals, to a large degree in the E and S meta categories, and somewhat less so in the leadership/g meta category. And although we are reluctant to identify a causal relationship between such volatility and corporate market values, stock returns or other performance measures, our findings indicate that changes in ESG can be observed in the short term which in turn suggests the potential materiality and value of ESG data. Greg Bala is Lead Data Scientist, TruValue Labs. Henrik Bartel is CEO, TruValue Labs. James Hawley is Professor, Department of Management, School of Economics and Business; Senior Research Fellow, Elfenworks Center for Responsible Business, Saint Mary s College of California; and Chief ESG Strategist, TruValue Labs. Yung-Jae Lee is Professor, Department of Analytics; and Associate Dean, Graduate Business Programs, School of Economics and Business, Saint Mary s College of California. 18. We compute CTV as a time series by applying a compounding rate in the compounding expression P(new) = P(old) x (1 + q x r) ^ (Dt), where Dt is the number of time ticks between events, and r is the compounding rate per time tick. The prevailing compounding rate r is based on a maximum metric goal M, and in our case we stipulate that if a company sustains a TruValue rating of 100 for an entire year, then it is rewarded with a 2x multiple at the end of the year. Anything below that diminishes the return rate by a factor q, and it is diminished negatively if the rating falls below a neutral value N, which is 50 in our case. Our particular time tick is in minutes so our parameters are set thusly: maxreturnratioperyear = 2, returnintervalinminutes = 365 * 24 * 60, r = Math.Pow(maxReturnRatioPerYear, (1 / returnintervalinminutes)) - 1 M = maxvalue = 100, N = neutralyvalue = 50, q = (TV(new) - N)/(M - N), TV(new) is the latest TruValue rating that triggered the scoring event. The very last value in the series spread over a particular interval, such as the six months here in our sample set, is the Compounded TruValue for that interval that can then be compared with that of other companies. 100 Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

102 Technical Appendix We developed a metric called Compounded TruValue (CTV) and applied it over the approximate six-month period during which the data was generated. 18 The CTV metric is a derivative quantity based upon the real-time TruValue time series that is intended to be accretive in nature (either positive or negative, depending of course on sustained sentiment performance of the firm). CTV is designed to show steady growth, or lack thereof, of a more rapidly varying, underlying sentiment function of time. The general intent is the important recognition of value over longer terms in these extra-financial areas, yet in a way that is different from conventional summary ratings. These longer-term indicators are based on underlying real-time series and are much more precise and consistent than other methods. For example, if we look at the accumulation of value over time (i.e. sustained better than neutral scores), we can accumulate them into this integral -like index, called CTV, showing what is analogous to compounded annual growth on the financial side. Figure 3 Distribution of CTV in the Environmental Meta Category Percentage of Tail Distributed from Median Compounded TruValue: Environment (representative S&P 500 companies) 60% 50% 40% 30% 20% 10% 0% -35% -30% -25% -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Compounded TruValue (% change) over the 6-Month Period July 19, 2014 through January 21, 2015 Figure 4 Distribution of CTV for the Social Meta Category Percentage of Tail Distributed from Median Compounded TruValue: Social (representative S&P 500 companies) 60% 50% 40% 30% 20% 10% 0% -35% -30% -25% -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Compounded TruValue (% change) over the 6-Month Period July 19, 2014 through January 21, 2015 Journal of Applied Corporate Finance Volume 27 Number 2 Spring

103 Figure 5 Compounded TruValue vs. Coefficient of Variation Volatility: Social (representative S&P 500 companies) [correlation = , RSQ = , p-value = ] 120% Coefficient of Variation Volatility over same period 100% 80% 60% 40% 20% 0% -30% -20% -10% 0% 10% 20% 30% 40% 50% -20% Compounded TruValue (% change) over the 6-Month Period July 19, 2014 through January 21, 2015 Figure 6 Compounded TruValue vs. Coefficient of Variation Volatility: Environment (representative S&P 500 companies) [correlation = , RSQ = , p-value = ] 120% Coefficient of Variation Volatility over same period 100% 80% 60% 40% 20% 0% -30% -20% -10% 0% 10% 20% 30% 40% 50% Compounded TruValue (% change) over the 6-Month Period July 19, 2014 through January 21, Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

104 Models of Best Practice in Integrated Reporting 2015 by Robert G. Eccles, Harvard Business School, Michael P. Krzus, Mike Krzus Consulting, and Sydney Ribot, Independent Researcher BI n March of this year (2015), we reviewed the reports of 25 multinational companies that participated in in the International Integrated Reporting Council s (IIRC s) Pilot Programme Business Network. 1 (See Table 1 for a list. 2 ) Pilot Programme companies worked as a network of peer group organizations to exchange knowledge about integrated reporting. These 25 randomly selected reports were among the first to be published since the IIRC International <IR> 3 Framework was released in December The publication of these reports gave us the opportunity to assess the extent to, as well as the effectiveness with which the companies have made use of the framework. Our aim in this article is to provide a brief review of the approaches and quality of this first batch of reports, and a sampling of best practices. We began our review with the assumption that there are three distinguishing marks of a truly integrated report one that is not simply the outcome of combining two separately conceived and prepared reports: (1) an explanation of a company s strategy for creating value and how it uses and affects the six capitals (Financial, Manufactured, Intellectual, Human, Social and relationship, and Natural) 4 ; (2) a clear and detailed explanation of the relationships between financial and nonfinancial performance; and (3) identification and effective presentation of the material risks and opportunities facing the company...for this reason, instead of attempting to assess the quality of entire integrated reports, we looked for examples of best practice by focusing on these three related elements: (1) Strategic focus; (2) Connectivity of information ; and (3) Materiality. To provide some objective basis for our assessments and choices, we established benchmarks for disclosures using the Guiding Principles and Contents Elements in the International <IR> Framework as well as suggestions regarding prioritization of stakeholders and the role of the board in the materiality process in our recently published book, 1. The IIRC Pilot Programme Business Network came to an end in September 2014 after three years of developing and piloting the principles and concepts behind integrated reporting. In its place, the IIRC established a business network of organizations committed to the adoption of integrated reporting. org/ir-networks/irbusiness-network/, accessed May Not all participants in the Pilot Programme, including some of those identified in Table 1, published an integrated report. Some continued to issue separate annual financial and sustainability reports, while others simply combined their financial and sustainability reports into a single document. The Integrated Reporting Movement. 5 By highlighting these requirements (summarized in Table 2) and the ways in which companies have attempted to satisfy them, we aim to provide a sense of how companies are doing as they apply the <IR> Framework to their integrated reports in Evaluating Strategic Focus As we argued in our book, A sustainable strategy is one that enables a company to create value for its shareholders over the long term while contributing to a sustainable society. 6 A high-quality integrated report not only explains a company s sustainable strategy, but also it establishes board and management accountability for creating value over the long term for all stakeholders. While companies explained their sustainable business strategies with varying degrees of thoroughness, SASOL, BASF, and AkzoNobel provided exemplary qualitative links between their overall strategies and the roles played by ESG factors in those strategies. At the same time, the reports of Crown Estate, Eskom, and Aegon were all distinguished by memorable uses of graphics to accomplish the same objectives. One trend that emerged in our analysis was the tendency of companies, particularly manufacturers, to connect their integrated strategy to product innovation, with specific changes in their development pipelines that reflect their goal of developing and marketing products that consume fewer resources. Meanwhile, companies that do not produce physical products, such as Aegon, the Dutch insurer and asset manager, linked their strategies to actions that leave their communities in better shape in terms of developing human capital or helping customers secure their financial future. In all cases, the companies left no question about the reason for including nonfinancial variables in their discussion of business strategy: The measurement and reporting of nonfinancial factors were essential to a fuller understanding of the businesses continued ability to operate in its context. 3. The authors use the International Integrated Reporting Council convention <IR> to denote the term integrated reporting. 4. International Integrated Reporting Council. The International <IR> Framework, pp Robert G. Eccles, Michael P. Krzus, and Sydney Ribot. The Integrated Reporting Movement: Meaning, Momentum, Motives and Materiality, New York: John Wiley & Sons, Inc., Ibid. p. 80. Journal of Applied Corporate Finance Volume 27 Number 2 Spring

105 Table 1 Reports Reviewed Company Country Industry AEGON NV Netherlands Financial services AkzoNobel N.V. Netherlands Chemicals ARM Holdings plc UK Technology hardware & equipment BAM Group Netherlands Construction & materials bankmecu Limited Australia Banks BASF SE Germany Chemicals BRF S.A Brazil Food Clorox Company USA Chemicals Coca-Cola Company USA Beverages Crown Estate UK Real Estate Management Diesel & Motor Engineering PLC Sri Lanka Industrial engineering Eskom Holdings SOC Limited South Africa Electricity Kirloskar Brothers Limited India Manufacturing Marks and Spencer Group plc UK General retailers Microsoft Corporation USA Software & computer services National Australia Bank Limited Australia Banks Novo Nordisk Denmark Pharmaceuticals & biotechnology Sainsbury s UK Food retail SASOL South Africa Chemicals Slater & Gordon Lawyers Australia Legal Services Stockland Australia Real estate investment & services STRATE South Africa Financial services Takeda Pharmaceutical Company Limited Japan Pharmaceuticals & biotechnology Tata Steel India Steel producers Telefónica S.A. Spain Telecommunications Table 2 Assessment Criteria Criteria Strategic focus Explain the time frames (short-, medium-, and long-term) associated with strategic objectives. Explain the strategic importance of material risks and opportunities in the discussion of business strategy. Explain how the company plans to use the capitals and the impact of business activities on the capitals.) Reference <IR> Framework 4.27 and 4.28 <IR> Framework <IR> Framework 3.3. Connectivity of information Explain how financial and nonfinancial performance impact each other. <IR> Framework 3.8 and Link and explain the relationships between <IR> Framework Content Elements. <IR> Framework Materiality Explain material risks and opportunities in greater detail, especially in terms of known or potential effects on financial, environmental, social, or governance performance. Identify the time frames (short-, medium-, and long-term) associated with material risks and opportunities. <IR> Framework 3.17, 3.18, and <IR> Framework 3.18 and Prioritize material risks and opportunities based on their magnitude/importance. <IR> Framework 3.18 and Prioritize the perspectives of stakeholders consulted. Explain the role of the board of directors in the materiality process. The Integrated Reporting Movement, Chapter 5. Eccles, Krzus, and Ribot, The Integrated Reporting Movement, Chapters 5 and 6. Eccles, Krzus, and Ribot, <IR> Framework Journal of Applied Corporate Finance Volume 27 Number 2 Spring 2015

106 Figure 1 SASOL s Use of Natural Capital Our value creation scorecard Managing the critical capital input we require The resources and relationships that are critical to our ability to create value are all interdependent, which, at times, necessitate certain trade-offs between them. In managing these trade-offs, we aim to minimise our negative impacts on the capital inputs and maximise positive outcomes, in the interests of all our stakeholders. Relevance Natural capital As an integrated hydrocarbon monetiser, we make a substantial net-positive contribution to most of the capital inputs. However, we acknowledge that the key natural capital inputs to our business are non-renewable resources, which may impact negatively on human and social capital. For example, by competing for resources such as water. Our strategic decision not to pursue coal-to-liquids growth, but to focus, instead, on gas as a bridge to a low-carbon economy, demonstrates our commitment to reducing the negative impacts of our operations on natural capital. We also invest significantly in reducing our own environmental footprint and in enhancing the environmental contribution of our products and processes. Key capital inputs Coal (kilotons) Crude oil (kilotons) Natural gas (kilotons) Water (cubic metres) Total energy use (gigajoules) Oxygen (kilotons) Nitrogen (kilotons) Other (e.g. Chemicals) (kilotons) Land area used (hectares) * The increase in area affected by operations is due to the inclusion of two new mine projects: Impumelelo and Shondoni. Outcomes (impacts on the capital) GHG emissions (Scope 1 & 2) (kilotons) Nitrogen oxides ( NOx) (kilotons) Sulphur oxides (SOx) (kilotons) Particulates (fly ash) (kilotons) Liquid effluent (cubic metres) Total waste (kilotons) Activities Applying a risk-based approach to integrating environmental considerations into our decision-making, with clear performance targets, policies and procedures. Investing more than R20 billion in the last 10 years in capital projects to minimise our environmental footprint. Continuing to invest in research and development (R&D), and form partnerships with industry leaders, to find innovative environmental solutions. Partnering with municipalities and communities to reduce water usage and minimise air pollution. Implementing a product stewardship strategy to minimise the impacts of our products through their life cycle, and identifying opportunities to use our products to assist customers to reduce their environmental footprints. Working to set new Greenhouse gas ( GHG) mitigation targets separately for our South African and international operations, including updated energy efficiency targets. Working with our partners in Canada to ensure the hydraulic fracturing process is conducted safely and in an environmentally responsible way. Securing feedstock for our coal requirements as part of our commitment to extending the lifespan of our existing assets in Southern Africa to Source: SASOL. Annual Integrated Report 2014, p.10. The integrated report of SASOL, a South African integrated chemical and energy company, explained its main value proposition as doing more with less: Our unique value proposition remains our ability to convert coal and natural gas into high-quality fuels and chemicals, and low-carbon electricity, using our proprietary technologies. 7 The report explains not only what the company is doing to meet the challenges of nonrenewable resources, but how and why it is in their interests to use fewer resources to make their products. As a result, readers can readily see that company efforts to reduce emissions and increase productivity come from a strategic vantage point for shareholders as well as for society. 7. SASOL. Annual Integrated Report p.26. Journal of Applied Corporate Finance Volume 27 Number 2 Spring