THE TOBACCO TABOO WILL IT ALL GO UP IN SMOKE? OCTOBER 2013

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1 THE TOBACCO TABOO WILL IT ALL GO UP IN SMOKE? OCTOBER 2013

2 THE TOBACCO TABOO WILL IT ALL GO UP IN SMOKE? AN INVESTMENT PERSPECTIVE FROM MERCER S RESPONSIBLE INVESTMENTS TEAM. Has tobacco become a dirty word within investment portfolios? Mercer s Dr Richard Fuller reveals that the major impetus for a divestment of tobacco stocks has been risk to reputation, and that attitudes within the investment industry to tobacco have potentially reached a tipping point. In the past, a prohibition on tobacco investments would typically have been permissible in three broad circumstances: For a traditional ethical investment provider - in which case negative screens would generally have been applied against other so called sin stocks across the portfolios. For a particular product option in an investment range i.e. members able to choose a tobacco free option from alternate offerings that do invest in tobacco. For an investment fund where tobacco was regarded as impossible to reconcile with the core purpose and values of the fund s organisation for instance, cancer councils and medical research foundations. However, outside the delineation of these tobacco-free preserves the exclusion of tobacco otherwise required some real contortions. The arguments against divestment from tobacco included: reducing the investable universe would hurt returns; exclusion is not in the direct economic interests of members therefore it runs counter to (in spirit at least) fiduciary obligation and the sole purpose test; and as much as we may personally dislike tobacco, it remains a legal product. What s more, tobacco stocks generally performed well. This is still valid, with an investment case supported by an expected growth in returns due to sales expansion by tobacco companies in emerging markets. While the social and regulatory environment in Australia suggests a decline rather than growth in sales, this is not the case in many other markets. The arguments for the anti-tobacco proponent generally involved what were then seen as reasonably nebulous considerations of reputation: the reputation of the investor i.e. it isn t a good look to be investing in a product that kills our members or policy holders; and the economic impact of a deteriorating tobacco company reputation i.e. this company will lose value as regulation on tobacco tightens. The problem was, however, that this was hard to quantify and it was often a long term consideration, leading to the view that divestment could happen at a time closer to any price collapse. And a final frequent argument (this time in favour of divestment) was that it s only a small part of the portfolio in any case, so we may as well get rid of tobacco. Tobacco investments currently include a choice of 13 listed companies, which equates to around 1.46% of the MSCI AWCI as at 30 June 2013 (Note, there are no tobacco companies listed on the Australian exchange any longer). However, despite perceptions around exposure, the practicality of managing this screen as part of a pooled fund as opposed to a mandate is, however, a valid consideration. The upshot was often that the status quo (investing in tobacco) remained in the default position: put it on the agenda for review again next year. However, in interesting recent developments, the context for these debates seems to have changed a tipping point appears to have been reached. A new kind of just do it philosophy has entered the decisionmaking process. The shift in the Australian context seems to have created a bigger space for tobacco divestment. It may be said that reputation and the significance of reputation in terms of competitive advantage have grown as factors to be considered in the economic case for divestment. 2

3 REGULATION EFFECTS There is another potent factor in this equation beyond broad social change and that is regulation. If there is a new social predisposition to divestment then changes in the regulatory framework, especially in relation to disclosure, will almost certainly deepen and accelerate that shift. Regulatory change is most evident in the superannuation industry with new portfolio holdings disclosure requirements scheduled to come into effect from mid It is our view that this level of disclosure and transparency will become the industry standard and expectation of this level of disclosure by stakeholders will come (relatively quickly) to be expected of all large institutional investors including insurance companies, and endowments and foundations. These requirements will, in effect, mandate a new level of transparency. For the first time there will be an ability to look through to investments in individual companies and other investments made by a fund. Whether tobacco stocks are held and how much will become visible. Of course many institutional investors already disclose portfolio holdings, often via disclosure of share voting records, but most do not and this will become for institutional investors a new consideration in reputation management. It should be added, that tobacco will not be the only investment to attract interest. The new transparency will attract interest from members, stakeholders, and special interest groups on a range is issues such as, for example, carbon intensive assets. Whether a change is ascribed to prospective regulation, broad social change, or a mix of the two, there really is little doubt that tobacco divestment has intensified in recent times. NSW government funds (such as the NSW Worker s Compensation Investment Fund) have been directed to get out of tobacco, with similar scenarios in the ACT last year and South Australia this year. Australia s Future Fund has elected to divest this year, consistent with sovereign wealth funds in Norway, New Zealand and five US states. The superannuation sector in Australia also seems to have embraced divestment with the list of funds now including HESTA, First State, Local Government Super, State Super, Unisuper, Christian Super, Sunsuper, VicSuper, and GESB. 3

4 INDUSTRY TRENDS SUPERANNUATION For super funds, the key arguments for divestment are connected with the reputation of the fund. This is related to the increased capacity that social media and other technology has to improve engagement and dialogue with members, but this seems to be particularly important where at least some part of the membership has some connection to the health care sector. State Super chief executive John Livanas is quoted as saying in The Insto Report s May article, Super funds call it quits, The board has reviewed the environmental, social and governance (ESG) merits of investment in tobacco securities and has decided to divest its holdings in tobacco product manufacturers. Certainly there will be an attempt to quantify this reputation risk (via market analysis, surveys), however, the important driver is a sense that things have moved on that there is now a gap and a disconnect between status quo investment practices and members attitudes. This gap represents a real (albeit mostly potential) risk for funds in terms of member retention and new members. INSURERS For insurers, key arguments for divestment are deeply connected with corporate reputation, with health insurers having a more direct connection. Typically health insurers factor in the financial claims connection to tobacco by excluding coverage for smokers or charging a higher premium. However, insurance brands are associated as being an integral part of the social fabric and tobacco is increasingly seen as being at odds with this image, creating the threat to corporate reputation. Divestment in the insurance sector is currently very limited, but this is clearly growing as an issue and is a consideration in terms of both corporate bonds and equities. ENDOWMENTS AND FOUNDATIONS For endowments and foundations, these organisations tend to have some of the most engaged and thoughtful stakeholders, making the shift in the Australian political and social context on tobacco potentially more paramount. The risk of a disconnect between the stated aims of organisations and their investment practice is not to be underestimated e.g. universities banning smoking on campus but still profiting from investing in tobacco. Harvard and City University of New York are two examples of recent divestment, with Harvard President Derek Bok acknowledging a desire not to be associated as a shareholder with companies engaged in significant sales of products that create a substantial and unjustified risk of harm to other human beings and the City University of New York noting that owning stock in a company whose purpose is to addict to a lethal drug as many young people as possible calls our educational leadership into question. For this reason, divestment has been implemented already in this sector, but it is anticipated that this will accelerate. CONCLUSION The argument regarding investing in tobacco stocks appears to have been flipped, with the onus now on those who would argue for continuing investment. The tenor of the discussion has altered. Before it was enough to state there was a cost involved in prohibition it was a violation of principle, of modern portfolio theory, and that was the end of the matter. Now it seems that cost is now measured in terms of reputational backlash which potentially outweighs cost of divesting. Mercer believes that investors should understand that the tide is turning on attitudes towards tobacco as a source of investment returns and there is increasing pressure to divest. Investors should quantify what tobacco divestment would mean in terms of risk and return, and weigh up any cost against the potential impact on brand equity thus member retention of continued investment in tobacco. Mercer can help investors quantify the impact of tobacco divestment on the overall portfolio and advise on a strategy for divestment. We can also help with a cost benefit analysis in terms of their own fund and against a peer group and the risk that they may encounter if they are perceived to be behind the eight ball on this issue. Please contact Dr Richard Fuller on (03)

5 For more information contact Dr Richard Fuller on or visit Important notices This document has been prepared by Mercer Investments (Australia) Limited (MIAL) ABN , Australian Financial Services Licence # This contains confidential and proprietary information of Mercer and is intended for the exclusive use of the parties to whom it was provided by Mercer. Its content may not be modified, sold or otherwise provided, in whole or in part, to any other person or entity, without Mercer s prior written permission. The findings, ratings and/or opinions expressed herein are the intellectual property of Mercer and are subject to change without notice. They are not intended to convey any guarantees as to the future performance of the investment products, asset classes or capital markets discussed. Past performance does not guarantee future results. Mercer s ratings do not constitute individualized investment advice. This does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances. Information contained herein has been obtained from a range of third party sources. While the information is believed to be reliable, Mercer has not sought to verify it independently. As such, Mercer makes no representations or warranties as to the accuracy of the information presented and takes no responsibility or liability (including for indirect, consequential or incidental damages), for any error, omission or inaccuracy in the data supplied by any third party. MERCER is a registered trademark of Mercer (Australia) Pty Ltd ABN Copyright 2013 Mercer LLC. All rights reserved.