Environmental, Social, and Governance (ESG) Investment Integration
Bill Nygren, CFA, Partner & CIO of Oakmark Funds, a $123 billion value-oriented asset manager, recently discussed their approach to “ESG” (environmental, social, and governance) investing in his second-quarter market commentary. In simple terms, ESG investing is the integration of environmental, social, and governance best practices and considerations throughout the investment process. Oakmark does not offer specific ESG branded investment offerings as they believe ESG has been a major component of their investment process for decades. Bill discusses the importance of incentive alignment, capital allocation, diversity of thought, and Oakmark’s approach to the “G” in ESG investing.
“Oakmark’s thinking on ESG probably differs from what you’ve read: We don’t offer ESG strategy funds because to us, these factors, along with many others, have always been an integral part of good long-term value investing. In this commentary, I’ll cover Oakmark’s thoughts on governance in relation to our Funds’ selection of undervalued stocks. Governance is a back-burner issue for investors who trade their portfolios frequently. When you only hold a stock for a few months, it barely matters. But when your holding period is measured in years, like it is for Oakmark, governance can be the difference between success and failure.
Single proprietorships don’t have the same governance issues as publicly traded companies. The owner is usually the operator and can see that maximizing personal wealth is accomplished by maximizing the long-term value of the business. In publicly traded companies, however, the owners are shareholders who are dispersed and, therefore, are represented by a board of directors. The board in turn hires the CEO who, along with the board, sets and implements strategy. Day-to-day decisions are made by the CEO who reports regularly to the board. The control of the owners, the shareholders, is limited to electing the board of directors.
When checklist-based investors evaluate corporate governance, they often look for separate individuals serving as CEO and chairman of the board, executive pay at or below peer levels, equal voting rights for all classes of stock, and gender and racial diversity of the board. If those boxes are checked, many analysts would give that company a good grade on governance.
We don’t think it’s that simple. The majority of Oakmark holdings have separated the CEO and chairman roles. However, we are open to investing in those that haven’t once we’ve gained an understanding of board dynamics, including the influence and independence of the lead director. Oakmark opposes excessive executive compensation for mediocre results. However, we want salaries to be high enough to attract talented individuals and any additional compensation to be tied to exceptional performance that benefits all shareholders. We prefer to invest in companies where each share gets one vote. However, we are willing to invest in companies where founders own super voting shares if management compensation is strongly tied to growth in business value.
Last, and certainly not least, Oakmark believes a good board must be diverse. When we evaluate diversity, we look well beyond what can be seen in the board photos. What we most highly value is diversity of thought, which is enhanced through areas, such as diversity of age, geography, background, experience and professional expertise, in addition to race and gender. We want the companies we invest in to either have diverse boards or be actively working to improve diversity.
Importantly, board members with different business backgrounds can be a valuable resource for the CEO. As Dambisa Moyo states in her book How Boards Work, “Someone interested in gaining a place on a corporate board must ask themselves: Who from the management team would call me for advice, and when and why?” We always ask new CEOs to assess the board they inherited and explain what skills they would like in new members. That almost always gives us a better understanding of both the business and the person running it. We view it as a giant red flag when a CEO sees the board as a necessary evil and wants to add new members who will merely rubber stamp their proposals. In contrast, we like it when a company that’s expanding globally seeks to add a new board member who has successfully done just that at their company. In our view, a diverse board is more valuable to the CEO than outside consultants.
Looking beyond these common considerations, other governance issues can have even more impact on the success or failure of Oakmark’s long-term investments. We believe it is important to learn as much as we can about the people managing the businesses we own. Most importantly, we want to understand what their long-term goals are and make sure they align with Oakmark’s. During our engagements with management teams, we spend a lot of time discussing the board’s philosophy toward allocating capital. We want independent directors to have a history of optimizing capital allocation in businesses they’ve run or, at a minimum, have the background to understand how businesses create value.
It seems obvious to us that the best use of capital is to invest where the company has a meaningful competitive advantage to enhance growth either organically or via acquisition. Those investments usually return well above the cost of capital and, therefore, increase the value of the company. Many companies, however, produce more cash than they can reinvest at high returns. This is especially common for holdings of value investors, who—for the right price—are willing to own businesses with below-average growth opportunities. For these companies, deploying excess cash could be management’s most important challenge. This high-class problem has only three solutions:
- The company can deleverage by either reducing debt or increasing cash reserves,
- The company can invest in unrelated businesses, either internally or via acquisition, or
- The company can distribute capital to its owners, either as dividends or by repurchasing shares from current owners.
We rarely own companies that we think have too much debt, so we’re not big fans of using excess capital for deleveraging. We’re also opposed to capital being used to start or acquire unrelated businesses. That doesn’t mean, for example, we don’t want Alphabet and Facebook to invest in autonomous vehicles and augmented reality. Given their engineering talent, we view those as competitively advantaged investments. What we oppose is a company diversifying into an area where it has no advantage, such as the recently written down media acquisitions of legacy telephone companies.
When a company earns more than it can invest where it is competitively advantaged, we’d like the excess returned to shareholders. CEOs who are focused on ego gratification or on maximizing their personal income rarely want to give money back to the owners. Because the board is our best check against empire building, we carefully analyze how they compensate management: Does management own a meaningful amount of stock? Are incentive plans based on total sales or net income, which reward making unrelated investments? Or are they based on other factors, such as return on capital, that encourage giving excess cash back to the owners? We would much rather receive a dividend and invest it ourselves than have the company invest it where it isn’t competitively advantaged. We want the path that maximizes personal income for a CEO to be the same path that maximizes long-term business value.
We generally prefer share repurchase to dividends because we only own stocks we believe are worth more than their current price. If our analysis is accurate, then dollars invested in repurchase immediately have a positive return. Share repurchase is often criticized as a non-recurring boost to earnings per share that comes from increasing debt. But mature businesses that consistently produce excess cash can routinely repurchase stock without increasing their leverage. The sustainable boost to earnings per share growth that comes from decreasing the denominator (shares outstanding) is just as valuable as the growth that comes from increasing the numerator (net income). And unlike an acquisition, share repurchase does not require paying a premium, does not divert management attention, does not produce restructuring costs and does not expose us to the risk that the seller knew something the buyer didn’t. While most companies today at least pay lip service to “maximizing shareholder value,” we believe the best management teams strive to maximize long-term, per share value.
Some investors like to buy shares in companies that are not maximizing long-term value and then fight for change. We would rather avoid poorly run businesses and invest only in those that are already well-managed. Experience has taught us that bad management teams can destroy a lot of value while “activist investors” push for change. We don’t often have to vote against management in proxy contests because we voted “no” by avoiding the bad actors in the first place. When we disagree with strategic decisions our managements make, we first engage with them privately. Then if we are not satisfied, we escalate to private engagement with the board. After that, if we still believe management is doing the wrong thing, we typically sell the stock and move on. In rare cases when we conclude management is acting against our interests and the stock appears much more undervalued than alternative investments, we will maintain our investment and be public about our desire to replace management.
In conclusion, commonly cited good governance checklists barely scratch the surface of what we want to know about the businesses we own. When you expect to own a company for five or more years, like we do at Oakmark, accurately assessing corporate governance is just as important as accurately valuing the business.”