Assessing ESG risks
We assess a company’s ESG risks throughout our investment process, particularly during our ‘risk assessment’ stage. To assess a company we gather data from multiple sources:
- annual reports
- financial statements
- meetings with company management
- site visits
- industry contacts
- industry publications, and
- a company’s ESG policy.
Our assessment of ESG factors is qualitative. In many instances it can be difficult to determine the cash-flow impact on a business. However, where we can make a proper impact assessment, we will capture it in our valuations.
Significant ESG risks
We believe some ESG factors pose significant risks to the value of a firm if they are mismanaged. These include:
- Air, water and land pollution (e.g. carbon dioxide)
- Destruction of water or land (e.g. mining)
- Occupational, health and safety (e.g. time lost, injury frequency)
- Human rights (e.g. child labour)
- Health (e.g. tobacco)
- War (e.g. weapons)
- Board skills/tenure/independence
- Audit, nomination and compensation committee independence
- Conflicts of interest
- Shareholder rights
- Transparent communication
- CEO behaviour
Of all the ESG factors, we believe a CEO’s behaviour is one of the most important because their actions can directly lead to a company’s economic value creation or erosion. Even within the boundaries set by an independent board, a CEO has a lot of flexibility in terms of how they manage their company. If CEO behaviours are not properly monitored, their decisions can lead to corporate collapse as evidenced by HIH Insurance, Enron and Royal Bank of Scotland.
The common element among many corporate collapses is an overconfident CEO suffering from hubris who overestimates their ability to control a bigger company. Typically, these dominant CEOs create a ‘group-think’ environment either directly (remuneration) or indirectly (culture) to ensure they are not challenged by constructive feedback. In an ‘emperor wears no clothes’ environment, these CEOs tend to over-commit on projects or acquisitions, which eventually erode shareholder value.
Overconfident CEOs typically behave in the following way:
- Enjoy positive media attention (Malmendier and Tate, 2005)
- Large size of CEO’s portrait in the company’s annual report (Chatterjee and Hambrick, 2007)
- Greater reference to the CEO in company press releases (Chatterjee and Hambrick, 2007)
- Greater use of first person singular pronouns (Chatterjee and Hambrick, 2007)
- Greater size of CEO’s compensation relative to senior executives (Chatterjee and Hambrick, 2007)
- Hold in the money options (Malmendier and Tate, 2005)
Corporate growth strategy
- Greater capital expenditure programs (Malmendier and Tate, 2005)
- Serial acquirers (Malmendier and Tate, 2008)
- ‘Diworsify’ into other industries (Malmendier and Tate, 2008)
- Overpay on acquisitions (Hayward and Hambrick, 1997)
- Pay less dividends to increase retained earnings (Deshmukh, Goel and Howe, 2010)
- Prefer using more cash for acquisitions (Malmendier and Tate, 2005)
- Prefer higher debt levels and issue debt more often (Hackbarth, 2008)
- Less conservative accounting practices (Ahmed and Duellman, 2013)
- Less candid communication (Ahmed and Duellman, 2013)
- More management forecasts (Hribar and Yang, 2016)
- More optimistic forecasts (Hribar and Yang, 2016)
- More forecasts with a narrow range (Hribar and Yang, 2016)
- Likely to misstate earnings (Schrand and Zechman, 2011)
We recognise highly confident CEOs are often required for young, growing companies or companies in innovative industries where they thrive on competition and are the firm’s force for creativity. This type of CEO (for example, Walt Disney, Steve Jobs and Jeff Bezos) can create tremendous shareholder value because they galvanise all stakeholders to embrace their vision to create entirely new products. However, they also tend to over-commit on internal projects (for example, having a large research and development budget), which sacrifices short-term profits to create future value (Hirshleifer, Low and Teoh, 2012).
We also recognise in mature companies, a CEO’s hypercompetitive drive can create a destructive workplace of group-think and bullying. Alternatively, a CEO with a long history of success in a mature company may breed an environment of complacency because of their ‘halo’ effect. Without constructive feedback, these CEOs may over-commit on external projects (for example, large acquisitions) which may eventually lead to shareholder value erosion.
Having an inflated sense of self-worth is not a prerequisite to shareholder value erosion, but it is a potential warning sign. It is only when an overconfident CEO is placed in the wrong environment, that the seeds for poor future returns are sowed. Greater vigilance is required to monitor governance issues under these circumstances.
We actively vote at annual or extraordinary general meetings. The team reviews all company resolutions, with Vertium’s portfolio managers responsible for the determination of our votes.
We record all of our voting activities.
As a shareholder, we will engage with companies if we identify an ESG issue. If we deem the risk to be serious, we will write to the board and senior management and continue monitoring the risk. If an ESG risk becomes too great, we will not invest in the company.
We record all ESG issues raised with companies.