Q A spate of corporate scandals have rocked the investment industry. What should investors and fund managers do to avoid some of the losses that portfolios have experienced recently?
When I joined Investec Asset Management, CEO Hendrik du Toit said to me: “Do the right thing.” Responsible investing is at the heart of what we do. Our purpose is to invest clients’ capital in a responsible manner, to preserve and grow the real purchasing power of their capital.
In 2001 when Enron imploded, their auditors, Arthur Anderson, went down with them. Everyone blamed Arthur Andersen for what had happened. As a result, regulators got together and codes of governance around the world exploded in an effort to prevent such issues in future. These codes speak to the three pillars of governance – the shareholders, the board, and the auditors. Each of the three pillars has unique roles and responsibilities in an overall system of governance. If any of these material role players don’t do what they should be doing, clearly, there is the potential for capital losses.
The executives of a company have the prime responsibility of implementing strategy and putting a solid governance structure in place, which includes a robust risk management system and an appropriate incentive scheme. The three pillars need to hold one another accountable. The directors have to hold the executives to account; the shareholders need to actively engage with directors; and the external auditors need to provide assurance to the directors and shareholders that their financial statements are accurate. So the whole system has to work.
Q Are the regulatory watchdogs doing enough?
The regulatory watchdogs create the structure in which a regulatory and governance system should operate. The regulations governing the three pillars are included here. These regulations have to be maintained and updated; innovation needs to be applied in terms of what is happening internationally, but ultimately, the regulations are implemented by human beings not computers. It’s a behavioural and professional issue – are the role players in the governance system actually doing what they should be doing? Shareholders, board members, management and the auditors, all need to take responsibility.
We regularly engage boards to discuss governance issues, which allows us to get a better insight into the real dynamics and skill set of board members. The announcement of the Steinhoff accounting irregularities, and the resulting destruction of shareholder value, highlight the need for an acute sense of responsibility from all role players in the governance system.
Q Do we see more corporate scandals in SA than in rest of the world?
It happens all over the world: In the UK, the latest example is Carillion. Our King Code is considered to be the leader in the world in terms of governance guidance, but ultimately it is about people doing what they should be doing. We have one of the best stewardship codes in the world – the Code for Responsible Investing in South Africa. Furthermore, Regulation 28 of the Pension Funds Act requires us to take into account material environmental, social and governance (ESG) factors. We cannot really complain about our frameworks.
Q How do you incorporate responsible investing in your investment process?
When we consider investment opportunities, our investment philosophy is focused on the sustainability of earnings over the long term and whether the valuation is reasonable. We need confidence that the earnings built into our analysts’ models will come through, and in turn, this leads to a conviction to allocate capital to these opportunities. The link between earnings and responsible investing is the system of governance. Confidence in the system of governance gives us conviction about the earnings that we are projecting into the future. So responsible investment is the integration of governance in fundamental analysis, and active ownership.
There are different pathways to active ownership. Our investment philosophy incorporates an engaged, predominantly collaborative relationship between investors and corporations to encourage sustainable value creation. We vote at all meetings and engage on material issues to preserve and grow the real purchasing power of our client portfolios. This responsible investment approach can change from collaborative to assertive engagement if we become concerned about material corporate governance or strategy issues. We believe our approach is in the best interests of our clients and in direct contrast to the short-term, often adversarial, route adopted by activist investors to extract value from a company.
An integral part of our responsibility as active shareholders, is to ask tough questions to management and board members on ESG factors. David Couldridge, Head of Investec Asset Management ESG Engagement, always reminds me that “ESG is about responsible investment, not compliance, and needs to be integrated before the allocation of clients’ capital. Active engagement continues after we have built a position.”
We believe effective engagement and proxy voting can reduce risk and improve governance by influencing the way that businesses operate. We regularly interact with companies about the tenure of board members and the rotation of board members. In many of these cases we were a serious voice in effecting change. Developments over the last few months have highlighted the importance of directly engaging with the audit committee of boards. An audit committee is a sub-committee of the board; it holds the direct line to the internal and external auditors and is responsible for the compliance and the governance framework. While it is important that the three pillars of governance work well together, it is also key to engage on a sub-committee board level – be it on auditing, remuneration, transformation or succession planning.
Proxy voting is also an important tool of responsible investing – are the directors with the right skills on the board? Is there diversity? Where appropriate, we vote against companies’ remuneration proposals. We want to ensure there are prudent incentives in place that encourage the creation of sustainable value over time. If that is in place, there is less risk that our clients’ capital will be impacted negatively.
We also actively encourage companies that have an impact on climate and the environment to implement the TCFD (Task Force on Climate-related Financial Disclosures) framework. This framework requires companies to disclose what governance it has in place to manage climate risk; what the specific risks and opportunities are; what scenario planning it has been doing; and what metrics it is going to use to ensure it reduces its risks.
Q What steps do you take to mitigate the risk of excessive losses from a single investment that goes bad?
We build diversified portfolios to achieve the best possible risk-return profile for our clients. It will be incredibly difficult to spot the next corporate scandal. But we believe the rigour of our investment process, and the way in which we approach fundamental analysis (earnings and reasonable valuations), together with our integration of material ESG factors, give us the opportunity to exercise active ownership.
Large, well-run companies that have large stock market index weights are very often going to sensibly have a reasonable weighting in client portfolios. There is nothing wrong with this. What is important, however, is that we match our level of investment conviction with the size of the absolute and active position, and ensure that any investment is consistent with our overall investment philosophy. Our risk management framework is key. We limit the amount of absolute and relative risk in a portfolio coming from one individual stock or idea – a well-constructed portfolio consists of a blend of a number of differentiated ideas, not just one dominant idea. Lastly, there are numerous specific ‘hygiene’ research considerations to ensure that risk is not excessive, including balance sheet strength, level of accounting aggression and exposure to external uncontrollable variables.
Q What lessons can be learnt from the recent corporate scandals?
One of the lessons is valuing independent, investigative journalism. Society will always need watchdogs and they can come from various quarters. Journalists and NGOs can balance out the Wall Street ‘sell-side’ influence of our industry. Furthermore, there is a lot of pressure on businesses to perform. So there is a danger that executives can cross the line, to make management look like super heroes delivering super profits. Journalists have a unique vantage point and are able to raise issues that may not necessary come to light during boardroom engagements.
Clever people can rationalise to get around rules, but only effective leadership and sound judgment can ensure good governance. Good corporate governance should, in the long term, lead towards both better corporate performance and improved shareholder value.
We need to grow our clients’ money in real terms, but a key part of that is active ownership, to make sure that ‘the right thing’ happens inside a business. That is why you have board members and sub-committees that cover areas such as auditing, remuneration and transformation. It all comes back to the importance of integrating governance into investment analysis and decision-making. Better governance improves confidence in our investment thesis.
All information provided is product related, and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Past performance is not necessarily a guide to future performance. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. This is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA). Issued by Investec Asset Management, August 2018.