Download Becoming an Expert Investor: Combining Analysis and Intuition

Long Horizon Investing
and
Extra Financial Factors
James O’Loughlin,
JOL Consulting Ltd
Two Questions
• Who put the “bop” in the “bop
sh-bop sh-bop?”
• Who put the “extra” in “extra
financial factors?”
Extra-Financial Factors
• Include but not restricted to
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Intellectual capital management
Human rights
Occupational health and safety
Human capital management
Innovation
Research and development (R&D)
Customer satisfaction
Climate change
Corporate governance
Consumer and public health
Reputation risk
Environmental and social impacts of corporate activity
Plan of the Presentation
• The opportunity for long horizon
investing and enhanced analytics
• A new generation of investor
• How fund managers might use extra
financial factors
• Partnership for investing
• The additional prize
• Getting from here to there
The Disconnect
• Sophisticated
analysis
• Short-term and
narrow focus
DCF valuation
Earnings-based
models
Considered
treatment of
intangibles
heuristics
Single period
PE ratio
analysis
Pattern Recognition
The Investor’s Task
• Pattern recognition
 See what we expect to see
EPS
Sales
Growth
Pricing
 ‘Blindness’
f
m
Corporate
Gov’nce
Equity
Value
ROIC
l
k
Cost of
Capital
M&A
h
i
j
Profit
Margins
• Salience
g
 Tangibility
 Measurability
 Trustworthiness
 Ambiguity aversion
 Truncation
Extra-Financials Defined
Extra-financial factors are those which are
likely to have at least a long-term effect on
business results but which lie outside the
customary span of variables that get integrated
into investment decisions, irrespective of
whether they are part of the research process.
• Not an artifact of the data
• An artifact of our proclivity to pay attention to
salient data and to process it according to
learned models
The Opportunity for Long Horizon
Investing and Enhanced Analytics
• Industry-wide focus on narrow financial
indicators of corporate performance
• Diversity siphoned from investment
decision making
• Alpha left on the table for investors who
know better
• Widespread misallocation of capital
 With additional knock-on consequences
Enhanced Analytics for a New
Generation of Investor
• Enhanced Analytics Initiative (EAI)
 Over $1 trillion under management
 Minimum allocation of 5% of brokerage commission
 Incentivises broader and longer-term perspective
• A new Generation of Investor
 Novel data in familiar and trusted format
 Required knowledge
 Appropriate models
 Greater salience
Sources of Alpha
• Existing extra-financial information overlooked
 R&D intensity
 Pro-shareholder corporate governance structures
 Minority shareholder rights
 Eco-efficiency
 Human capital management
• New extra-financial information priced in slowly
 Accruals as extra-financials
 Corporate governance
Corporate Governance as Exemplar
0.2
0.15
0.1
Raw Returns
0.05
0
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
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-0.1
-0.15
-0.2
Months
Coming-into-Compliance
Always-in-Compliance
Never-in-Compliance
The Case for Diversity
• Fund manager
experience
 Expand set of variables
 Deliver new perspective
• Radars retuned
 Relevant information
finding them
 Sufficient diversity not
preordained
How Fund Managers Might Use
Extra-Financial Factors
• Individuals
Staff
Brand
Training
Power
Eco
Growth
Efficiency
 Use a realistic model
Minority
Pricing
Rights
 Apply filters
 Consult a checklist
f
m
Corporate
Gov’nce
Equity
Value
g
ROIC
l
k
h
i
j
• For organisations
 Join EAI
 Develop in-house capability
Profit
R&D
Margins
Cost
Climate
of
Change
Capital
M&A
 Deliver data in usable form
 Encourage desired
behaviours
A Partnership for Investing
•
e
e
e
e
 Explain contribution of extra-
Staff
Training
e
Eco
Efficiency
financials
 Enable comparison
 Communicate consistently
Minority
Rights
e
e
f
e
Corporate
Gov’nce
CEOs and CFOs
m
Equity
Value
ROIC
l
•
g
k
Trustees and consultants
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h
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j
Climate
Change
R&D
M&A
•
Develop indicators of short-termism
Gather evidence
Check quality of data
Review models
Build necessary resource
Unions
 Reject dogma
 Focus on systemic issues
The “Additional” Prize
• Permanent gains factored into higher
asset prices
 Productivity effect
 Growth effect
 Risk effect
• Better alignment of investment
processes with long-term needs
 End beneficiaries
 Investee companies
Getting to Here from There
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GRAY
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GREEN
PINK
BROWN
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BLACK
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Getting to Here from There
RED
BLUE
GREEN
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BLACK
YELLOW
GREEN
ORANGE
GREEN
RED
PINK
BLACK
BROWN
YELLOW
GRAY
BLUE
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GREEN
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Conclusion
• We put the “extra” in “extra-financial
factors”
 Leaving alpha available
 Misallocating capital
• EAI addresses oversight at source
– Redefines salience
– Promotes diversity
• A new generation of investor emerging
 Informed partnership
 Additional prize
The Lexicon of Investing
“When an investor systematically
integrates all relevant variables
into their decision making there is
no such thing as an extra-financial
factor: just enhanced analytics.”
Hendrik du Toit
Seeing What We Expect to See
Corporate Governance as Exemplar
10.00%
9.50%
9.00%
8.50%
8.00%
7.50%
7.00%
6.50%
y-1
y
Always-in-Compliance
y+1
Coming-into-Compliance
y+2
y+3
Never-in-Compliance