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  Business   In Other News  09 Jan 2020  Should the Business of Business be Just Business?

Should the Business of Business be Just Business?

Published : Jan 9, 2020, 12:42 pm IST
Updated : Jan 9, 2020, 1:15 pm IST

The total market value of the stock of Asian Paints (its ‘market capitalization’) at around Rs1.7 trillion .

An ESG focused business, while creating value through increasing the size of the economic profits.
 An ESG focused business, while creating value through increasing the size of the economic profits.

There is increasing evidence that portfolios weighted in favor of companies with higher Environmental, Social and Governance (ESG) scores outperform their benchmarks (Financial Times, August 12 2018: “Companies with strong ESG scores outperform, study finds”; “Morningstar’s ESG Indexes Exhibit Attractive Investment Attributes”, Morningstar, March 2019). And this outperformance is across geographies, across sectors, and independent of company size. 

So what could explain this out performance of portfolios containing stocks of businesses that are perceived to be operating in ‘good’ ways? Asset prices (in this case stock prices), we know, are determined by two things investors’ “tastes” or preferences and the characteristics of the asset under consideration. For example, if a company like Asian Paints were to be characterized by the size of its Profit after Tax (PAT) we would cite it’s PAT of around Rs 2100 crores. Investors’ tastes or preferences on the other hand get reflected in the price they are willing to pay for the stock of Asian Paints.

The total market value of the stock of Asian Paints (its ‘market capitalization’) at around Rs1.7 trillion (as on 22nd October 2019) indicates that investors were willing to pay 80 times the profit for the shares of Asian Paints (this is nothing but the stock market’s favorite ratio, the P/E ratio).

Given that the value of a business is influenced both by its fundamental performance and by investors’ preferences, could both of these factors therefore explain the out performance of the stocks of ‘good’ businesses?

Let us focus on investors’ changing tastes and preferences first. If indeed there is a shift in investors’ preferences for companies that do well while also being ‘good’ and scoring high on ESG like factors, it should get reflected in higher valuation multiples (like the P/E ratio) that investors are willing to pay for these stocks. This would be what markets refer to as a ‘technical’ factor: rise in prices merely due to higher demand.

So are investors’ tastes changing? There are many indicators that seem to suggest so. George Kell (“The Remarkable Rise of ESG”, Forbes, July 11, 2018) estimates that a quarter of all professionally managed assets in the world, amounting to USD 20 trillion in Assets Under Management (AUM) are accounted for by ESG focused investing. Kell also says that in 2018 there were thousands of professionals from around the world holding the job title “ESG Analyst”. 80 percent of S&P companies now report on ESG metrics. An entire eco-system has developed therefore indicating strong investor interest in “good’ investing.

In Kell’s words “It is now, quite literally, big business”. The biggest of investors have taken the lead in this movement. Some of them like Larry Fink the Chairman and CEO of BlackRock (one of the world’s largest asset management companies with $6.84 trillion in AUM) has been very direct in expressing their preferences.

In his 2018 annual letter to CEOs of companies in which BlackRock invests, he asks CEOs to explain how their companies contribute to society. And, there is soon likely to be regulatory pressures too on investors to factor in ESG issues while investing; the European Commission is likely to bring in legislation that makes it the responsibility of investors and asset managers to do so.

While there may be increasing demand for stocks of ESG focused companies because of changing investor preferences, does being ESG focused also make good business sense? If it does not, the increase in demand because of a change in investor preferences runs the risk of becoming a passing fad. Here again, there is increasing evidence that doing business the good way also makes good business sense. In his letter to the CEOs Fink says that if companies do not make positive contributions to society, if they do not have a purpose they “will ultimately lose the license to operate from key stakeholders”.

A BCG Henderson Institute report of June 27 2019 (“Optimize for Both Social and Business Value”) says that excessive focus on optimizing operating models have made them less resilient and undermined their social contracts. Both these statements seem to indicate that ESG focused companies might have less downside risk. This is also borne out by the research done by Axioma, a portfolio analytics firm. According to Axioma “increasing exposure to ESG rarely underperforms the market, and often outperforms the market”.

Financial economists would tell you that the value of a financial asset, being the present value of all future economic profits, is a function of the size of the stream of economic profits (the larger it is, the more valuable), the riskiness of the stream of economic profits (the riskier it is, the less valuable) and the longevity of the stream of economic profits (the longer it is, the more valuable).

For too long has been the focus on the size of the stream of economic profits; on optimizing operating models, streamlining supply chains, building specialized assets and teams, and the like. An over-focus on creating value through efficiency improvements opens up businesses to the tantalizing temptation to take shortcuts: extract too much work for too little pay; reduce costs while being lax on safety, quality and harm to the environment; skip the good-governance path to save on costs and time.

An ESG focused business, while creating value through increasing the size of the economic profits is also more likely to be cognizant of the risks that come with an over-focus on efficiency. And therefore their economic profit streams are likely to be less risky and more resilient.

The mathematics of valuation are in favor of a longer-lasting, less risky economic profit stream over a shorter but larger economic stream; the present value of a stream of economic profits of Rs 20000 crores every year forever (sustainable till eternity!) discounted at 10 per cent is Rs 200000 crores whereas the present value of a much larger economic profit stream of Rs 40000 crores per year that lasts only for 5 years and is discounted at 15 per cent because it is more risky is only Rs134086 crores.

Maybe therefore it is time to build businesses that are less risky and survive longer by being sensitive to the interests of all stakeholders: employees, customers, suppliers, the community in which they operate, and society at large.Companies must target long-term financial performance which will take into consideration the social impact of their business. Business as a whole should be mindful of the long term social trends which could be the outcome of irreversible policy decisions of the day(e.g.: automation, climate change, slow wage growth, etc.).

There is an increasing realization that “it’s time to awaken the humanity in business” says Sebastian Buck, co-founder of Enso. Buck goes on to say “Everything is efficient but everyone is miserable!” The BCG Henderson Institute Report states that while financial performance is essential, “stakeholders expect companies to use their resources and capabilities for a higher purpose: addressing the urgent issues society faces. The business of business can no longer be just business.”

Delving deeper into the idea of “humanity in business”takes us to a rich, enlightening proposition. In their book “Business of Humanity”, John C Camillus(Katz Graduate School of Business,University of Pittsburgh), Bopaya Bidanda (University of Pittsburgh), and N Chandra Mohan (Woodrow Wilson School, Princeton University) propose a strategic decision making toolthat focuses on incorporating and integrating social benefit in business models while enhancing both profits and long-term sustainability.

They propose that businesses that focus on serving humankind (example, focusing on the bottom of the pyramid) with humaneness (example, being sensitive to environment, safety, ergonomics, diversity) will yield superior economic performance and sustainability.

The authors provide some examples of businesses from across the world that have been able to do this: Alcoa: making safety the highest priority; Arvind: incorporating social causes in the business model; Bandhan Financial Services: uplifting the socially disadvantaged and economically exploited women; Grameen Bank: catering to poor ‘potential’ entrepreneurs; and many more. They cite the statement of purpose of Whole foods:” With great courage, integrity and love- we embrace our responsibility to co-create a world where each of us, our communities and our planet can flourish”. There thus seems to be a growing conviction that businesses built the ‘good’ way “created with courage, integrity and love” are indeed here to stay, and are likely to earn long term economic profits while helping all stakeholders to flourish.

By Prof. Ms Suma Damodaran, Faculty, IIM Udaipur

Tags: iim udaipur