In the 1970s, Nobel prize-winning economist Milton Friedman famously noted that “there is one and only one social responsibility of a business – to use its resources and engage in activities designed to increase its profits”.
This quote is often cited as a rejection of the ideas behind responsible investing. If all that matters is a company’s profitability, there is no value in analysing how it scores on environmental, social and governance (ESG) issues.
However, the rest of this quote is often overlooked. Friedman added the caveat: “so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud”.
Even Friedman, therefore, recognised that how a company behaves matters. Maximising profits does not justify all means. And although Friedman himself may have disagreed, it doesn’t take much to extend that thinking to include much more than just avoiding deception and fraud.
“Times have changed,” says Allan Gray equity analyst Tim Acker. “Society’s view on investing and business has evolved. The social contract between companies and society has changed. Today most people would expect a company not to pollute, to treat its employees fairly, to contribute to its community. Being a responsible corporate citizen has become more important.”
The way a company behaves has also become increasingly important to investors. According to data from Morningstar, ESG funds attracted new inflows of $8.9 billion in the first six months of this year. That is a substantial increase from the $5.5 billion of inflows into these funds for the whole of 2018.
As Acker notes, this is not just about fuzzy ideas of doing social good. Responsible investing is about generating long-term, sustainable returns.
Businesses that exploit their workforce, destroy the resources they rely on, or are built on fraud are unsustainable.
Those that encourage productivity by looking after their workers while managing their resources responsibly and holding themselves to high standards of governance are more likely to generate superior returns for shareholders.
For Acker, there are four areas where this is impact can be clearly apparent for investors:
The potential profitability of some companies is very closely related to how they interact with society. In the South African context, Capitec is a good example.
“This is a lending business that lends at high interest rates – above 30% for many of its clients,” Acker explains. “It’s also an extremely profitable business. But the concept of sustainability is a key question when looking at the valuation of Capitec, because we have to ask ourselves how sustainable these high profits are over the long run.”
This, Acker explains, is based on a social question.
“When they lend money at high interest rates, arguably many borrowers are not getting a great deal,” he argues. “You could say that maybe this business is extracting more profit from society than the value that is added. So that creates a risk from a regulation point of view.”
The National Credit Regulator has already lowered the maximum interest rates that businesses like Capitec are allowed to charge, and may do so again in future. This limits its potential profitability.
Besides regulation in specific sectors such as the case with Capitec, there are moves in certain parts of the world, particularly Europe, to compel investors to consider ESG factors when making any investment. If this leads to them excluding certain kinds of assets from their portfolios, or favouring other assets, this would impact on how those assets are priced.
“The trend we are seeing is that these kinds of regulations are becoming more and more binding, and we would expect more of them to come to South Africa,” says Acker. “This actually affects how investors are behaving. It affects the assets they are buying and selling, and therefore affects the value of those assets.”
Related to this is that many large investors like sovereign wealth funds, endowments and big pension funds are even moving ahead of regulation and disinvesting from certain industries altogether. Coal mining is a good example.
“Some of the larger investors have said that we will not buy any coal mining assets, and we will sell out of our existing coal mining assets,” explains Acker. “This can create a scenario where you have stranded assets.”
In other words, if you buy shares in a coal mining company today, you might find that when you want to sell that asset in the future there are no buyers.
“So even if you don’t personally care about the issue, you have to think what the rest of the market is doing, and what is the rest of the market is going to think in five or 10 years’ time.”
The South African market has had plenty of experience of poor corporate governance in recent years. The most high profile was the lack of board oversight that allowed the Steinhoff fraud to perpetuate, but there are a number of other examples.
MTN, for instance, was hit with a substantial fine in Nigeria because the company failed to work appropriately with the regulator, accounting irregularities have surfaced at Tongaat Hulett, and at Old Mutual it appears that the board may have failed to follow proper process in dismissing CEO Peter Moyo.
In each instance, investors have suffered as these company share prices have come under pressure.
“Governance is not just a box-ticking exercise,” says Acker. “It’s clear that when you have a failure in governance, there are lots of ways that value can be destroyed for shareholders.”