Financial Reporting Advisory Group and Lab conference

June 23, 2018 Ben Yeoh

I’ve joined the investor advisory group (IAG) of the Financial Reporting Council (FRC, tiny news release) and this week I spoke at the FRC Lab conference.

The IAG aims to “provide a regular forum for the FRC to engage with representatives from across the investment chain on various issues, including our strategy and plan and new policies and standards, on governance, stewardship, reporting and audit matters.”

Business has more than investors as stakeholders (it includes YOU and civil society etc.), so if there is any item in the corporate reporting agenda that you wish to communicate to the FRC – first, you can write direct to the FRC! but second, feel free to tell me and I will pass the views on as part of my work in this area.

I joined Sallie Pilot and Stephanie Maier and Douglas Radcliffe for a discussion at the FRC Lab conference this week. If you'd like to share a view on corporate reporting, ESG, intangibles, wider-metrics, GAAP, Non-GAAP and what would be useful to you as an investor or wider stakeholder then do get involved with a Financial Reporting Lab project (see link here).

I made the point that intangibles are a large part of companies values today but many aspects are poorly reported (eg human capital, brands, innovation). See blog post on Intangible Capital.

AI and technology will impact future reporting, but arguably we are not using the tools today as effectively as we could.

From the corporate side, the demands are ever increasing. It will be up to boards and management to self-define what is material and sustainable to them, (and to convince their stakeholders) but if key items are missing then pressure will be seen from investors, wider stakeholders and regulators.

Other discussion centred around are disclosures:

Clear on how they are aligned to strategy
Transparent in regard to calculation and adjustments
Contextual, including description of both performance and position and what went well an what went badly.
How the metrics are reliable including information on monitoring
Clear on the level of consistency year on year and across time

The current Arts blog, cross-over, the current Investing blog. Cross fertilise, some thoughts on autism. Discover what the last arts/business mingle was all about (sign up for invites to the next event in the list below).

My Op-Ed in the Financial Times (My Financial Times opinion article) about asking long-term questions surrounding sustainability and ESG.

Some popular posts: the commencement address; by Nassim Taleb (Black Swan author, risk management philosopher), Neil Gaiman on making wonderful, fabulous, brilliant mistakes; JK Rowling on the benefits of failure. Charlie Munger on always inverting; Sheryl Sandberg on grief, resilience and gratitude.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

Divesting sectors. The impact on returns. Evidence that oil divestment may not impact returns.

June 22, 2018 Ben Yeoh

Source: Jeremy Grantham, writes (see link to LSE talk  here): note cavests below. — Source: Jeremy Grantham, writes (see link to LSE talk here): note cavests below.

Grantham and colleagues have looked at the S&P500, over the last 28 years, 60 years, and 90 years; excluding a major sub-component sector each time. Grantham’s overall conclusion it that it didn’t make much difference in return - although some might argue at the max range of 50bps that compounded over 28 years may be significant. Others might suggest that the power of diversifcation and time, also makes this conclusion unsurprising.

Caveats could include: not peer reviewed (although I have found similar conclusions with slightly different data sets), different exclusions may produce different answers (specifically Tobacco might come up as a narrow exclusion; cf Dimson’s data set on “sin stocks”), and that S&P500 is not world representative (however it has the best long run data set, and is a widely used index that does represent a facet of corporate America).

Grantham writes (see link to LSE talk here)

“So my colleagues and I finally carried out a test to see exactly how an investment portfolio would have been affected by divesting from a group of companies that are listed in the Standard and Poor’s 500, the index based on the market capitalisations of 500 large companies listed on the New York Stock Exchange or NASDAQ.

These companies can be divided into 11 sectors (not including real estate). We considered the 10 long-term sectors (real estate was added relatively recently), and analysed how the index performed without each sector.

Initially, we considered the period from 1989 until 2017. [The results are shown in Figure above]. You will see how dramatically the index changes with the removal of each sector – there is only a 50 basis points difference between the best and the worst. They are basically all the same!

You will see that excluding the information technology sector made a small difference for a few years around the turn of the millennium. That was the technology bubble. Beyond the burst of the bubble, all of the indices track together again, as if nothing had ever happened.

But basically, all of those 10 variations of the index track between 1989 and 2017 as if they were the same. So we decided to see what happened if we chose a different period, incase there was something extraordinary about the past 28 years. We extended the analysis, first to start from 1957, and secondly to begin in 1925.

You will see in chart above that changing the period of analysis does not make much difference. The difference between the best and worst is 54 basis points instead of 50. So over 90 years, it would not have cost an investor to have divested from any one of the sectors.”

Grantham further writes:

“Who knew that the stock market was that efficient? It may be hopeless in bubbles and busts, but it has evidently priced these groups of big companies pretty well. And there is no advantage to an investor of choosing the high-growth information technology sector over, say, utilities. Utilities are priced down and information technology is priced up, but they produce the same returns. It is amazing.

What does this mean for divestment? It means that if investors take out fossil fuel companies from their portfolios, their starting assumption should not be that you have destroyed the value. Their starting assumption should be until proven otherwise. that it will have very little effect and is just as likely to be positive by 17 basis points as negative. That is an amazing contradiction to what every investment committee has ever said, as far as I am concerned.

It obviously takes a major miscalculation to move the dial when it comes to divestment. I think that decarbonisation is just such an event. And the reason I think that is that the oil companies and the chemical companies are not rolling with the punches. They are fighting decarbonisation tooth and nail. They are still funding obfuscation programmes in North America. And if you do that as a corporation, as a capitalist, you are likely to bite the dust if you are facing a major change, if you fight it. And they are fighting it. If they rolled with the punches, they might do quite well, and bleed off their capital and pay big dividends. But they are not doing that.”

I’d like to add a thought or two on the theoretical framework here. There are two to note one is

The Active Law of Fund Management which suggests the bigger the investment universe the better the risk/return potential, and,

The Efficient Market Hypothesis which suggests information is priced in efficiently such that it is hard to outperform large diversified markets

Both are theoretical although backed up by certain lines of empirical evidence (I’ve been drafting a long blog on the EMH for a while, hopefully out one day), although both are not considered perfect to explain what we can observe empirically.

As Grantham alludes to, this suggests the power of reasonable large scale diversification, and time. It seems to suggest over long periods of time, no one sector has such strong outperformance that it significantly dwarfs a large fairly diverse group of companies/stocks. I’m guessing there are always 400 to 450 stock left in any one excluded portfolio.

It’s an interesting challenge to certain notions of thematic and smart beta ideas as well, although those assessed differently.

Many of us are in the forward looking future prediction game. Although again, this might suggest, as Warren Buffet and Jack Bogle do that the average investor is then best off in low cost trackers (although note possible limited stewardship??!!), and if they wish to lose a sector or two it’s not likely to be a big impact (perhaps a small plus or minus in the order of 25 to 50bps; and arguably hard to predict although as Grantham argues, it might be oil, chemicals but for business related reasons).

I actually see Grantham’s work replicated in shorter run indices. You can look them up put the ex-Tobacco or ex-fossil-fuel type indices over the last 5 to 10 years have all done better or in the same ball park than the standard index. 5 years is short run, but might suggest that something has happened in the last 5 years perhaps different to eras further back.

In any case, back to oil divestment, so you need to know Grantham has a long time view (bias) here and sponsors the Grantham institute. Might mean he is right and has spent a long time thinking about this. He’s being doing investment (albeit more macro and asset class lens) for much longer than me.

Still, this is a decent evidence base and theoretical framework for arguing for the divest – stranded asset argument. It also highlights the area for engagement, if it can help bend these companies at all.

This all comes from a talk given in April 2018 at the LSE.

Source: LSE lecture (link here), although Grantham is quoting HSBC work

In the lecture, Grantham is mainly focused on climate, weather and food. Slides here, talk below.

On climate - click here for more carbon related posts. There's an argument made by risk philospher and Black Swan author Nassim Taleb on why we should lower pollution regardless of models.

My Op-Ed in the Financial Times (My Financial Times opinion article) about asking long-term questions surrounding sustainability and ESG.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

The dawning of Japanese Corporate Governance

June 20, 2018 Ben Yeoh

Source: Board Independence graph is Yanagi's book quoting ISS survey 2012-13

I recently finished a positive stewardship engagement with a Japanese company on the nature of independent directors. ESG ignored 10 years ago, is increasingly in focus in Japan. In my view, this trend is set to continue.

One resource to examine in this area is Ryohei Yanagi’s new book on corporate goverance in Japan (Amazon link here). Yanagi has a book event in London 4 July 2018 (link to event here).

Yanagi examines the Ito review (cf UK Kay review, a blog on Kay here), the corporate governance and stewardship codes in context of Abe’s reforms, and gives the historic background of why Japanese corporates are managed and governed like they are today.

Source: the RoE (Return on Equity) chart is based on RoE average primary index of each country (cap weighted), on 4Q (2004-2013( by Bloomberg data, from Moving the Mountain study group, 2014 from Yanagi (2018)

He discusses RoE (Return on Equity) and RoE - cost of capital spreads.

Since the work of Stern Stewart and others on EVA (Economic Value Add) from the 1990s and before (see a background paper here) which focus on Return on Invested Capital (or for some in modern day expressions Cash Flow Return on Investment) over some assumption of cost of capital, this thinking has been a dominant feature in US and EU corporate thinking and finance. Less so, seemingly in JP corporates.

Yanagi then synthesises this with ESG and intangibles and coins a concept of RoESG.

Yanagi suggests many Japanese corporates view some of their intangible ESG/CSR management as good (although again one can debate on reporting on it). (I also think many non-Japanese investors may not concur with what Japanese manager tout on CSR)

He then suggests that intangible/ESG management and management of RoE are two lens which are not opposed – in fact almost could be joined more symbiotically.

Not an entry level book, it draws practical thinking about how to look at financial and non-financial metrics for corporates and investors alike and roots it in the historic and cultural context of Japan.

Impact Investing in the UK

June 16, 2018 Ben Yeoh

Impact Investment Opportunity in UK, this week I was listening to Elizabeth Corley and expert speakers on the opportunities and challenges for impact at a social impact investing conference.

Some questions raised:

What are the dangers and advantages of speaking about ESG and Impact in the same breath? How important is a common language? Taxonomy? Standardised outcomes?

Fear of unintended consequences of regulation? “Backed by regulators” not equal to “regulated” ? Is it beyond the wit of the industry to find a better way to represent individuals wishes re: Impact ?

Will SDGs used as part of "SDG washing" - something that looks good for marketing but doesn't make real impact.

There is debate in impact world on if you can make market returns and still have measured deep impact. This notion of a continuum or spectrum of thinking about these ideas is one which is taking shape.

However, when thinking about this in mainstream instiutional or retail investment, I think it has a long way to go before it's embedded in thinking. I base this observation on the minimal mainstream press or adviser coverage and the small knowledge base / marketing at retail or adviser level. Still, the movement is growing and ideas which start here will hopefully go on to seed bigger things in the mainstream too.

My Op-Ed in the Financial Times (My Financial Times opinion article) about asking long-term questions surrounding sustainability and ESG.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

ESG matters, both for operational and share price performance. Nordea.

June 4, 2018 Ben Yeoh

Nordea “As ESG performance has grown significantly in importance for companies and asset managers in recent years, it's time to look at the numbers. Is ESG screening a worthwhile tool? In a word, yes. High ESG focus contributes to risk mitigation; our research shows this is mirrored in strong operational and share price performance. We also note that predictive attributes as to future earnings stability and share price volatility suggest that ESG research belongs in company valuation. We argue that companies and investors simply cannot afford not to care.

Note sample size for CCC is small and "special sit" companies often fall in here too eg post a poor ESG controversy.

Key conclusions: We see solid evidence that ESG matters, both for operational and share price performance The relative performance of the top versus bottom ESG performers amounted to as much as 40% in 2012-15 ESG is largely uncorrelated with our quant factors, and incorporating it adds alpha to our value and quality strategies.

ESG as a driver for operational improvement. We find a consistent correlation between ESG ratings and operational metrics. For example, companies with top ESG ratings have higher ROE and ROCE, and lower net debt/EBITDA than the market. Returns, margins and share prices are also more stable for the top-rated companies and we find that improving ESG performance bolsters stability in returns, implying it is not a lagging indicator.

ESG adds alpha to already proven quant factors We find ESG of great interest as an addition to our quantitative framework. An intuitive auto-correlation between ESG and quality, which share a lot of characteristics, did not materialise, but ESG added alpha to our quality strategy.

Link to research from Nordea

This chimes with a recent BAML Study using a different ESG database – see blog here.

You can also see it in conjunction with these papers here:

from MSCI and ESG and higher RoIC companies

from Caroline Flammer on long term incentives and causal evidence for ESG nad other Academic ESG papers.

My Op-Ed in the Financial Times (My Financial Times opinion article) about asking long-term questions surrounding sustainability and ESG.

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

A provoking read on how to raise a feminist child.

Teeth. The forces behind straightening.

May 27, 2018 Ben Yeoh

I’ve been exploring the forces behind people straightening their teeth. Grooming and beauty have been in human culture for thousands of years and those behavioural forces are very much alive in our culture today as well.

Source: Instagram, teeth_by_teki (Dream Smile Dental, Dr Teki Sowdani)

One force is Instagram (see teeth_by_teki snap with Rio Ferdinand, above). Here the compulsion to show your smile to your friends and the world at large persuades people to straighten their teeth.

I learned from the rather amazing and passionate orthodontist Mo (Dr Mohsen Tehranian, Mo does several hundred cases a year, that's a lot of experience) that you can choose to have a smile optimised for Instagram selfies or one optimised for face to face conversations. The angle is different with selfies taken from a high angle.

I also learning about the astonishing technology that allows a details 3D image of your teeth and what they could look like in a matter of minutes.

If you like what you see and want to go ahead, your Dr might discuss your imaging with technicians in Costa Rica based on technology developed in California. Once satisfied, your clear aligners (see first picture above) are made in Mexico and shipped by UPS back to London or Hong Kong in a few days. Wow.

It’s a level of personalised healthcare that would seem like science fiction. While the driver behind this is often the straight smile (and hence the consumer often liking the clear aligner system over metal braces) rather than medical problems, I still find it incredible.

While this is not investment advice, medical advice or any other kind of advice if you want to know the pro and cons of teeth straightening techniques, I know a man who knows... (or there's also me with the faux expertise of a few hours knowledge...)

How to live a life, well lived. Thoughts from a dying man. On play and playing games.

If you'd like to feel inspired by commencement addresses and life lessons try: Neil Gaiman on making wonderful, fabulous, brilliant mistakes; or Nassim Taleb's commencement address; or JK Rowling on the benefits of failure. Or Charlie Munger on always inverting; Sheryl Sandberg on grief, resilience and gratitude.

A provoking read on how to raise a feminist child.

Cross fertilise. Read about the autistic mind here.

Elon Musk Productivity Tips

May 21, 2018 Ben Yeoh

Elon Musk (Telsa CEO) productivity recommendations:

- Excessive meetings are the blight of big companies and almost always get worse over time. Please get of all large meetings, unless you’re certain they are providing value to the whole audience, in which case keep them very short.

- Also get rid of frequent meetings, unless you are dealing with an extremely urgent matter. Meeting frequency should drop rapidly once the urgent matter is resolved.

- Walk out of a meeting or drop off a call as soon as it is obvious you aren’t adding value. It is not rude to leave, it is rude to make someone stay and waste their time.

- Don’t use acronyms or nonsense words for objects, software or processes at Tesla. In general, anything that requires an explanation inhibits communication. We don’t want people to have to memorize a glossary just to function at Tesla.

- Communication should travel via the shortest path necessary to get the job done, not through the “chain of command”. Any manager who attempts to enforce chain of command communication will soon find themselves working elsewhere.

- A major source of issues is poor communication between depts. The way to solve this is allow free flow of information between all levels. If, in order to get something done between depts, an individual contributor has to talk to their manager, who talks to a director, who talks to a VP, who talks to another VP, who talks to a director, who talks to a manager, who talks to someone doing the actual work, then super dumb things will happen. It must be ok for people to talk directly and just make the right thing happen.

- In general, always pick common sense as your guide. If following a “company rule” is obviously ridiculous in a particular situation, such that it would make for a great Dilbert cartoon, then the rule should change.

Source Jalopnik. See also Musk in more detail on communication here.

"If I had more time, I would have written a shorter letter." which is attributed to many different writers.

This difficulty in free expression is one of the reasons why psychological safety as researched by Amy Edmondson and Google Research is so important.

Few people like being told they are not doing their job well. Nevertheless, we should judge if constructive criticism is coming from a place of malicious intent, or positive intent. If positive, then it needs to be taken in the spirit it is given and we can all improve. I believe much internal commentary is with constructive intent - when that is believed, a team gains psychological safety.

If you'd like to feel inspired by other addresses and life lessons try: Ursula K Le Guin on literature as an operating manual for life; Neil Gaiman on making wonderful, fabulous, brilliant mistakes; or Nassim Taleb's commencement address; or JK Rowling on the benefits of failure. Or Charlie Munger on always inverting.

Cross fertilise. Read about the autistic mind here. On investing try a thought on stock valuations. Or Ray Dalio on populism and risk.

Quant Survey ESG and other Factors

May 20, 2018 Ben Yeoh

BAML 2018,   Savita Subramanian (BofAML, Quant team) — BAML 2018, Savita Subramanian (BofAML, Quant team)

What to learn from Quant and ESG? Assets in smart beta have grown at a ~30% annualized rate since 2009, quant jobs outnumber fundamental jobs 5-to-1, and >60% of investors blend quant and fundamental techniques. Quant models have grown increasingly complex, with investors using 17 factors in their models today vs. 7-8 in the 90s.

ESG saw the third-biggest increase in usage of any factor – 26% of clients use it today vs. 19% last year. Social/moral considerations were still the primary driver for use, followed by risk-mitigation.

Investors with both short- and long-term time horizons are using ESG, vs. a skew toward longer-term investors a year ago.

This from the BAML US Equity & US Quant Strategy. See previous blog on their ESG work. Also of note:

Momentum is crowding out Growth & Value

Value and Growth factors were tied as most popular (both used by 38% of clients), but both saw a decrease in usage vs. last year, while Momentum strategies saw the biggest increase in usage.

Value still dominates the models for the 12th year running, thought it saw a drop in popularity vs. a year ago (used by 70% vs. 80% of clients). Relative Strength, a Momentum factor, saw the biggest uptick in usage vs. last year.

Still only a minority of quant funds are using ESG as a signal, even though they are using around almost 20 signals on average.

This gives me some comfort as a bottom-up fundamental active manager. However, the data is looking increasingly powerful on the quant side as well. There have been positive findings across other ESG data sets (with Sustainalytics and MSCI being the two other most used data sets; this one is the Thomson Reuters data set), although the correlation between these data sets remains relatively poor at between 0.3 to 0.5 in the studies and work I have seen.

The other factor this work and similar raises is the power of passively managed funds. They now make up over 40% of US-dom equity funds up from 20% in 2009, and I do not see this trend changing any time soon. In fact various forces may if anything accelerate this trend.

Vanguard now owns more than 5% of over 494/500 S&P 500 companies. Vanguard is now the steward of many people's capital. That man in the street through Vanguard now owns 1/20th of the largest companies in the US. It will be interesting to see how stewardship evolves in this situation.

More thoughts:   My Financial Times opinion article on the importance of long-term questions to management teams and Environment, Social and Governance capital.

One of the best Munger speeches on how to think about a mental model of inversion can be found here.

March 2018 thoughts on greed, fear and risk.

MSCI paper on high ROIC companies and ESG.