Public Sentiment and price of Corporate Sustainability

Recent Prof. George Serafeim paper combining TruValue Labs ESG data (machine learning) with MSCI ESG data (rules based analyst) “combining big data and analyst driven ESG data allows one to identify ‘value’ opportunities in the ESG space and as a result construct an investment strategy that delivers alpha while investing in companies with greatly superior ESG performance scores.” [scores as defined by these data sets] “the price of corporate sustainability performance has increased over time. This is the estimated premium (if positive) or discount (if negative) that firms with better sustainability performance trade relative to peers after accounting for several factors such as current profitability, size, leverage, past returns and other firm characteristics.” “The higher price of corporate sustainability poses a challenge for ESG investors. Do you get a good value for money from your investments? It is not only a matter of the value of corporate sustainability anymore, but it is also a function of the price you are paying for it. Value for price is key.”

H/T George Serafeim (LI link)

Study link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3265502

“Combining corporate sustainability performance scores based on environmental, social and governance (ESG) data with big data measuring public sentiment about a company’s sustainability performance, I find that the valuation premium paid for companies with strong sustainability performance has increased over time and that the premium is increasing as a function of positive public sentiment momentum. An ESG factor going long on firms with superior or increasing sustainability performance and negative sentiment momentum and short on firms with inferior or decreasing sustainability performance and positive sentiment momentum delivers significant positive alpha. This low sentiment ESG factor is uncorrelated with other factors, such as value, momentum, size, profitability and investment. In contrast, the high sentiment ESG factor delivers insignificant alpha and is strongly negatively correlated with the value factor. The evidence suggests that public sentiment influences investor views about the value of corporate sustainability activities and thereby both the price paid for corporate sustainability and the investment returns of portfolios that consider ESG data.”

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Comment: There is still a lot of practioner debate about the value of various ESG datasets and ratings. However, for those who go down a deep fundamental analysis route a variety of data sources is often seen superior than one. This is one of the first papers I have seen that has looked at combined two datasets/ratings that are developed from very different methodologies.

A thought on why ESG ratings will never agree.

Cycles, economic, market, debt...

Where are we in this up-leg part of this cycle? Two recent books address how investors - and other interested parties - can look at the world and approximately place where we are in a cycle and have a view on what has gone before which impacts what happens now in the future. It chimes with an earlier post on Hyman Minsky, who constructed a model of a cycle that uses human psychology (see link end).

Ray Dalio recently wrote Principles (see links end) and is now giving away a book on his understanding of the debt cycle. Dalio is convincing on why debt cycles will always occur (and like Howard Marks and Minsky) explains the human psychology behind why this might be the case.

Howard Marks, who writes a widely read investment letter for his money management firm, has recently published his work focusing on the economic and market cycle (but touches on the debt and other cycles too - he makes the point that they are inter-related).

Both are very valuable for investors giving practical thoughts on how to assess cycles, but for those simply interested in what are powerful trends and forces that have shown patterns through out human history, it will also give insights into why we have booms and busts - and why we will continue to have them.

Both books are recommended.

As to the state of the world now? Both Dalio and Marks sound notes of caution in recent months. I will note Marks recent Memoo

“I’m absolutely not saying people shouldn’t invest today, or shouldn’t invest in debt.  Oaktree’s mantra recently has been, and continues to be, “move forward, but with caution.”  The outlook is not so bad, and asset prices are not so high, that one should be in cash or near-cash.  The penalty in terms of likely opportunity cost is just too great to justify being out of the markets.

But for me, the import of all the above is that investors should favor strategies, managers and approaches that emphasize limiting losses in declines above ensuring full participation in gains.  You simply can’t have it both ways. 

Just about everything in the investment world can be done either aggressively or defensively.  In my view, market conditions make this a time for caution.”

And

“In memos and presentations over the last 14 months, I’ve made reference to some specific aspects of the investment environment.  These have included:

• the FAANG companies (Facebook, Amazon, Apple, Netflix and Google/Alphabet), whose stock prices incorporated lofty expectations for future growth;

• corporate credit, where the amounts outstanding were increasing, debt ratios were rising, covenants were disappearing, and yield spreads were shrinking;

• emerging market debt, where yields were below those on U.S. high yield bonds for only the third time in history;

• SoftBank, which was organizing a $100 billion fund for technology investment;

• private equity, which was able to raise more capital than at any other time in history; and

• cryptocurrencies led by Bitcoin, which appreciated by 1,400% in 2017.

I didn’t cite these things to criticize them or to blow the whistle on something amiss.  Rather I did so because phenomena like these tell me the market is being driven by:

• optimism,

• trust in the future,

• faith in investments and investment managers,

• a low level of skepticism, and

• risk tolerance, not risk aversion.

In short, attributes like these don’t make for a positive climate for returns and safety.  Assuming you have the requisite capital and nerve, the big and relatively easy money in investing is made when prices are low, pessimism is widespread and investors are fleeing from risk.  The above factors tell me this is not such a time.”

And here’s Dalio on Debt:

“To summarize some of the key points found in the book:

1. All big debt cycles go through six stages, which I describe and explain how to navigate:.

• The Early Part of the Cycle

• The Bubble

• The Top

• The Depression

• The Beautiful Deleveraging

• Pushing on a String/Normalization

2. Getting the balance right between having too much debt (that causes debt crises) and too little debt (which causes suboptimal development) is never done perfectly. Cycles always swing from having too little debt relative to the opportunities to having too much and back to having too little and back to having too much. These swings are exacerbated because people tend to remember what happened to them more recently rather than what happened a long time ago. As a result, it is pretty much inevitable that the system will face a big debt crisis every 15 years or so. 

3. There are two major types of debt crises—deflationary and inflationary—with the inflationary ones typically occurring in countries that have significant debt dominated in foreign currency. The template explains how both types transpire. 

4. Most debt crises can be well-managed if 1) the debts denominated in one’s own currency and 2) the policy makers both know how to handle the crisis and have the authority to do so. As I write in the book: “Managing debt crises is all about spreading out the pain of the bad debts, and this can almost always be done well if one’s debts are in one’s own currency. The biggest risks are typically not from the debts themselves, but from the failure of policy makers to do the right things due to a lack of knowledge and/or lack of authority.”

Both Marks and Dalio are billionaires, who have been investing over decades. Their thoughts are worth reading.

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Hyman Minksy - "We fat all creatures else to fat us, and we fat ourselves for maggots. " Hamlet, Shakespeare.

Are we headed for another Minsky moment? Minsky describes how a boom or periods of stability by their nature and human nature cause increased risk taking (for yield and return) which becomes excessive risk taking which leads to bust.

Ray Dalio - thoughts on populism. His book on debt available here.

The Amazon Link to Mark’s book is here.

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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.

Current highlights:

A thought on how to die well and Mortality

Some writing tips and thoughts from Zadie Smith

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.

Some popular posts:  the commencement address;  by NassimTaleb (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.

Buy my play, Yellow Gentlemen, (amazon link) - all profits to charity

Why ESG ratings will never agree and some of the problems of ratings

Tesla vs Exxon? ESG ratings are like stock opinion reports more than fact. WSJ article unpicks methodology and score of 5 major companies and higlights the wide dispersion of results and different methodologies. (Summary outcomes above)

Like a stock report, you should understand the assumptions and methods to derive “Buy/Sell/Target Price” when utilising analysis.  An  investment analyst rating is an opinion, so is an ESG rating.  The WSJ piece dissects why the ratings are so different. The components of methodology and weighting. 

“The problem here isn’t the ESG ratings, but that they are used as though they were some sort of objective truth... they are no more than a series of judgments by the scoring companies...and investors who blindly follow their scores are buying into those opinions, mostly without even knowing what they are.”

“Investors should not treat ESG scores as settled facts to be used on their own, but as potentially worthwhile analysis that needs to be understood before being acted on. The thick ESG reports behind the scores offer useful detail about the policies and controversies around each business. But just as with financial accounts, investing without understanding is unlikely to deliver what you want.” 

My Linkedin Post is over 10,000 views and 100 likes and counting, with many of the ratings providers (most who I know) providing comments.

From FTSE: 

• The comparison to sell side research & buy/sell ratings is an interesting one. It should be valid but in reality the high correlation & herding that you see in sell side ratings is actually not seen in ESG ratings – as shown in the article.

• As far as I’m aware, no one in the ESG data / ratings market is claiming to provide some form of objective truth. All outputs are based on methodologies and as the article points out – it’s essential to consider how scores and ratings are derived and that as an end investor / user you are comfortable with this. 

• For example, at FTSE we have always maintained separate datasets for assessing how a company operates (our ESG Ratings) and the products and services that companies manufacture / provide (our Green Revenues data). We have found that investors appreciate this distinction. Just because a company is contributing to the green economy does not mean that it is doing a good job of managing a range of operational ESG issues…Attempting to net these things off in a single number is problematic. 

• Generally speaking, at FTSE we aim to be as transparent as possible – in particular with the issuers we rate e.g. in addition to sharing all of our data with each company in our universe as part of our annual research cycle we now provide (for free) a “Corporate Peer Comparison Tool” which allows companies to see both the scores & ratings (including for Green Revenues) that we have derived as well as comparison to their peers by sub sector, industry, country etc. 

From Xi Li (of Active Ownership paper fame):

“Academics have criticized these ESG ratings for a long time.... not surprising. A better way to use these ratings is to compare it in a time-series manner (i.e. Tesla's rating last year vs. current year), not cross-sectionally (i.e. Tesla vs Exxon). However, even this may have problems, because these data providers' algorithm may change over time...  “

From Mike Tyrell (of SRI-Connect)

It would indeed be an encouraging evolution if both suppliers and users of ratings came to regard them as opinions rather than in any respect as objective reality.  However, I fear that we are still some distance from a situation in which asset managers buy / sell / focus on / ignore a stock bsed in a rating from one provider are treated with the same derision as they would be if they bought / sold a stock based on the recommendation from a single broker.  ... and we should note that James Mackintosh's main concern seems not to be the fundamental active managers who can pick and choose ratings and research but the "billions of dollars of exchange-traded funds based on ESG indexes ... [and] ... fund managers [who] are being pushed to produce portfolios with better ESG ratings, encouraged by public mutual-fund ESG scores." There is, it seems to me, a real problem with the same research processes being used to produce pre-trade investment advice (counter-consensus opinion needed) and post-trade portfolio analytics (objective exposure data needed).  I can't quite articulate the nature of the problem and I certainly can't see a business model that would fix it ... but I think it's one to watch.  … He also comments back to FTSE… Aled Jones - I agree that no-one would openly claim 'objective truth' but I suspect that both sides are guilty of treating opinion as if it were this.  There is equally a small number of research firms claiming "this is just the opinion of an analyst" 

From Sustainalytics:

…Sustainalytics tries to differentiate itself from its competition by the transparency we provide to our clients.  We are not a black box.  That said, we don’t provide full methodological details publicly.  … but do give more colour on the Tesla rating…Fully agree with your points and many of the points in the article.  Sustainalytics agrees that ESG is a separate signal and one that needs to be interpreted alongside other financial information.  Also, ESG Ratings and what they measure are not as standardized as traditional financial signals.    In regards to Tesla, from our analyst: “Tesla’s management of these issues ranges from one extreme to the other. What it manages well – the carbon impact of its products – it manages very well, while on the other hand, its management of human capital and product governance risks reveals significant shortcomings. As a company committed to the production solely of electric vehicles and other products related to renewable energy, Tesla is the global leader among automakers when it comes to the carbon emissions of its fleet – no small achievement. However, the company has been involved in a steady stream of controversies related to the timely delivery of cars, the safety of its autopilot technology, and its management of its workforce, and despite such controversies, commitments to labour rights and programmes governing product quality are lacking.”  

The WSJ piece is here.

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Some quant data looks at some of the ESG ratings sets are here (not peer reviewed): A look at using the Thomson Reuters Data set and by BAML can be found here.

Another lens in a more quant fashion can be found in this MSCI look through its own data and a return on capital lens. And Nordea Quant also look at it through the MSCI lens.

Other papers and thoughts to look at:

Why ESG might be so important in an intangible world

and an academic paper on Active Ownership and why and how it adds value.

Cancer improvement rates, biomedical capital allocation

Cancer survival rates and cures have enormously improved over the last 40 years. From 5 out of 10,  5 year survival rates to close to 7 out of 10 5 year survival rates (although sadly not for pancreatic).

Much like the Hans Rosling Factfulness book argues, we should acknowledge how much better certain items are despite considerable challenges going forward.

I think there are some hard conversations to be had on the allocation of resources on aspects of innovation, especially towards very end of life care.

This you can sense from Atul Gawande’s book, Mortality (Gawande Mortality blog post ).  If someone is facing average survival of 3 to 6 months, and the tail chances of survival of eg. 2 years are extremely low then a balanced conversation is needed.

One parallel to this can be seen in the Biomedical Bubble paper. I have several critiques, which I haven’t the capacity to spell out properly here, but one of the central ideas could be epitomised by the notion of spending $1bn on development a treatment that increases survival, say  6-12 months, and is not a cure vs spending that money on prevention or other system innovations is a mis-allocation of capital. I think that argument has some validity - although the pricing of life and innovation is a tricky area particularly in second order insights and technology from biomedical research (and that plenty of biomedical cost is late stage and undertaken by private companies). Perhaps, that needs more input from philosophers (some of the basis of the UK’s NICE framework of pricing Quality Life Adjusted Years springs from this philosophy work and ideas of distributive justice, as well as the value/costs of road building - see Value of life, under constrained budgets )

Some provoking reads on health innovation in those above/below links.

Blog on Rosling data

World in Data - cancer data

Atul Gawande Mortality blog post

Biomedical Bubble paper

Value of life, under constrained budgets - see the work of philosopher Jonathan Wolff on a somewhat accessible look at this.

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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.

Current highlights:

A thought on how to die well and Mortality

Some writing tips and thoughts from Zadie Smith

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.

Some popular posts:  the commencement address;  by NassimTaleb (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.

Buy my play, Yellow Gentlemen, (amazon link) - all profits to charity

Climate science 100 over years ago

Published in 1912 (source link here), the climate impact of coal and carbon dioxide (CO2) was known then. Indeed Eunice Foote in 1856 was one of the first to suggest CO2 would lead to a warmer planet. (See American Journal of Science and Arts, google embed below). There was anouther paper in 1896 from Arrhenius in Sweden, also eloborating on these ideas (pdf here)

This highlights two factors to me: (1) Data and reporting is insufficient to bend demand-side human behaviours. Given the economic growth fueled by fossil  energy (see the work of energy economic historian Vaclav Smil) and the view from 1/3 of Americans who disbelieve man-made climate change (see Yale Survey on climate).

Data are not enough. Experts are not enough. Marketing, stories and convenience rule.

Observe how pink is for girls and blue is for boys simply because of marketing that becomes entrenched. 150 years ago this was not the case. My high school tie is pink, at a boys school, as we choose that colour in many years ago.

Observe Nespresso coffee pods, a solution for a problem we don't really have (and that makes mainly worse coffee, or not better, than other methods) but created a problem with waste recycling (that was not thought about fully until years after launch), but it's more convenient (by a small margin) and well marketed. The man who invented the idea now has regrets.

Climate is not unique in this.

The (2) point is the necessary imprecision and variability of climate models. It has taken 100 years to get to this point.  However given, this imprecision you can take risk-philosopher Nassim Taleb’s view: “We have only one planet. This fact radically constrains the kinds of risks that are appropriate to take at a large scale. Even a risk with very low probability becomes unacceptable when it affects all of us - there is no reversing mistakes of that magnitude. Without any precise models, we can still reason that polluting or altering our environment significantly could put us in uncharted territory, with no statistical track-record and potentially large consequences... While some amount of pollution is inevitable, high quantities of any pollutant put us at a rapidly increasing risk of destabilising the climate, a system integral to the biosphere. Ergo, we should build down CO2 emissions, even regardless of what climate-models tell us..." (Noted in this previous blog here).

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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.

Current highlights:

A long read on Will Hutton looking at Brexit causes and solutions.

Some writing tips and thoughts from Zadie Smith

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.

Some popular posts:  the commencement address;  by NassimTaleb (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.

Buy my play, Yellow Gentlemen, (amazon link) - all profits to charity

Axioma Quant ESG study

Quant ESG Axioma Study. Residual company specific ESG (not regressed by factor models) tilts often outperform and rarely underperform “a question for PMs is to what extent are ESG scores different from the factors found in commercial fundamental factor risk models, such as value, size, industries and countries?…

...To the extent that ESG scores overlap with traditional factors, then ESG can be interpreted as beta (“smart beta” to the marketers); to the extent these scores do not overlap with traditional factors, then ESG can be interpreted as residual, idiosyncratic or company specific (“alpha” to the quants)...”

Me: company specific ESG theoretically should be a skill for fundamental managers. ESG is not time invariant in materiality or other domains.

“...be wary of ESG studies that treat the historical data in a uniform manner...variable history make it challenging to find statistically

meaningful conclusions based....that said, with the notable exception of the US prior 2016, Residual ESG has rarely underperformed.. [this] should be welcome news to skeptical PMs who may be under pressure to include ESG in their processes…”

Study is technical, not peer reviewed, relies on Owl data but adds to research on ESG Quant.

The study suggests current ESG tilt indicies are potentially not well constructed: ESG indices often have considerable tilts to other factors, such as value and growth, which are just as large as the active ESG tilt, meaning it is difficult to attribute any outperformance to an ESG screen.
“A significant portion, if not the majority, of existing ESG indices are constructed using a simple sorting approach....While this approach is simple to implement and explain, it suffers from the defect that the active tilt on ESG is typically small. In many cases, the active tilts on other risk model factors such as value and growth are just as large.”

It also notes “there is no standard, accepted methodology for combining separate E, S, and G scores into a composite ESG score. It is possible, indeed, likely, that ESG scores from different vendors will exhibit different performance characteristics. Hence, there is yet one more reason to be cautious when forming expectations about ESG: it varies across both time and vendors.”

Copy of the study can be found here.

A different look at this area, but using the Thomson Reuters Data set and by BAML can be found here.

Another lens in a more quant fashion can be found in this MSCI look through its own data and a return on capital lens.

And Nordea Quant also look at it through the MSCI lens.

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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.

Current highlights:

A long read on Will Hutton looking at Brexit causes and solutions.

Some writing tips and thoughts from Zadie Smith

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.

Some popular posts:  the commencement address;  by NassimTaleb (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.

Buy my play, Yellow Gentlemen, (amazon link) - all profits to charity

ESG Survey, US Callan

Callan US ESG Survey of 89 US funds shows 43% of funds using ESG (much lower than global CFA, MS, RBC, other surveys). (see CFA Survey here suggesting about 70% of global funds use ESG, and academic paper suggesting closer to 80% use ESG; also more recent MS survey also mainly US suggests asset owners are more interested, although below global levels)

Corporate funds = 20%, public funds =39%, Foundations = 64% (this looks low to me => 36% not using ESG), Endowments = 56%.

General adoption rates have doubled since 2013 (at start of this survey). 13% of all DC plans (both public and corporate, and incorporating ESG or not) include an ESG option in their plan lineup, compared to a 40% incorporation rate for defined benefit plans.

Over half of all respondents have NOT incorporated ESG factors (wow!) into investment decision-making (54%) in 2018 [ 2013 (78%) ]

Source: Callan Survey 2018

The most common reason to not incorporate ESG: “the fund would not consider factors that are not purely financial in the investment decision-making process (52%).”

This has been one of the top three reasons against incorporating ESG since the inception of the survey. Nearly half of respondents that are not incorporating ESG cite a dearth of research tying ESG to outperformance.  Personal view: This survey highlights the US difference, and (on small data) the DB vs DC, and corp vs non-corp fund differences.

(It might also be an effect of the way they asked the question.

Survey is free to access but needs registration here. 

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Compare it to Amel-Zadeh ... 

Amel-Zadeh: ...ESG information is material to investment performance. However, which information is material likely varies systematically across countries (e.g. a country where water pollution is a more serious issue versus a country where corruption is a more serious issues), industries (e.g. an industry affected dramatically by climate change versus an industry affected by violations of human rights in the supply chain) and even firm strategies (e.g. firms that follow differentiation versus low price). For example, Khan et al. (2016) show that the vast majority of ESG data for any given industry is immaterial to investment performance and that the material information varies across industries within a sample of US stocks. Understanding how the materiality of ESG information varies across countries, industries and firm strategies therefore is of primary importance...”

This to my mind, along with this study on the benefits of Active Ownership and ESG engagement and if one puts this work together with the work on the outperformance of Global Equity managers described here, one can start to build a defense of Active Management for global managers for those using ESG....

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(see CFA Survey here suggesting about 70% of global funds use ESG, and academic paper suggesting closer to 80% use ESG; also more recent MS survey also mainly US suggests asset owners are more interested, although below global levels)

---

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.

Current highlights:

A long read on Will Hutton looking at Brexit causes and solutions.

Some writing tips and thoughts from Zadie Smith

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.

Some popular posts:  the commencement address;  by NassimTaleb (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.

Buy my play, Yellow Gentlemen, (amazon link) - all profits to charity

Postive R&D Culture, Hal Barron Thoughts

Positive R&D Culture: (1) Follow the science. If it tells you to go into an area, don't force it to try to work where it's not supposed to.   

(2)  Incentivise smart risk. Make people feel appreciated for making courageous decisions, and taking risk and not fearing failure.

(3) Single people make key decisions. Committees spell death to innovation.

(4) Focus. Fund aggressively the best projects. Say No. No. No. … how Steve Jobs said it. I'm as proud of many of the things we haven't done as the things we have done.

Innovation is saying no to a thousand things….in Apple, there's a little sign that says, simplify, simplify, simplify, with the last 2 simplifies crossed out.

(5) What you do with a bad decision that had a good outcome, that's called lucky. Do not reward lucky... Luck is not a good strategy.

(6) what if you make a really good decision that's wrong, that has a bad outcome? We need to celebrate that as much. Otherwise, we're going to teach people, only make those decisions that work.

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Hal Barron is considered to be one of the most thoughtful and successful biopharmaceutical R&D leaders (with stints at Genentech/Roche, Calico/Google and now GSK).  

At a recent public R&D meeting (slide pack 25 July 2018) he spoke about science, technology and culture of R&D as three strands needed to be successful (and if one scores zero in any strand, it will be zero overall like multiplication).

While from a healthcare/pharma point of view his comments on technology and science are interesting (GSK is reinforcing / becoming science led (again), embracing AI, functional genomics, cell therapy and 23me – see full slide pack)

His comments on an R&D culture are also insightful about innovation in general (see below from transcript). I can’t give a view publically (standard disclaimers apply no endorsements etc. I’m not predicting the sun to rise tomorrow), you’ll have to come speak/message to me! But you can see my question on culture as a matter of public record at the end.

His point on focus (see below) – might very relevant to many research processes. He claims it is not number of ideas that needs work but it is the full resources to execute on ideas.

Barron: “....as exciting and as challenging as it is to deliver, to execute on the science and technology, having a culture of innovation is incredibly important, and one that I'm really excited about focusing on.

We've divided it into 5 different areas, really following the science. And by that, I really mean -- and I want to highlight this piece -- is that sometimes, particularly with genetically validated targets, but also in immunology, we need to make sure when the science sort of speaks and says, "Look, I'm a target, and I'm supposed to go into neurodegeneration," that we don't say, "That's too bad. We're a company that focuses only on these 3 areas, and we'll force you to look like you work in one of those."

So what I mean by follow the science is to do so in research, as you're discovering targets and trying to figure out what a disease is, in a therapeutically agnostic way. Follow the science. If it tells you to go into an area, don't force it to try to work where it's not supposed to. And we have to make sure that when we do that, we're not taking molecules into diseases where there's not very much unmet medical need, that's not commercially viable. But we need to make sure we're not pushing it into places where the science tells us it won't work.

Probably the most exciting area for me in culture is ensuring we have a culture where we're incentivizing smart risk. And by that, I mean making people feel appreciated for making courageous decisions, and taking risk and not fearing failure. And I'll talk about that in a second.

The third is something that I've basically grown in -- up in, the biotech culture of having single people identified to make decisions, people who have the context needed and the skill set needed and the courage really to make the right decision, and not simply take a vote, not simply to see what everybody can live with because consensus will get everybody happy. There'll be nobody who disagrees or at least disagrees violently. But it's almost rarely -- it's rarely, I should say, the best answer. And it's -- I think it's part of a culture that drives innovation, is feeling that you can be bold and be courageous and be rewarded for taking smart decisions even when they're wrong. Focus, focus, focus. We're not going to be successful if we don't identify those projects that are most likely to work and fund them aggressively at the expense of the ones that probably won't work or clearly won't work. It sounds simple. It doesn't always happen.

And lastly, a bit cliché, but really takes outstanding people in this environment with the right tools and resources to really drive innovation. And we're going to demand that we have these outstanding people. We're going to make sure we develop them, and do everything we can to retain them because outstanding talent attracts outstanding talent.

Let me quickly go through this grid. I've shown this grid, I don't know, 30 times in my -- when giving talks. It's easy to show, a little harder to operationalize, but you'll get the concept. I divide decisions that people make into either good or bad decisions and then either right or wrong. In other words, is there a good outcome or a bad outcome? And then, of course, you get a 2-by-2 grid with 4 different options. Good decision that was right, we don't have to talk about that. Everybody gets happy about that. But as we celebrate a bad decision that was wrong, that's not good. At best, that's a learning opportunity. I want to make sure you've got the people in the right roles.

Source: GSK

The 2 boxes that you can't get wrong for an innovative culture are what you do with a bad decision that had a good outcome, that's called lucky. Do not reward lucky, because what you're doing is you're telling people that we only care about the outcome. And if you just reward luck, I can guarantee you, over the long term, that's not going to work. Luck is not a good strategy. But you laugh. But people reward luck all the time, okay?

Now even more challenging sometimes, what if you make a really good decision that's wrong, that has a bad outcome? We need to celebrate that as much. Otherwise, we're going to teach people, only make those decisions that work. So what do you do? You incentivize a very conservative sort of nature. And over time, that's not going to be terribly innovative. In fact, I would argue that over the long term, that's going to destroy a company. So you need to make sure that you put incentives and reward people when they make good decisions even when they're wrong.

If you think about it, if we came up with this great strategy that was going to double the probability of success, and I told you my first 3 failed, I would say, "Well, 80% failure rate. The first 3 just by -- that's not inconsistent with a 20% success rate, 0 out of 3." We have to celebrate that if that's a good decision and not say, "Ooh, I wonder if we got it wrong. You didn't have enough data." This is probably still a good decision. But a lot of people are rewarded 0 out of 3, people in my job, 0 out of some number. You're not going to be in your job very long. What you really have to ask yourself, is this a good decision?

Focus. And I love focus. I think this is critical. I love these 2 quotes. David Packard, who founded Hewlett-Packard, spent a lot of time [in the barrier] advising companies. And he said this to all of them: More organizations die of indigestion than starvation.

And you might even think that's intuitive. But again, these companies believe not only that, that wasn't true, but believe the opposite, that they would likely die of starvation. And they eat too much. They have too many projects. And that's why they die because none of them are adequately resourced.

And one of the things I heard over and over, when I met with the folks in R&D, was that despite spending a lot of money, we did not have many teams saying I'm adequately resourced. And I think that what we did was we didn't get rid of the least likely to work, to fund aggressively the ones that are most likely to work.

I like how Steve Jobs said it. I'm as proud of many of the things we haven't done as the things we have done. Innovation is saying no to a thousand things. And supposedly, in Apple, there's a little sign that says, simplify, simplify, simplify, with the last 2 simplifies crossed out. And I think this is the kind of culture that I would love to have at GSK, and R&D in particular, so that we can really incentivize people to focus.

Now we have been focusing. As Emma said, the -- when you saw the numbers earlier, R&D spend is down. And that's not surprising. We have made 65 decisions to terminate partner or divest programs since April 2017. 42 programs were in the clinical phase, and the remainder were preclinical. There was more than 400 FTEs freed up to be able to work on programs, like I said, with BCMA and GM-CSF, and other programs that we want to push aggressively to do this. And we're going to be continuously looking at the portfolio to find opportunities to see things that are working and aggressively move them forward, and things that are less likely to work, and removing them.

This is the pipeline. There's a lot of upcoming milestones that will inform our progress. Again, my commitment to you is that every 6 months or so, we'll be very transparent about what decisions we've made, what progress we've made, what things haven't worked for efficacy or safety or whatever that are being removed. Sometimes we can tell you right away. Sometimes, we have to wait for the data to mature and be presented at a meeting. But we're going to be much more transparent about this, so that you can actually see, is this strategy bringing value as measured by the kind of assets that you see in the pipeline?

So the new approach, really, will go from an organization that we believe was spread quite thin across many different programs. A consensus-driven making organization and an organization where R&D and commercial are a bit siloed, and where we have limited business development activity, to an organization where we aggressively back the best potential medicines, removing those that don't look promising. Create a culture of accountability, where smart risk-taking and courageous decisions are made by individuals. And that's not to say we won't have teams, but teams will have leaders, who are accountable for making a decision. And those decisions are rewarded when they're smart risks.

We'll have robust governance models with scientific peer review, commercial input. Emma [CEO] mentioned that [Luke] and I -- one of the fun things about my job is I get to work very closely with Luke . We've reorganized the portfolio investment board. We've got really terrific analytics that help us make good decisions from Kate Priestman's group. And I think we're together seeing how to optimize the portfolio because that's how you help the most number of patients and provide shareholder value. And of course, you heard that we're going to be investing significantly in business development to further optimize the portfolio. Where and what depending on data readouts.

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Ben Yeoh: I have a question on the culture piece. In large organisations, particularly, we have seen that it is very difficult to do cultural change. I was wondering what are the metrics that you are looking at, which might be showing you that the cultural change is on track, and whether there are any early signs of what you are doing having some traction. A sub-part to that is, how do you incentivise people to say ‘no’? It is almost a mindset thing, and it is quite a difficult thing to get right in the process. We hear about it … we see organisations that do it well, but turning an organisation to think about that is quite a challenge.

Hal Barron: That is a terrific question. First of all, on this backing up. We, I – we all believe strongly that we need metrics to figure out how we are doing, so that if we are not doing as well as we would like to, we can figure out what is missing. The metric, specifically on culture – and it is hard to imagine how we could tackle it all – one simple way is that we have HR surveys to see how engaged people are. How well do we think we are doing at decision-making? How fast are we at moving things forward? There are a number of different questions. We have been benchmarking for different reasons, but we have been benchmarking this over the last couple of years, and those who know more can comment. I would expect that we could look at those questions and pull out, prospectively, those that we think will reflect the cultural change and use them, to some extent, at a very level but as a metric. The second one is just asking people to do these things, I don't think personally is going to work. I think you actually have to ensure that you have things in place that make it easy to do that, in fact that incentivise you to do that. For example, if we have a metric called "Put eight targets into Phase 1 next year", we will have at least, probably, eight targets in Phase 1. Now that is a progression-seeking culture rather than one that is necessarily going to be incentivised to kill things that don't deserve to move forward. When we set goals, I think we need to be mindful of goals that incentivise what we want. For example, and I don't mean that we should do this for every goal, but certain goals should say 'at the end of Phase 2' - I will make this part up - 'we should take no more than three weeks to assess the quality of the data, its impact and whether we want to move forward. Now, that might be really easy because it's negative, or it might be really hard because it's grey, or it may be really easy because it's super-positive, but incentivising to do things quickly rather than incentivising to make it go to Phase 3 - because if we incentivise to make it go to Phase 3, we are not telling people to look carefully at the data; do whatever you think is right. There is a subtle bias towards wanting to progress things, so I think it comes in measurable from the surveys, but also creating goals that will incentivise that. Also, doing a lot of talking with employees and seeing how it's going. I'm sure we will come up with other metrics that we think are useful in assessing this.  […]

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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.

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A long read on Will Hutton looking at Brexit causes and solutions.

Some writing tips and thoughts from Zadie Smith

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.

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