What lies beneath
While the spectacular implosion of Enron in 2001 appears to have been the immediate catalyst for reform, other accounting horror stories have now also emerged at WorldCom, Tyco, Global Crossing, HIH Insurance in Australia, and other prominent companies. These cases, and others like them, have fundamentally shaken both investors’ and the general public’s confidence in the reliability and even the relevance of audited financial statements, once among the most basic raw material of securities analysts everywhere. This is creating unprecedented opportunities for proponents of alternative (or at least supplementary) analytical approaches.
In our view, this disenchantment is by no means a bad thing, nor is it premature. If the Enron and other fiascos trigger or accelerate a thorough re-examination of company valuation techniques and the disclosure requirements upon which they are abjectly dependent, it will have been well worth it.
The recent scandals in the US concerning the dubious objectivity, and therefore value, of much Wall Street research only adds fuel to the fire. It is time we examined not just the objectivity of investment research but also its fundamental intellectual adequacy and dynamism.
As recently as the mid-1980s, financial statements captured at least 75% of the true market value of major corporations. According to New York University accounting guru and business professor Baruch Lev, however, in the intervening years that figure has dropped to a paltry 15% on average. That leaves roughly 85% of a company’s value which cannot be explained by traditional, accounting-driven financial analysis. (In the case of Microsoft, the figure is actually more than 99%.) This yawning gulf between companies’ book value and what they are really worth – their market capitalisation – is now at an all-time historical high.
This leaves institutional investors and fiduciaries with a severe information deficit. One of the most succinct assessments of the situation that I have seen comes from the highly-respected CFO of pharmaceuticals company Merck: “The accounting numbers don’t tell us anything, really.”
Let’s take a few recent examples to illustrate the sheer magnitude of the analytical bankruptcy of accounting numbers. In 2001, three high-profile technology companies – Intel, Dell, and Cisco – reported combined profits of $4.4bn for the first three financial quarters. If one had instead followed best practice and the advice of the accounting regulators (not to mention investment deity Warren Buffett) and treated share options as a company operating expense, this figure would transform itself instantly into a combined $1.4bn loss! Another popular piece of accounting legerdemain is the use of so-called ‘pro forma’ accounting, an approach that conveniently allows companies to bypass a good deal of unhelpful financial news. Using this approach, the bellwether US technology stock index NASDAQ claimed that its component companies earned a combined $80bn profit in 2001. Using the less generous but more widely accepted US GAAP that profit would have become a $20bn loss.
It seems to me that if traditional financial analysis cannot even tell us definitively whether many of the most closely followed companies in the world actually made money or lost it, there is plenty of room for improvement and innovation.
As we move deeper into the era of knowledge-value and intangibles, conventional balance sheets and profit and loss statements will capture and reflect less and less of a company’s true value and competitive potential. What is needed instead is a new, more dynamic ‘iceberg balance sheet’ approach. This is one that focuses investor and senior management attention where it belongs: on the 80–85% of companies’ true value that cannot be explained by traditional, accounting-driven securities analysis.
In point of fact, it is the unseen part of the ‘value iceberg’, the much larger portion below the surface, which contains the primary drivers of the company’s future value-creation capabilities and unique comparative advantages.
These intangible value drivers are of course notoriously ethereal and difficult to measure, but they will be absolutely central to companies’ competitiveness and profitability going forward. Among the most powerful of the contemporary intangible value drivers are:
q human capital;
q stakeholder capital, and
q sustainable governance.
The good news for investors is this: contrary to popular belief, these so-called ‘wooly’ issues are amenable to analysis that is every bit as robust as mainstream investment analysis – if not more so.
Eco-value is the intangible value driver with the strongest documented ability to generate positive alpha. It is now increasingly widely recognised by leading-edge financial analysts and investors that there is a strong, positive and growing correlation between industrial companies’ ‘sustainability’ (environmental, social and governance performance) and their competitiveness and financial performance, whether measured as return on investment, return on equity or total stock market return .
The alpha-generating potential of environmental factors has been demonstrated consistently – most recently in an analysis conducted in 2002 by independent quantitative analysis firm QED. This study used a sophisticated optimised time-series methodology, which normalised away all other investment risk factors that could have explained the outperformance.
Of perhaps even greater importance, however, is the confluence of at least eight strategic ‘mega-trends’ that give every indication of creating an even larger financial ‘sustainability premium’ in the future. These are:
q tougher disclosure requirements for both companies and institutional investors;
q globalisation of capital markets and industrial competition into emerging markets, greater social/ environmental risk;
q tightening global and domestic regulatory pressures – for example, the Kyoto Protocol, UK/European pension reforms;
q changing consumer and investor demographics – greater sensitivity to social/environmental issues;
q NGO pressures – increased transparency, quality and velocity of company information, plus greater credibility for NGOs;
q expanded purview of fiduciary responsibility to include social, environmental and governance issues;
q growing capacity and inclination for institutional investor shareholder activism, and
q growing CEO/CFO awareness of competitive and financial benefits of sustainability.
Since there is now incontrovertible evidence that superior environmental and social performance does in fact affect the risk level, profitability and stock performance of publicly-traded companies, fiduciaries can be seen to be derelict in their duties if they do not consider environmental and social performance and risk factors in their analysis.
Paying attention to SRI factors should not be about paying lip service to the requirements of new pension fund regulations. Nor should it necessarily be about identifying and punishing corporate ‘villains’ based on frequently arbitrary ethical judgments. What it should be about is the future of mainstream investing itself: using new, robust, non-traditional performance indicators to identify hidden risk factors and out-performance potential in both their equity and fixed-income portfolios. Given the parlous state of both pension fund finances and the capital markets themselves, thoughtful fiduciaries cannot really afford to do otherwise.
Matthew Kiernan is chief executive of Innovest Strategic Value Advisors in Toronto