Identifying a misalignment
In our view, it has become clear that increased recognition of the long-term challenges facing society - including growing inequality and the degradation of the environment - led to a financial marketer's dream as far as ESG is concerned. But in the end the misalignment between our industry's desire to create relevant products, and its customers' hoped-for outcomes, has led to accusations of greenwashing and a regulatory and political backlash that has not helped make progress on these serious issues. Trust has suffered. An investment manager in the US, for example, justifying an about-face on some of its ESG commitments, has quoted laws that now require money managers to act solely in clients' long-term economic interests, with the implication that investing in companies that are pushing sustainable agendas is bad for business. As an independent fund manager, Skerryvore is immune to pressure from a marketing department or a CEO worrying about quarterly earnings and, indeed, we have long held the opposite view. Why is this?
Simply, because the actions businesses take to address governance, environmental and social challenges also lead to the building of a reputation. The average company in the MSCI Emerging Markets Index trades, at the time of writing, on a 1.7 times multiple of its net asset or book value. Net asset value is what is left when you take what a company owes away from what it owns - buildings, factories, machinery, trucks, fridges, inventory etc. By contrast, at the time of writing our funds are nearly double that average, with a multiple of over 3 times. What could justify this difference in price?
Quantifying the abstract
This gets us into the territory of 'intangible' value, that part of a company's value that doesn't have a physical presence. Some of these elements can be valued, such as customer relationships or patents, which typically have a defined lifetime and decline over these useful lives.
However, in many cases there is still a lot of unaccounted-for value that is covered by the catch-all term 'goodwill'. This manifests on balance sheets as the price one company pays for another minus all the things that can have a value ascribed to them and was first defined in law in the UK in 18101. We opt for a simple understanding: that this intangible value represents a company's reputation - often embodied by the company's brand, which Jeff Bezos once described as 'what people say about you when you're not in the room'.
Behaviour: The foundation of trust
So if reputation is valuable, how do you go about building it? Henry Ford once said that 'a business that just makes money is a poor business2' , implying that for a business to endure it has to do more than simply make money in the short term. What then are the other things that matter? Oddly, it turns out these seem to line up with the kind of things that people talk about when they discuss ESG.
Take, for example, governance - a company that is well governed by people with integrity can build trust. Voltronic, a Taiwanese maker of uninterruptible power supplies (UPS) among other electrical equipment, has built a very successful business by deciding only to act as a manufacturer for brand owners, which is possible because the company is run by a founder with high integrity, Alex Hsieh.
Another example is Cipla, a manufacturer of generic medicines. The willingness of international companies to partner with it and employees to work for it, we believe, is tied to the company's environmental record of not dumping effluent into waterways, which many of its competitors do3. Despite the fact it makes generic medicines, one of the most cutthroat and commodity industries that exists, Cipla, like Voltronic, is priced at a significant multiple of its book value. Cipla has built a trusted brand in India and other emerging markets by maintaining higher standards which has created significant long-term value for shareholders.
Reputation only really matters over the long term, and this gives us an advantage as patient investors. We can see, often at a relatively early stage, whether a company cares about building this intangible value and understands that, despite all the time it takes to build it, it can be destroyed by one bad decision that adversely affects any of its stakeholders. For those who are patient enough to commit to the behaviour required overtime, the rewards are persistent and difficult to copy.
Tata Consultancy Services makes a point of treating its employees well, for example, training them in new technologies instead of acquiring existing companies. This results in lower staff turnover and higher returns than any of its competitors. Indeed, the Tata family in India has long understood the importance of integrity and the long-term benefits it can bring. One of its most famous products, even today, is salt, a basic commodity with which Tata has been able to engender trust and, as a result, price it at a premium.
FEMSA, a Mexican holding company, was able to sell its beer brands to Heineken, the Dutch brewer, to focus on retail and Coke bottling, but the family's reputation for integrity was such that the deal included shares in the Heineken holding company, owned for many generations by the Heineken family.
Goodwill as a beacon in stormy waters
It is perhaps when things go wrong that the real value of reputation reveals itself. Recently an Indian business magnate who had previously been targeted by a short-selling report found himself charged with fraud by the SEC. When this happens, as an investor in that business, what confidence can you have that you own what you thought you owned, or that the value of the business will ever recover? This makes it difficult to buy when the company stumbles. Contrast this with the companies that we own which, if they fall in price, don't leave us wondering about the integrity of the owners but rather how much of the company to add to our portfolio while it's available at a more attractive price, as we have been doing recently with FEMSA.
Conflating morals, values or business agendas with the act of investment is dangerous territory when thinking about returns. We favour management teams who recognise that their intangible value represents the ultimately fragile reputation of the business for integrity and treating all stakeholders in a fair manner. For those companies that take the time and care to build it, a good reputation can serve as an enduring competitive advantage as long as the owners and culture support it. As investors and owners of a business, we love to invest in these kinds of companies because we believe that they are capable of generating great returns over the long run.
1. Accounting Information (no date). Goodwill in Accounting: A History of the Issues and Problems. https://www.accountingin.com/accounting-historians-journal/volume-10-number-1/goodwill-in-accounting-a-history-of-the-issues-and-problems/.
2. Henry Ford (1922) My life and Work.
3. Changing Markets (2015). Bad medicine - How the pharmaceutical industry is contributing to the global rise of antibiotic-resistant superbugs. https://changingmarkets.org/report/bad-medicine-how-the-pharmaceutical-industry-is-contributing-to-the-global-rise-of-antibiotic-resistant-superbugs.
Any information provided in this document relating to specific companies/securities should not be considered a recommendation to buy or sell any particular company/security.
