JUNE 2018

Lies, Damned Lies, and Statistics

Category: Impact Investing, Portfolio Management, Senior Management

By Doug Cohen, Managing Director, Portfolio Management

The origin of this blog post’s title could serve as an interesting topic in and of itself (long story short, the phrase was popularized by Mark Twain but its derivation is unclear). However, to the extent that there is often a significant amount of ambiguity in the ESG world, it strikes me as an appropriate warning.

As an example, a colleague recently circulated an article from the New York Times titled “Is Capital or Labor Winning at Your Favorite Company? Introducing the Marx Ratio.” The article highlights that as a byproduct of the 2010 Dodd-Frank law, one can now easily compare companies across Corporate America based on shareholder returns relative to rank-and-file compensation. More specifically, the so-called Marx Ratio—coined by the article’s author, Neil Irwin—contrasts the return to capital on a per employee basis to median employee compensation. The name is, of course, a nod to philosopher Karl Marx, who famously argued that there is a fundamental and perpetual conflict between the interests of capital and labor. Marx’s capitalistic opponents argue that capital and labor are inherently linked given that profitable businesses create a virtuous circle that rewards investors and workers.

The article does a good job of highlighting the ways the Marx Ratio can be useful, as well as its limitations. However, I do see two additional issues.

1) Without getting too philosophical, it’s probably not a good name to use. Not necessarily an inaccurate one, but not a wise one. If one conflates Marxism and Communism (and not everyone does), let’s just say that the track record in terms of both lives lost and economic success is dreadful. Even if one doesn’t equate the two, Marxism’s track record isn’t too good (an understatement). To the extent Irwin or anyone else wants to popularize a metric and gain broad appeal with mainstream capitalists, it’s probably best to choose a different name.

2) Metrics like this tend to get tossed around in overly simplistic ways. It reminds me of the widely publicized CEO to average worker pay ratio—one that has value in an era when CEO pay has skyrocketed, but also meaningful limitations and potential unintended consequences. The Harvard Business Review explored this topic in an article titled, “Why We Need to Stop Obsessing Over CEO Pay Ratios.”

Reality Check

On June 11, 2018, Robert Jackson Jr., a member of the Securities and Exchange Commission, put forth evidence that many top US executives have been selling their shares just after announcing major share buybacks, profiting from the stock price rally that typically follows a repurchase declaration. Jackson and his team assessed activity at the 385 companies that announced buyback programs in 2017 and the first quarter of 2018. They found that the announcements boosted share prices by 2.5%. Meanwhile, insider selling occurred twice as often in the eight days after a repurchase announcement. In that eight-day period, insiders sold an average of $500,000 worth of stock each day, five times the daily level from before the buyback announcement.

This is just a small example of how many management teams operate. There’s nothing at all illegal about it (at least not yet—Jackson is working on that). Rather, they often operate within the existing rules to help feather their own nest. One could argue as to whether the self-serving approach is a fundamental shortcoming of capitalism, a result of perpetually lax regulation, or simply an unfortunate but ultimately minor byproduct of human nature in the most successful economic system the world has yet to know. However, the reality is that executives are exceptionally adept at finding ways to exploit loopholes.

That same deftness is apparent when corporate executives are assessed on specific metrics. As the Harvard Business Review article argues, executives will routinely find ways to navigate around virtually any metric—often to the detriment of both shareholders and workers. When called out by the media or shareholders for having a high CEO to average worker comp ratio, why not simply outsource lower paying jobs? Or better yet, automate those jobs into non-existence?

Improving ESG Measurement

So if many C-Suite inhabitants will consistently find ways to stack the deck in their favor, how do asset owners best identify the companies that don’t play games and that do operate in the best interest of their shareholders, employees, and society at large? How can we effectively motivate more companies to behave responsibly?  For starters, it’s certainly more difficult to game a system with dozens if not hundreds of relevant metrics than a small handful. As such, we think the folks at JUST Capital who rang the opening bell at the NYSE on June 13, 2018, are onto something. JUST is Paul Tudor Jones’ foray into socially responsible investing.

For almost two years, the JUST team has been closely tracking the performance of America’s largest 1000 companies based on about one hundred metrics related to workforce management, job creation, the nature of their products, environmental impact, community relations, and management/governance. The specific criteria reflected extensive polling of the American public regarding the values they deem most important. Companies are ranked across all industries (except tobacco) in large part to identify the companies that rank toward the bottom of their respective industries and to encourage them to improve.

We’ve heard Mr. Jones, a legendary hedge fund billionaire and philanthropist, exclaim that JUST has the potential to be the largest thing he’s ever done. Sure enough, the bell-ringing was to celebrate the launch of JUST’s new ETF, in collaboration with Goldman Sachs Asset Management, which includes the companies that rank in the top half of their respective industries. Suffice it to say that the launch from one of America’s foremost capitalists will be an interesting test of the ESG’s world’s promise to do well by doing good—by incorporating a broad array of metrics that collectively are almost impossible to game.

Tags: , , , , ,