Knowable-but-Ignored (ESG) Factors that Drive Valuation
Since the financial crisis of 2008, mainstream investing’s reliance on indexing has resulted in index-based investment strategies growing to a tripling of assets.
While John Bogle’s first index fund at Vanguard is nearing its fortieth birthday, investors are now shifting to “smarter” indexing – based on fundamental metrics, volatility, or other factors that could more closely link to true fundamental value creation. This implies that market-weighted indexes lack fundamental drivers of value creation – and below we show you how these “new fundamentals” – which include impact and ESG factors – can affect your portfolio.
In this first contribution by HIP Investor to Equities.com’s impact investing section, we cover how many indexes could be even more closely linked to fundamental factors which are not always disclosed in the 10-K, but still discoverable from openly public sources. These intangible factors – which include impact and ESG – are very measurable and valuable to investors, thus providing the opportunity to enhance risk-adjusted returns for your portfolio.
Market-Cap Indexes Presume Market is Efficient; Fundamental-weighted Indexes May Be More Efficient
Market capitalization-weighted indexes are the standard in index constructions, and thus, the fund choices for core positions in many investment accounts. Automated investment management tools such as $2 billion (AUM) adviser Wealthfront rely on market capitalization-weighted ETFs, mainly Vanguard, in portfolio construction that fulfills asset class targets. Charles Schwab’s ($SCHW) new robo-advisor platform is following suit, including its own Schwab market-cap index ETFs. Many of the highest asset value mutual funds and ETFs are market-cap weighted funds, as shown in the top 25 largest funds list.
In a market cap-weighted index, stocks with greater market value get greater weight in the index. As a stock's price changes, the value and weighting of the stock in the index changes. The impact that individual stock's price change has on the index is proportional to the company's overall market value.
Indexes constructed on factors other than stock price or current market value are increasing in popularity, and fundamental “factor-based” investing has been showcased in many seminars and articles in the last year. Firms such as BlackRock Inc. (BLK) , WisdomTree Investments, Inc. (WETF) , and Invesco, Ltd. (IVZ) operate a variety of ETFs on factors such as value, earnings, momentum, and low volatility. WisdomTree, partnering with Wharton professor Jeremy Siegel, constructs its own indexes based on factors like earnings and dividends, and benchmarks its investment strategies to these indexes to reflect fundamental factors of potential future value.
Several leading firms are focused on the fundamentals found in “new fundamentals” like human, social, and environmental capital factors. These are intangible, but measurable, sources of potential future value and potential risk reduction. Traditionally, these have been classified as low or negative return on investment factors. In fact, these factors seem to be leading indicators of future performance, and many times accretive to cash flow and shareholder value, while frequently reducing risk.
Hence, looking at a common index construction, such as the S&P 100 Index versus a fundamental index strategy that includes “new fundamentals” such as ESG, stark differences appear when these new fundamental factors are quantified and applied to the index. The following table shows the top ten holdings of the S&P 100 versus the top ten of the fundamental-weighted HIP 100 Index as of 12/31/2014.
Source: S&P, Morningstar, HIP Investor
Leading, innovative firms like Microsoft, Intel, and Johnson & Johnson do not differ widely in rankings between the two indexes. There are moderate differences – such as General Electric (GE) , Procter & Gamble (PG) , JP Morgan Chase (JPM) , 3M (MMM) , and Biogen (BIIB) . And then there are wide differences – ExxonMobil (XOM) is the third highest component of the S&P 100 but sixty-fourth in the HIP 100 Index, contrasted with Baxter International (BAX) , the third highest in the HIP 100 Index, but seventy-sixth in the S&P 100. Wells Fargo (WFC) is eight in the S&P 100, but fifty-ninth in the HIP 100 Index, where Texas Instruments (TXN) holds essentially this same spot in the S&P 100, but is fifth in the HIP 100 Index. The following analysis looks at some of the major factors that cause these splits and how they link to expected risk-adjusted returns.
Long-term Investing versus Short-Term Maneuvering: Accenture, Dow Chemical and Those Who Pay Well
Accenture (ACN) and Dow Chemical Co. (DOW) are ranked sixty-first and sixty-seventh, respectively, in the S&P 100 Index. Yet both these firms are in the top 10 of the HIP 100 Index with their emphasis on investing in human capital. One measurable element of this factor uses the metric of employee pay. Data on employee pay from Payscale.com shows both Accenture and Dow compensate well above the median in average employee pay.
Employee pay is a hot topic as of late. Wal-Mart Stores, Inc. (WMT) announced in February 2015 it would raise wages for a half a million workers, and the decision doesn’t seem to be based on minimum wage regulation. Wal-Mart CEO Doug McMillon says higher pay will “play through retention [and] the ability to hire the talent that we need to hire…that’s got to show up in sales. Won’t happen immediately, but it will happen.”
Integral to this topic is “living wage” as a human right, but as Walmart described, the issue goes beyond high-minded social justice considerations. Paying employees well is also a competitive factor to attain and retain the best talent. It is an investment in a company asset. Human capital on traditional financial statements is currently listed as an expense or a liability. Though most CEOs claim that workers are a firm’s most important asset, traditional finance and accounting statements do not accurately capture this value in GAAP-approved statements, nor disclose it adequately in mandatory documents like the 10-K. Thus, a firm’s valuation may not fully represent the future risks or returns, especially as 80% of all stock market value of the S&P 500 is intangible, according to Ocean Tomo.
Many non-S&P 100 companies are acknowledging the value of this asset, seen by recent proactive wage increase plans at Aetna (AET) , H&M ($HMB), IKEA, Novartis (NVS) , and Gap Inc. (GPS) . The Container Store (TCS) , a consistent presence on Fortune magazine and The Great Places to Work Institute’s “100 Best Companies to Work For” list, made clear it wants investors that think this way, too. When CEO Kip Tindell faced investor scrutiny recently on his policy of generous worker pay, he responded by discussing long-term value generation and product innovation, stating that important decisions about the company long-term are not based on performance over a single quarter.
Fortune magazine and The Great Places to Work Institute released their annual list on March 5. We will write more in depth about human capital factors in the coming weeks on Equities.com. Professor Alex Edmans, formerly of Wharton business school and now at London Business School, has shown that a portfolio of the Best Companies list can outperform the returns of market-cap indexes, (which also showed a four-factor alpha) for the years 1998 to 2010.
In addition to investing in employees, an index based on new fundamentals like human and social performance also values company capital allocation toward more balanced compensation between executives and employees. Very high multi-million dollar CEO compensation packages are cited as reward for value creation, but analysis by HIP Investor and AsYouSow.org shows no correlation between Total Shareholder Return and CEO total disclosed compensation, as shown below:
Source: As You Sow 2015 report on Most Overpaid CEOs
Fundamental indexes can use these ratios to assess equities. Accenture and Dow have relatively low ratios of CEO pay to average employee pay, thus allocating capital towards all employees and away from high CEO compensation. Investors seeking more details can read the 2015 analytically rich report by As You Sow, which incorporates additional criteria on overpaid CEOs relative to TSR. Of the S&P 100 top ten, four are listed in the top 100 as “overpaid” in As You Sow’s report, versus two out of the HIP 100 top ten listed as “overpaid.”
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