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Lawrence A. Cunningham’s Quality Investing: Stock investors want companies on board with ESG but principles have a price

Investors have been drawn into culture wars and other divisive debates in the U.S., distracting them from their traditional focus on business quality and prosperity. Wading into these waters is the country’s investor protection agency, the Securities and Exchange Commission, but the SEC should recognize the perils of the current predicament and proceed cautiously.

Traditionally, investors cared most about preserving capital and generating returns, only steering clear of investments that were illegal or immoral. Drawing the line was easy, as investors sold shares or withheld capital from companies behaving perniciously. Investors would otherwise defer to managers on nuanced topics, such as whether to market a product guaranteed to save a thousand human lives but at the expense of as many laboratory animals, and politics were not central to corporate practice.

Such deference has diminished significantly in recent years, as many institutional investors and their advisers insist that all companies prioritize their views on a wide range of topics from internal corporate administration, such as board composition, to contested topics of public policy, such as workforce makeup and manufacturing processes.

Two prominent investment trends of the past 15 years are most responsible for this inversion of the traditional model of shareholder deference to managerial judgment and political reticence.

The first is the rise of powerful index funds. In the index fund business model, investors make no judgments about individual stocks. Instead, they buy every stock in the index. Since this business model focuses on the whole system rather than particular companies, index funds produce general requirements of all investees on a wide range of matters over which management traditionally had discretion to tailor as needed or social topics corporations generally stayed out of.

Financial industry behemoths including BlackRock
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and Vanguard Group, as well as others, have increasingly dominated equity ownership, and now command a majority. Larry Fink, CEO of BlackRock, is famous for issuing missives instructing corporate leaders on the proper norms of contemporary business behavior. Institutional Shareholder Services (ISS), which dominates the market for advising institutional investors, is well-known for its prescriptive guidelines on a variety of topics that it says are best for all companies.

The second factor has been the proliferation of the United Nations’ investing principles based on environmental, social and governance priorities. While many such “ESG” principles capture issues of longstanding interest to long-term focused shareholders (quality shareholders), index funds glommed on to ESG concepts as a cheap and defensible way to direct all companies to follow universal standards concerning a host of topics.

These began, innocently enough, with defining ideal boards of directors, insisting they be independent and active monitors of management. Lately, these standards reach more broadly, now mandating written policies and disclosures concerning such matters as workforce diversity and carbon emissions. An expanding list of topics has enticed investors and companies alike to wade into political debates spanning from animal rights and voting laws to transgenderism.

Since rigorous debate on such topics is vital to a free society, it is impossible to believe that any single shareholder, shareholder adviser or shareholder cohort could specify a policy position that is universally correct for every company and situation.

The genius of the corporate model is to consolidate corporate decision-making power in a board charged with appointing and overseeing managers. The corporate model is well-designed to enable shareholders to disagree with each other and with managers over business policy and strategy. Battles for corporate control have raged over such subjects for many decades, from dueling tender offers in the closing decades of last century to bruising proxy fights for director elections in the opening decades of this one.  Such a system is designed to produce optimal business results, not political ones.   

The corporate model is ill-equipped as a political forum for resolving public policy.  In fact, the corporate model will fail when shareholders pull managers in different directions on political disputes of the day that often have little to do with a company’s business. A company that comes down strongly for or against one policy idea will please some constituents while alienating others. For example, it was the debate over abortion that doomed an otherwise attractive shareholder charitable giving program at Berkshire Hathaway
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Ideally, investors and markets will self-regulate to restore some balance to the shareholder-manager relationship. Index funds and institutional investor advisers are unlikely to continue to rule if they fail in the traditional function of preserving and growing capital in favor of inserting themselves into national politics. Governmental agencies such as the SEC, charged with investor protection, should certainly avoid using regulation to impose political views on corporate America. Such a step would assure political backlash, exactly the opposite of investor interests.  

Lawrence A. Cunningham is a professor at George Washington University, founder of the Quality Shareholders Group, and publisher, since 1997, of “The Essays of Warren Buffett: Lessons for Corporate America.” Cunningham owns shares of Berkshire Hathaway. For updates on Cunningham’s research about quality shareholders, sign up here

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