Responsible capitalism: why every long-term investor should care
300 guests joined us at the IET in London to learn more about thinking, acting and investing responsibly. Broadcaster, Andrea Catherwood, hosted the panel and began by asking us to think about the changing role of businesses in society and how a sole focus on maximising shareholder value can lead to damaging short-term decisions. Rathbones’ Head of Asset Allocation Research, Edward Smith, used a parable about a Prussian forest in the 18th century to explain the dangers of today’s capitalism and Matt Crossman, Rathbones’ Stewardship Director told us about all the good things that capitalism can do, when considered responsibly. Giles Bolton, Tesco’s Responsible Sourcing Director, finished by explaining how corporates are putting responsible capitalism into practice.
Read on to find out what Edward and Matt had to say about responsible capitalism.
A parable for responsible capitalism - Edward Smith CFA, Head of Asset Allocation Research
It’s clear that capitalism isn’t all that popular. Even here in London, the supposed hotbed of avarice, just 24% of people identify as capitalist. Nationwide, there isn’t a single age cohort in which more people view capitalism favourably than they do unfavourably. What’s behind capitalism’s popularity crisis?
This fall in popularity is often attributed to rising income and wealth inequalities, but that’s been happening since the 1970s. I think its unpopularity can be better attributed to the fall in living standards, which have undergone the most protracted slump since decent data began about 150 years ago. The vast majority of real incomes have been contracting and people want change.
Is capitalism to blame for this? We don’t think it’s capitalism per se, but we do have grave concerns about the particular form of capitalism that’s taken hold since the 1970s. I’m going to explain this by way of a parable: the parable of a Prussian forest.
Imagine that you are standing in the middle of a forest in what we now call Germany in the 18th century. In front of you are elm trees and beech trees and fruit. A mixed choir of birds fills the canopy with tumbling descents, while below, deer and rabbits dance to its tune. There’s a family too; a mother gathers kindling and two children forage for mushrooms. A blissfully sylvan scene, but one that was a profitable and flourishing source of wood for the Prussian state.
Now, transport yourselves 100 years into the future. You’re standing in exactly the same spot in the same forest, but you wouldn’t know it. It’s eerily silent and the elm and the beech are gone, so are the flora and fauna. The soil is thin, patchy and grey. There are no mushrooms for the children to forage. What happened? The Prussian state tried to distil the forest’s vastly complex ecosystem into a single number: annual revenue yield of timber. Everything that seemed unrelated to maximising that number, such as the birds and fungi was ignored. Everything that seemed to actively get in the way of maximising that number, such as the villagers or the fertile underbrush, was eliminated.
Well guess what - all that stuff mattered. Unfortunately, the grave consequences of this very narrow, short-termist approach weren’t seen until it was too late and production losses were pretty catastrophic: 20% - 30% by the second or third generation.
At some point in the late 20th century, we think that companies, boards and - I hate to say - investment managers, acted a bit like the Prussian state. They tried to resolve the complex set of relations that constitutes ‘the firm’ and its place in the socio-economic ecosystem, to a single number: the annual profit growth. We fear that this short-term approach has jeopardised the sustainability of company profits long into the future and with that, the growth of profits on which our clients depend in order to grow and protect their wealth. Thinking about the long term and how all the stakeholders in the socio-economic system are faring is important to ensure that profits are sustained long into the future.
The good news is that you may not have to wait long to reap some of the benefits. The studies that look at the link between a company’s environmental social and governance (ESG) policies and its financial performance find a positive relationship in almost 50% of cases. Good corporate social responsibility (CSR) really is linked to better financial performance. Some of the most thorough studies suggest that there’s a 5% annual return premium to be harvested from companies which rank highly in CSR, a huge amount.
The evidence is overwhelming: responsible capitalism is associated with higher returns on capital, lower cost of capital and better share price returns. Here’s just some of the things we are doing about it at Rathbones:
- Incorporating positive screening into our investment processes.
- Demanding better data and non-financial disclosures from companies and governments.
- Questioning what we mean by maximising shareholder value.
- Questioning short-term thinking and divergent pay practices.
Responsible capitalism - back to the future - Matt Crossman, Stewardship Director
Where do we find ourselves with capitalism today? Is the system broken? Perhaps we should look at our past and put today into context, starting with the inception of the corporation.
Companies were intended to be for big social purposes and the first corporate entities were granted to religious institutions. They were meant to be linked to long-term improvement in society; short-termism was always critiqued. There was privilege, but it was for a purpose.
Back in the 17th and 18th centuries, if you wanted to set up a business, it would have had to be a personal private partnership with a small amount of capital, and crucially, you took all the risk. We believe that it was not the discovery of penicillin, or the inception of the internet that changed the world, but the passing of the limited liability act in 1855. Before then, it was a wonder that anyone was willing to start a business at all - you would have risked everything.
After the act was passed, capitalism began delivering a pace of change like no other system, and the impacts have been huge. For example, in 1800, the average life expectancy around the world was 38. Now it’s 72. That enormous change has happened over just 200 years as a result of a huge investment in hygiene and public health infrastructure. Capitalism, when directed towards social purpose, delivers developments at a scale that no other system can hope to match.
Maybe you think I’m overstating the case, so ideally, what we would have is a control - an area where the only difference is the role of capitalism in the economy. We do: the Korean peninsular, separated politically in the 1950s. Fast forward over 65 years, and the difference is clear. One is a socialist dictatorship, and the other is a market economy. Millions of North Koreans are living their life in the dark. If you are a South Korean today, you will live on average 12 years longer than your North Korean counterpart and be 3 to 8cm taller. 0.7% of under fives are undernourished in South Korea compared with 15% in North and the transport is drastically better in the South: only 3% of roads in North Korea are paved compared with 92% in South.
If capitalism is so great, why are we facing such serious problems? I think it’s been a victim of its own success. The very infrastructure which enables the risk-free pooling of capital towards social good enables things to be driven towards short-termism. There are four big criticisms of capitalism, and I’ll address how to navigate them.
Short-termism. In the 1960s, the average holding period for UK equities was eight years. This had fallen to 7.5 months by 2007 and today, it’s under a minute: we are in a hyper phase of globalisation. We need to encourage the type of long-term ownership which provides businesses with the incentives to invest for the longer term.
Market failure. Companies operate within a market and that market can sometimes measure the wrong things, and not measure the right things. Traditionally, quality has been determined by financial measures only. What’s missing is how companies treat their stakeholders and that’s really important. We need to demand that the right things get measured.
Growth vs planetary limits. When capitalism and limited liability were founded, there were two billion people in the world. Now there are over seven billion. This idea of ‘limits’ was not something that occurred to the drafters of those laws, but we’re now coming rapidly up against them. Capitalism is not able to deal with limits and boundaries because it isn’t coordinated between sectors.
Inequality. The proportion of wealth owned by the top 1% is rising across the developed world. That matters because social welfare - social mobility, mental illness, obesity, homicide rates - is better in more equal societies.
What role do we play as investors? I think that’s active ownership - influencing corporate behaviour towards more sustainable outcomes. When we joined the Principles for Responsible Investment in 2009, there were under 200 members. There are now over 2,000. The world has changed around us, and we’ve grown with it by putting ESG thinking into our investment process and our ownership practices. We want to be active and engaged and recognising that we play a vital role in preventing companies pursuing an agenda that doesn’t align with the best interests of society.