Why value investors should be mindful of extra-financial factors driving company performance
As a value-focused strategy, the RBC Global Equity Leaders Fund focuses on stocks whose valuations are attractive based on the fundamentals of the companies’ respective business models. And to assess the fundamentals of those businesses requires asking a series of simple but tough questions.
“Firstly, they have to be great businesses,” says Jeremy Richardson, Senior Portfolio Manager at RBC Global Asset Management. “We define that by asking if it has a winning business model; does it enjoy a competitive advantage? Is it well-positioned in an attractive industry? Is the profit pool growing or shrinking? Does it have an opportunity to take market share? And is this a management team that we would like to partner with, including an explicit assessment of the firm's ESG credentials?”
All those questions are vital to adopting what Richardson calls an “ownership mindset,” which he argues is crucial for investors who are giving up consumption today in order to achieve a financial goal or meet long-term liability in the future. By considering not just the price performance of a stock, but also the factors that drive long-term returns, they’ll be in a better position to address their long-term requirements.
“I think it was Johnny Depp who said ‘The fastest car in the world is a hired car.’ Clearly, he was not an owner of that car,” he says. “Because if you do own something, you really care about how it's looked after, its stewardship, and whether or not it is gaining or losing value.”
While the traditional value investor’s fundamental analysis would focus on financial metrics, Richardson suggests issues that are extra-financial today may have material implications in the long run as they become recognized by market participants. That means for the modern value-oriented investor, extra-financial factors that are negatives should be a cause for pause, while those that are positive – which Richardson refers to as contingent assets – might be worth counting as a driver of future alpha.
By definition, extra-financial factors are difficult to capture and find in balance sheets, profit and loss statements, and cash flow statements. But a company’s culture, attitude towards risk and opportunity, organizational health, and quality of innovation, among other factors, can spell the difference between a high-growth business that’s not sustainable, and one that provides reliable returns through the years. To uncover these characteristics, Richardson and his fellow team-members engage with the companies that they consider for inclusion in their portfolio.
“In our experience, the nature of the engagement varies depending upon the industry. Different industries are sensitive to different issues,” he says. “But we haven't yet come across any company which doesn't rely to a greater or lesser extent on people or the planet. And so many of the conversations we have touch on how the business thinks about human capital and the natural world.”
The focus on human capital, Richardson says, has only risen over the course of the pandemic as issues of diversity, inclusion, worker compensation, and health have come to the forefront. The spotlight on environmental issues has also grown brighter with the mounting clamour for climate change action; plastic usage, recycling, and water consumption may be less talked-about, but they may also grow in importance and urgency as their impact on humanity becomes more acute.
“We don't want to be going into partnership with management teams and companies who have a casual approach to these things,” Richardson says. “We want to really partner with those businesses that have a value-creating attitude that includes extra-financial issues. If you're investing in these extra-financial factors over time, we’ve found they have a habit of rewarding you positively with the most financial flows.”
