Executives around the world increasingly recognize that the creation of long-term shareholder value depends on a corporation’s ability to understand, and respond to, increasingly intense demands from society.
Yet socially responsible investing has always been an awkward science.
Early approaches simplistically screened out ‘sin sectors’, such as tobacco. Subsequent evolutions tilted toward rewarding good performers, largely in the extraction industries, on the basis of often fuzzy criteria promulgated by the corporate social-responsibility movement. These early approaches tended to force an unacceptable trade-off between social criteria and investment returns.
Three years ago, former US vice-president Al Gore and David Blood previously the head of Goldman Sachs Asset Management, set out to put sustainability investing firmly in the mainstream of equity analysis. Their firm, Generation Investment Management, engages in primary research that integrates sustainability with fundamental equity analysis. Based in London and Washington, DC, Generation has 23 employees, 12 of them investment professionals, and a single portfolio invested, at any given time, in 30 to 50 publicly listed global companies.
The two recently sat down with McKinsey to discuss reconciling sustainability and socially responsible investing, with the creation of long-term shareholder value.
What do you mean by “sustainability,” and how does it influence your investment philosophy?
David Blood: Sustainability investing is the explicit recognition that social, economic, environmental and ethical factors directly affect business strategy—for example, how companies attract and retain employees, how they manage the risks and create opportunities from climate change, a company’s culture, corporate-governance standards, philanthropy, reputation and brand management.
Al Gore: When, several years ago, David and I were separately looking for ways to integrate sustainability into investing, mutual friends told each of us of the other’s search. We discovered immediately that we had a common goal, and that led to a series of meetings and a friendship and, ultimately, to a decision to form a partnership. We researched the history of sustainable investing under its various names and decided to start a new partnership in order to design it, from the ground up, according to the architecture that we believed was essential to address the challenges in the investment-management industry.
What did the history of sustainability investing teach you?
David Blood: Sustainability investing has a long history, starting back with the first wave of negative-screening strategies, where investors excluded entire sectors based on a set of ethical criteria. This strategy remained niche; returns were lacklustre due to the fact that your investment-opportunity set was limited. The next wave of sustainability investing was called the positive-screening, or best-in-class, approach. That’s the philosophy of the Dow Jones Sustainability Indexes and the KLD Broad Market Social Index—these indexes replicate the underlying benchmarks but select only the best performers on environmental, social and governance parameters.
However, the problem with this approach is that it’s difficult to get a real sense of what’s happening in those businesses, because it’s basically a one-size-fits-all approach, often using questionnaires for decision making. In addition, often, one team does the sustainability research and then hands it over to the investment team to do the financial research. That approach, we believe, has too much friction in it because it misses the explicit acknowledgment that sustainability issues are integral to business strategy.
Al Gore: We don’t think it’s acceptable to force a choice between investing according to our values or according to the ways most likely to get us the best returns. Our objective in innovating with this new model was to focus on the best return for our clients, full stop. But we wanted to do so in a way that fully integrates sustainability into the model.
What principles drive yourapproach?
David Blood: The first principle, categorically, is that it is best practice to take a long-term approach to investing. We think that the focus on “short termism” in the marketplace is detrimental to economies, detrimental to value creation, detrimental to capital markets and a bad investment strategy. It’s common corporate-finance knowledge that something on the order of 60-80% of the value of a business lies in its long-term cash flows. And if you’re investing with a short-term horizon, you’re giving up the value creation of a business.
The second principle is that the context of business is clearly changing. We are now confronting the limits of our ecological system and at the same time, societal expectations of business are widening. On top of that, multinational businesses are oftentimes better positioned than governments to deal with some of the most complicated global challenges such as climate change, HIV/AIDS, water scarcity, and poverty. Technology and communications have changed, and we’ve reached a point where civil society is now demanding a response from business.
What’s your perspective on how that changes corporate strategy?
David Blood: In effect, what’s happening, unbeknownst to many corporate leaders, is that the goalposts for their businesses’ licence to operate have moved. There are higher expectations and more serious consequences, and the implications go way beyond protecting your reputation or managing costs. Rather, we see this changing context for business as an opportunity for companies to establish competitive positioning, grow revenues and drive profitability. In the end, that’s the holy grail of sustainability investing—to seize the opportunities, not just avoid the risks.
What has been the reception from pension funds and longer-term investors to this notion?
David Blood: Very good. They recognize that they have long-term liabilities, and it is their fiduciary duty to match those liabilities with assets. The recent adoption of the UN’s Principles for Responsible Investment, by asset owners and managers representing over $8 trillion (Rs328 lakh crore), is a good example of the institutional-investment community beginning to commit to a long-term time horizon and the explicit recognition that environmental, social and governance factors drive value creation.
Why do you think that is?
David Blood: It’s because people realize that there are reputation issues related to sustainability, but they also recognize that, in the end, this is about driving profitability and competitive position. Asset owners are beginning to get this and they are looking to invest in companies that understand it.
Al Gore: The market is long on short, and short on long. There’s a widespread recognition within the industry that what has emerged over time doesn’t really make any sense. They know that it needs to change and they are ready.
We are in a period of history, right now, when the contextual changes are larger than the ones we’ve been used to in the past. Changes that we’ve associated with very long cycles are now foreshortened and are occurring much more rapidly. Positioning a company to ride out these changes and profit from them often means making stretch investments to change the infrastructure, change the energy source, change the physical plant, and adapt to the new realities. And if there is the tyranny of a three-month cycle, then companies won’t make those investments. So, focusing only on the quarter can blind you to the most important factors.
How many executives really understand the complexity and interconnection of the trends you describe?
Al Gore: It’s a rapidly growing number. I recently spoke at a conference, in Copenhagen, focused on carbon trading, with thousands of companies represented. As part of an internal survey, attendees were asked how many of them had internalized their “carbon budget” and begun to drive down their internal emissions.
A year ago, it was 15%. This year it was 65%. That would correspond with what we’ve found in multiple other areas—a kind of tipping point that we are at right now.
For example, I had a chance to visit Wal-Mart in Bentonville, Arkansas, around the time they launched their commitment to “green” their supply chain. And David and I spent time with [GE CEO] Jeff Immelt, and we could give you lots of other examples of CEOs who, a few years ago, might not have talked this way and yet are now not only knowledgeable but highly sophisticated. They may have started with concerns about brand protection and reputation and the like. But once they got into it, it was as if a whole new world of opportunity and new markets opened up.
What do those executives and companies, that are doing this well, see differently?
David Blood: The first is that they understand their long-term strategy. Secondly, they understand the drivers of their business—both financial and non-financial. The leading CEOs are the ones who explicitly recognize that sustainability factors drive business strategy. In our minds, the best businesses have always understood the importance of culture and employees and ethics. And they get it in their soul.
Can you give us an example?
Al Gore: In Denmark, Novo Nordisk clearly gets this. They take a holistic view and a long-term view. They look at the whole system. Take their presence in China. They went into China at a very early stage with genuine concern for what they could do to help forestall the diabetes epidemic there, which is growing at a faster rate than it is in the rest of the world due to the transition to a Western diet and lifestyle.
Novo Nordisk has 60% of the Chinese market for insulin and they’re focusing their business plan on trying to cure and prevent diabetes. If they succeed, presumably, sales of insulin will not increase at the current rate, but they think the problem is large enough that it is more important to address the root cause of the problem. This commitment comes out of the phenomena that David was just describing to you.
Is this approach possible in all sectors?
David Blood: There are material sustainability challenges in all industries. In the fast-food or food-manufacturing industry, there’s a very strong move toward healthy living and eating, organic food, and the implications for sustainable agriculture. And how do food companies deal with the upstream challenges of these trends, challenges such as water use? While we don’t invest in it, the tobacco sector faces a whole host of issues which are very much sustainability driven. But again, sustainable agriculture is a big story, as is litigation risk. In another sector, like financial services, the key sustainability issue is how a company manages its human capital. In the energy sector, climate change is one of the most significant issues. In the health-care sector, we look at ethical marketing practices between companies and doctors.
What I’m describing here is what we call a materiality-based approach to investing. Rather than looking at 50 different tick-box sustainability criteria, we think you need to tackle the three or four long-term issues that will really affect corporate profitability.
What examples come to mind of companies that have thought beyond managing sustainability risks and moved on to creating revenue opportunities?
David Blood: A company like Johnson Controls, for example, is interesting because of its focus on demand-side energy efficiency. About 50% of its business is batteries for hybrid cars and products to run buildings efficiently, the other 50% is automotive interiors and controls. We think it’s the former that’s going to be growing and driving that company. They understand their products will help reduce their clients’ environmental footprint. This strategy is completely revenue driven. GE’s Ecomagination is another example. If you think about how GE’s stock price is going to trade, it’s going to trade primarily on growth. Immelt knows this. He’s betting his reputation and his company on the notion that businesses related to the environment will enable GE to grow faster than GDP.
One of the important interfaces between the investing world and management is the board. What role do boards of directors play in trying to ensure this kind of mindset is embedded in corporate activity and communicated to investors?
Al Gore: I think that the board of directors has a growing responsibility to address these very topics. As stewards of shareholder interests, boards should be focused on the long-term sustainability of the firm, rather than on the market noise.
What must CEOs do more of?
David Blood: Some are taking on a host of issues and seeing the interlinkages, but there’s an enormous segment that is still single-issue focused. I think managing and understanding climate risk is the first wedge into that. You would hope that people then start to look at the second-order effects of climate change. I think one of the biggest things that CEOs can do is explain their longer-term story to the capital markets more forcefully. Increasingly, the research community is interested in the environmental, social, and governance factors that drive company strategy and is integrating these factors into mainstream research.
Lenny T. Mendonca is a director in McKinsey’s San Francisco office, and Jeremy Oppenheim is a director in the London office. This article was originally published in The McKinsey Quarterly’s online journal and can be found on the publication’s website, www.mckinseyquarterly.com. Copyright (c) 2007 McKinsey & Company. All rights reserved.