Today’s investors are looking for more than a healthy bottom line, which means companies need to give non-financial reporting some serious attention
There was a time when investors would look no further than the bottom line on the annual report. A healthy balance sheet, decent cash flow and a strong order book – check.
But in recent years, investors around the world have come to expect broader, more useful reporting of material non-financial performance information. They want a clearer picture of the type of business they might potentially invest in.
What has driven this change? High-profile corporate collapses such as Arthur Andersen and Enron in the early noughties scotched the myth that multinational Wall Street darlings were too big to fail.
Then there was the financial crisis of 2007/8, when Lehman Brothers spectacularly fell from grace and a host of international banks fought for survival in the aftermath of the sub-prime market fiasco.
Fiona Le Poidevin, CEO of The International Stock Exchange Group (TISEG), says the call for transparency has accelerated as confidence in corporate reporting has diminished. “I think investors over the past decade have increasingly demanded more detailed reporting from companies – certainly post financial crisis. Companies are now talking about corporate responsibility and are being mindful of all their stakeholders – not just their shareholders, but their customers and the public at large.”
Lack of transparency in reporting has understandably made investors wary as they’ve seen share prices fall and brand reputations tarnished as a result of flawed practices and poor communication.
High-profile non-financial news events, such as the Volkswagen emissions scandal and BP’s Deepwater Horizon oil spill, emphasise how swiftly financially robust and highly respected companies can find themselves embroiled in a major damage limitation exercise.
In a digital world, news and opinion travels fast. Rolling TV news channels, online news and social media ensure the public are not only kept better informed, but the masses can vent their spleen on social media and message boards.
Patrick Thomas, Investment Manager at Canaccord Genuity Wealth Management, believes this level of engagement means companies are increasingly aware that non-financial information does matter.
“It doesn’t take much these days to move a share price negatively and, increasingly, non-financial information is having an impact. Facebook is a
prime example of non-earnings-related views really affecting the share price.”
Facebook scandal
In July 2018, the social network suffered the biggest ever one-day drop in a company’s market value – 19% – after revealing to investors that its growth had slowed in the wake of the Cambridge Analytica scandal, which involved the breach of 87 million Facebook user profiles.
Thomas adds: “In an age of big data and 24/7 news, there will continue to be an increased focus on non-financial information. In addition, I think that more and more institutional investment will be aligned to an environmental social and governance (ESG) benchmark.”
Indeed, specific indices such as the JPX Nikkei 400 (composed of companies that meet specific investment standards, such as efficient use of capital and investor-focused management perspectives), and the MSCI ESG indices (which provide institutional investors with transparency into ESG sustainability) have had an impact.
As Thomas explains, there is peer pressure among companies to feature in these indices and this is really helping to focus the mind.
One of the advantages of technology is that armchair investors can conduct their own research into companies easily and cost-effectively. They’re able to make their own judgements – both financial and ethical – on where they place their money.
Lee Morris, an Investment Director at Quilter Cheviot, believes an increased focus on ESG is being driven by investors that are asking more questions about companies’ practices.
He points out that corporates are increasingly being taken to task on non-financial issues such as board composition and how equitably they run their business. Are pay rises awarded to the executive team in line with those given to all employees? How understandable are the targets behind long-term incentive plans?
In the past, companies might have been more inclined to just pay lip service to ESG, but that’s changing. A new generation of millennial investors are increasingly focused on non-financial factors rather than the balance sheet alone.
Rather than annual reports, companies are now more likely to produce regular and consistent updates, with compliance departments and internal/external audits ensuring all meaningful data is clear and available for scrutiny on an ongoing basis.
Critical mass is important here. As soon as more companies provide transparent ESG information than don’t, the onus will be on businesses to follow this best practice in reporting or they will miss out on crucial capital flows.
A company’s ESG credentials often help highlight enlightened and innovative operations. Even companies in sectors that may be screened out from certain ethical funds (or individual share portfolios) can enhance their reputation and win over new investors.
As Morris explains, taking ESG factors into consideration is different to employing an ethical strategy, which tends to focus on excluding certain sectors or activities. “As an example, looking at a tobacco producer, one considers a number of factors: environmental – in this case, water usage might be an important metric; social – how is the company adapting in a world that’s turning away from burning tobacco; and governance – the usual considerations of remuneration, board composition and so on.”
If investors don’t rigidly rule out a sector – for instance, alcohol or cosmetics – but retain some reservations on ethical grounds, they might be more favourably disposed to a company that’s operating more responsibly and sustainably than one of its rival brands. It’s an investment approach based on the ‘best of breed’ philosophy.
An ongoing problem, though, is being clear that a company is as principled and as focused on sustainability as it claims. As Le Poidevin explains: “Companies are increasingly focusing on ESG. However, they are not always living by the ESG principles outlined in their corporate literature.”
There are different levels of disclosure – some make worthy but largely vague references to ESG in their annual report, while others are prepared to go into greater detail on their specific ESG credentials. As a result, it is often difficult to compare like with like.
A global standard?
While there may be more incentive for corporates to improve transparency and depth in non-financial reporting, there’s still no mandatory global standard to which companies must adhere. Would it be feasible to have a global standard along similar lines to the International Financial Reporting Standard (IFRS)?
Thomas likes the idea in principle, but thinks it unlikely. “A globally recognised standard would be good, but I would be surprised to see large corporates lobbying for this. Also, there are different standards between emerging and developed markets. I wouldn’t want investors to shun emerging market companies on the grounds that they are not savvy enough yet on non-financial reporting.”
While a mandatory standard may be a bridge too far – in the medium term, at least – this doesn’t mean an array of sustainability and ethical benchmarks or accreditation can’t have the desired effect of inducing corporates to provide a clearer picture of how they operate and their inherent values.
Organisations continue to introduce ESG-focused verification features. Le Poidevin name-checks the recently launched green market segment, TISE GREEN, which provides greater visibility on investments that make a positive environmental impact. To qualify for the segment, the investments must be verified by a third party as meeting a global standard in green finance.
As such, it provides a platform for issuers to highlight certified green investments – whether bonds, funds or trading companies.
It is reasonable to suggest that ESG assessment will find itself progressively integral to the investment decision-making process. Investor interest in factors such as supply chain, human rights, fair trade, recruitment practices and climate change are not transitory.
Technology will increasingly be an enabler, too, in terms of trusted data – for instance, blockchain offers tamper-proof databases for any kind of information shared by a community.
In the past, for example, consumers would have to take data relating to food production and distribution at face value. Now, via blockchain, there’s an opportunity to track all information accurately, from farm to fork. This level of transparency represents progress.
Investors now have access to trusted information that would previously have been denied to them. Because they are better informed on all aspects of a company’s business, they are better placed to judge all risks when making their investment decision.
As Thomas stresses, investors are also less likely to follow the ‘don’t exclude anything’ mantra of previous years, which meant largely unquestioned exposure to FTSE large cap stocks. “People increasingly understand that many world problems will be solved by corporates rather than governments alone,” he says.
Thomas suggests that if companies can help investors to understand the contribution they are making to tackling these problems through better non-financial reporting, they can help bring investment to life and engage with people.