Productivity, resource use and systematic stewardship
“Productivity is a gift for rising living standards, perhaps the greatest gift.” So said Andy Haldane, then the Bank of England’s chief economist, in a 2017 speech. He was echoing Paul Krugman’s widely cited aphorism: ‘Productivity isn't everything, but, in the long run, it is almost everything.’ Productivity feels particularly important today, as countries and companies explore the interaction between corporate competitiveness and both the impacts and dependencies on society and the environment.
When analysing company performance through an investment lens, we pay close attention to productivity as a key component of how efficiently the company uses capital – particularly human and natural – to create shareholder value. Productivity is critical to creating the economic value that can accrue to shareholders. But it also points to how that value might be shared with employees through competitive remuneration and customers through greater accessibility of products and services or re-invested in the business to generate further economic value.
Focusing too much on any single indicator always brings dangers. In the case of productivity, these can be exacerbated by measuring it through a short-sighted and principally financial prism. Depending on the company and what we observe, we may focus on one subset of these dangers by asking: in the company’s effort to demonstrate near-term progress on return on capital, has it compromised asset health or the capacity to drive longer-term wealth creation?
HOW WE DEFINE SYSTEMATIC STEWARDSHIP
Engagement is active dialogue with a specific and targeted objective, where the underlying aim is to preserve and enhance the value of the company’s assets on behalf of clients and other beneficiaries. Engagement may be to create change (improved disclosure) or to gain information (is there a plan to publish in English?). Systematic, in this case, refers to extracting the same extra-financial (or ESG) metrics across a universe (or portfolio) of companies, which we can then feed into our RUPI model. As ESG disclosures are largely voluntary and unregulated, companies may publish an incomplete data series. Hence, systematic engagement employs a consistent and efficient process to identify gaps in ESG reporting or disclosure. This allows for specific and targeted discussions with investee companies to try to close these gaps or to seek further insight into the company practices which we believe may contribute to value creation. These discussions may then inform our voting decisions – to ensure alignment between what we are seeking through our engagement and how we cast our vote.
One way to approach this question is to expand the notion of productivity to include a range of inputs (beyond the narrowly financial) and environmental impacts. All the better if this can be done with an eye on innovation (across processes, products and business models) and the value proposition for customers.
To support this line of analysis, we have developed a holistic, quantitative resource usage and productivity indicator (RUPI).
In essence, RUPI is a model-based estimator of whether economic profit growth can be extended, relative to how it consumes resources to create shareholder value. RUPI aims to award a high score to companies that are improving economic profit whilst using fewer resources (such as energy, water and fixed tangible assets) and reducing environmental damage (emissions and waste).
RUPI currently takes nine variables (‘pillars’), including debt and shares outstanding, and seeks to identify their relationship to economic profit over rolling five-year periods. The further back in time you go, the patchier the data sets become for extra-financials, such as water consumption and carbon emissions. When data points are missing, we assume the company has not yet provided the necessary disclosures. This holds the company back from reaching a high score, but it also prompts us to explore the data gaps. Thus RUPI shines a light on disclosure quality – in particular data availability and data volatility – which we can then raise when systematically stewarding the companies held.
We adjust the score for materiality, based on the average resource dependency and impact intensity of the industry the company operates in. For example, if direct water usage is insignificant for a particular industry, a company in that industry which fails to use less water per unit of output will not be penalised with negative points (though the company will of course miss out on any positive points). However, if water consumption has not declined for a company in an industry where water usage is significant, that company will be penalised with negative points.
The final unadjusted RUPI score sits between 0 (worst) and 90 (best) – a maximum of 10 points per pillar. With materiality adjustments, scores for the worst offenders can even turn negative. However, companies that show broad-based signs of improved resource usage and higher profitability – that is, lower resource use, environmental impact and debt and shares outstanding and higher economic profit – will score towards the upper end of the spectrum. Note that, for the time being, RUPI does not consider elements of social or governance sustainability.
Being systematic and quantitative, RUPI can be easily integrated into the screening process for our equity strategy baskets. For example, if we construct a basket to give us exposure to companies with high free cash flow yield or restructuring potential, a company’s RUPI score can be considered alongside relevant financial criteria.
Our RUPI analytics dashboard allows us to
1. View the characteristics of an equity strategy basket as a whole, alongside aggregated valuation metrics
2. Create a short list of laggards to engage with on disclosure, targets, incentives and strategies
3. Probe an individual company’s score and dive into the drivers of underperformance on individual pillars, to prepare for engagement
4. Use the score as a holistic indicator of performance as an input into voting on management and shareholder resolutions
Figure 1 shows RUPI scores for a basket of stocks. We see the scores for the individual companies. For example, Merck performs well relative to the basket on ESG type metrics, but less well on debt and depreciating assets.
Figure 2 shows how individual scores are consolidated into a portfolio level score, where the basket overall performs less well on ESG type metrics.
