Enduring good: harnessing virtuous circles

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In 2015, The Guardian ruined Christmas – at least for shareholders of Sports Direct (now Frasers Group). The company’s value halved over the festive season after the newspaper’s investigation revealed a human rights scandal at the high-street retailer. Sports Direct was paying below minimum wage for working in appalling conditions.

In the couple of years prior, ambulances were dispatched to its facilities more than 80 times, including a disturbing case of a woman giving birth in the headquarters’ bathroom. The chief executive was later charged with a criminal offence for only giving union members 15 minutes’ notice of redundancy.

As more news emerged, the stock continued to grind lower, reaching a nadir in mid-2016 at 65 per cent below its early December 2015 level. UK readers will know that the company didn’t disappear altogether, but its market cap has only just recovered to 2014 levels nearly a decade later – despite gobbling up most of the UK high street in the interim.

Even without the public scandal, this was not a ‘sustainable’ business model: it worked while UK unemployment was 8 per cent, but once this started to fall, so did Sports Direct’s margins.

From risk to opportunity

Cautionary tales like this explain why many investors think of environmental, social and governance (ESG) and sustainability in terms of risk. Companies can destroy a lot of shareholder value by failing to meet minimum standards and focusing on near-term earnings at the expense of other stakeholders.

But avoiding harm or managing risks should be the bare minimum. We in the Sustainable Growth Team think it’s possible to do so much more, which is why our approach to sustainable investing is unashamedly opportunity-focused.

We believe there’s clear and underappreciated value in identifying companies whose sustainability credentials give them an edge over competitors, meaning a better chance of delivering enduring growth.  

This approach is admittedly more demanding, as it’s harder to identify opportunities than risks (true of investing more generally). Also, these strengths tend to play out through long-term compounding rather than sudden, newsworthy events, so it’s hard to prove a causal relationship. But intuitively, it makes perfect sense.

To see why, let’s go back to the meaning of the term ‘sustainable’. Before it became an industry buzzword, sustainable meant ‘able to be maintained at a certain rate or level’, ie enduring. So, a sustainable growth fund should be one where the companies can produce compounding, if not necessarily stellar, growth over a long time horizon.

Of course, that entails more prosaic things such as a large addressable market and a competitive moat. But it also requires a company to be managed with a focus on the long term rather than the next quarter, and with a purpose beyond profit.

Over the long term, there’s a virtuous circle between a company’s contribution to society and its operating performance. Companies have a mutually dependent relationship with their stakeholders and wider society, such that their products and behaviours will ultimately shape their operating environment. It’s a form of ‘corporate karma’ where what goes around comes around.

We’re looking for companies that are sustainable in both senses of the word: able to deliver enduring growth and enduring good. Because, over a long enough time horizon, companies can only grow if they create value for stakeholders and wider society, either through their products or their business practices.

Otherwise, they risk becoming irrelevant to customers, unable to attract employees, being harshly regulated, and losing their licence to operate. Sports Direct got stuck in a vicious cycle where it could only maintain attractive prices by mistreating staff, and ultimately shareholders lost out.

The key to opportunity-focused sustainable investing is just that – focus. The most valuable insights come from concentrating on a company’s most material stakeholders and the alignment of their core business with societal value.

Philanthropic initiatives or projects unrelated to the core business are unlikely to strengthen the long-term investment case (beyond maybe a tiny bump to reputation).

Similarly, we pay scant attention to the ESG scores assigned by third-party rating agencies or data providers. Given the subjective nature of the assessments, there’s no consistency between the scores given by different bodies. And again, these scores are limited to an opinion on financial risk management and provide no insight on where opportunities lie.

It’s not just what you do, but how you do it

There are two main routes to societal value creation for a company – either through the impact of its products and services or through the influence of its business practices. Put another way, corporates can make a difference through what they do or how they do it.

The virtuous circle for ‘product impact’ tends to be reasonably simple. If you are producing something that solves a societal problem, and does so better than alternatives, you should be able to grow sales and make a supernormal return for as long as that problem exists.

Moderna rose to fame during the Covid-19 pandemic as it helped meet enormous demand for vaccines. While demand has stabilised, Moderna’s mRNA platform should allow it to develop vaccines for other serious diseases, such as cancer and HIV. We don’t need to be able to quantify the societal value of that to know it’s ‘a good thing’.

A less high-profile example would be Advanced Drainage Systems, whose recycled plastic pipes are taking market share from concrete in the US due to superior cost, ease of use and environmental impact. Plastic pipes are not the only solution to urban water management, but they are substantially better than the status quo.

Or consider MSA Safety, a niche company producing life-saving equipment for firefighters and construction workers. It has consistently grown its market share because of its industry-leading innovation and laser focus on the safety space.

It also benefits from a less visible virtuous circle common to many of our ‘product’ cases. MSA is a mission-driven organisation where the product impact creates a unifying purpose for employees, aiding recruitment, employee retention and staff engagement. A strong sense of mission also acts as a guide for day-to-day decision making while keeping management focused on the long term.

Virtuous circles driven by business practices tend to be more nuanced but often surprisingly powerful. The choices an organisation makes about how to operate can create value for society by shaping industry standards, influencing wider change and bolstering the company’s resilience.

Take The New York Times, which we invested in for clients during spring 2023. We can probably agree there’s value to high quality, accurate journalism, especially in a world of fake news and AI hallucinations. But it’s the way that The New York Times is run that really sets it apart. The family ownership and strong purpose of the company have allowed it to continue investing in its journalism while newsrooms elsewhere have shrunk.

This has made it an employer of choice for talented reporters, with higher standards of journalistic integrity and the resources to investigate topics of huge societal interest, from Harvey Weinstein and the #MeToo movement to the US’ historic relationship with slavery. This, in turn, is what draws readers, and gives us conviction in the long-term growth and resilience of the franchise.

Another example would be Wise, a UK-based fintech focused on cross-border money transfer. It was founded by two Estonian immigrants who were shocked by the cost of sending money home to their families via banks or remittance firms. They built a business around the mission of making transfers easier, cheaper and more transparent – to the extent that the company even shows customers when competitors can offer a better rate.

Wise targets a ‘fair’ margin and passes further gains on to customers via lower pricing or new services. Its commitment to customer service and sharing economics have earned the loyalty of customers and employees, which should underpin long-term growth despite not maximising short-term earnings. As its value statement says, ‘No drama; Good karma.’

At first glance, UK industrial Spirax-Sarco might look like an obvious ‘product’ case: its market-leading heat transfer technologies help customers save money, energy and water.

But once you dig into the details, Spirax’s products are less distinctive than its choices around how it runs its business: its practices are what allow it to deliver consistently strong returns. Specifically, its direct sales model relies on highly-skilled engineers with deep knowledge of their customers’ business, and strong relationships built over years or even decades of service.

This model requires high and consistent investment in human capital and can impose a bottleneck on short-term growth, but it is borne out in pricing power and resilience. Despite operating in a cyclical industry, Spirax has never made a loss in its listed history.

There is also benefit beyond its immediate stakeholders: Spirax provides free online resources, offers accredited on-site courses and supports engineering faculties at universities. This helps address the industry-wide shortage of steam engineers while creating a pipeline of prospective employees and customers. With over a million steam engineers trained by Spirax, it’s not surprising that industry experts say ‘Spirax is synonymous with steam.’

These examples illustrate some of the many ways in which products and practices create virtuous circles that allow such companies to deliver consistently strong returns and societal value. But it’s not something that the market is necessarily primed to notice.

Therein lies the opportunity

It’s rare that human capital management is at the core of an investment case, as with Spirax, but it’s something we look for across our holdings as a source of competitive edge. It’s also a good example of a characteristic that is frequently underappreciated and hence mispriced by the market, creating an opportunity to generate superior returns for our clients.

A seminal study from 2008 (updated in 2020) found that companies featured on the Fortune 100 list of “Best Companies to Work For” subsequently outperformed their peers by 2–4 per cent per annum1. Interestingly, the transmission mechanism was via profits, as companies on the list beat earnings estimates for the next four years.

This suggests that strong human capital management generates a financial benefit, which the market is very slow to factor in. Per the author, “Stakeholder capital is a prime example of hidden treasure: it ultimately leads to profits, but the market doesn’t realise this.”

It may be that more motivated employees are more productive. Or it could be the lower costs associated with better staff retention. The cost of losing an employee can range from 1.5–2x annual salary resulting from hiring costs, training, and lower productivity for outgoing and incoming workers.

Academics have even found a growing ‘sustainability wage gap’ whereby companies perceived as ‘dirty’ can pay 10–15 per cent more for similar roles than in environmentally-friendly industries. This is consistent with wider research on the motivations of younger employees, in particular. In our discussions with companies, purpose and mission are increasingly cited as important for attracting and retaining the best people.

Given this is all in the public domain, why aren’t these advantages already captured in the price? Especially after the boom in ESG and sustainable investing over the past 5–10 years, it would be reasonable to assume that any market inefficiency has now been exploited.

Needless to say, we strongly disagree. What is more, we think Baillie Gifford is ideally placed to capture this opportunity.

First, many investors rely heavily on third-party providers such as MSCI or Sustainalytics for their ESG analysis. As mentioned above, these are backward-looking and focused on risk rather than opportunity. And, as the de facto industry standard, they’re not providing a differentiated view.

This is linked to a broader problem: the obsession with quantitative ESG data. Things such as supply chain audits, emissions, and the presence or absence of various policies are easy to screen for, but in many cases not material. Whereas culture, purpose, and customer or employee satisfaction are hard to measure and hence often ignored.

We focus on deep qualitative work, seeking insight on how a company’s products and/or practices might enhance their growth and return profile. As a result, we spend our time and attention focusing on completely different topics.

For example, MSCI’s rating for MSA Safety is dominated by its governance score (60 per cent weighting) which it considers sub-par given a somewhat entrenched board and lack of formal policies around business ethics.

Our analysis focused instead on the company’s life-saving products, which are completely absent from the MSCI report. In light of the strong corporate culture and proud 110-year track record, we see no problem with having two former CEOs on the board, one of whom is a member of the founding family. 

Second, our own corporate structure and culture puts us at an advantage. As an unlimited liability partnership, we lack the short-term pressures and external shareholders that constrain some of our peers. This enables us to take the time to dig deep into potential investments and build long-term relationships with management teams.

A long time horizon is particularly important for sustainable investing, given that non-financial factors can take a long time to come through in share prices.

I sense some eye-rolling among readers: don’t (almost) all active managers claim to be ‘long term’? Yes, but with very different understandings of what constitutes ‘long’.

Most professional investors are compensated based on one-, or at best, three-year performance, with severe career risk from periods of underperformance. As such, they focus their attention on forecasting the next few years, or even just quarters. This results in excessive discounting of future cash flows for companies with truly sustainable growth, especially when driven by non-financial strengths.

Being a private partnership also means we can be bolder about taking positions that may appear risky or expensive on a one- to three-year view, but we believe will deliver over the horizon that’s relevant for our clients.

A portfolio to be proud of

In our line of work, generating returns for clients is – rightly – first and foremost. But beyond the potential to generate outsized returns, I believe there are broader reasons that I and many of our clients want to invest sustainably.

For me, the motivation goes back to my first few years in investment management, which were a real baptism of fire. I started on the graduate scheme at my then-employer in September 2008, on the day that Fannie and Freddie went under, followed a week later by Lehman Brothers.

Looking back, it’s hard to describe the level of vitriol we witnessed in the public discourse and on the streets. During the April 2009 G20 protests, our security team told us to wear casual clothes and access the office by the back entrance. Repeating ‘I’m not an investment banker’ was not a strong defence.

At this point, I began to think I’d made a terrible mistake in my career choice. My search for purpose in my work (among other things) undoubtedly made me a pain to manage early in my career, but also led me to take an interest in the nascent field of sustainable investing.

When I was later asked to develop their first global sustainable strategy, I saw the opportunity to – as the cliché puts it – do good while doing well.

Sustainable investing, for me, is constructing a portfolio that we and our clients can be proud to invest in. Full of companies we want to see succeed, because we believe the world will be a better place if they grow. The Sustainable Growth portfolio invests in around 60 stocks that we believe do just this.

After all, investors, whether managers or asset owners, are never just investors. We are also employees, consumers, volunteers, parents and friends. Our values and morals influence all our decisions, including where we put our clients’ money and our own.

1. Edmans makes best efforts to adjust for inverse causation and spurious correlation. Original paper here; update to 2020 here.

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