James O’Loughlin, JOL Consulting Ltd

Long Horizon Investingand

Extra Financial Factors

Two Questions

• Who put the “bop” in the “bop sh-bop sh-bop?”

• Who put the “extra” in “extra financial factors?”

Extra-Financial Factors

• Include but not restricted to Intellectual capital management Human rights Occupational health and safety Human capital management Innovation Research and development (R&D) Customer satisfaction Climate change Corporate governance Consumer and public health Reputation risk Environmental and social impacts of corporate activity

Plan of the Presentation

• The opportunity for long horizon investing and enhanced analytics

• A new generation of investor• How fund managers might use extra

financial factors• Partnership for investing • The additional prize• Getting from here to there

The Disconnect

• Sophisticated analysisDCF valuation

models Considered

treatment of intangibles

• Short-term and narrow focusEarnings-based

heuristicsSingle period

PE ratio analysis

Pattern Recognition

The Investor’s Task

Equity Value

ROIC

Cost of Capital

Pricing

ProfitMargins

SalesGrowth

EPS

M&A

CorporateGov’nce

m

k

j

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f

h

• Pattern recognition See what we expect to see

• Salience Tangibility

Measurability

Trustworthiness

Ambiguity aversion

Truncation

‘Blindness’

Extra-Financials Defined

• Not an artifact of the data• An artifact of our proclivity to pay attention to

salient data and to process it according to learned models

Extra-financial factors are those which are likely to have at least a long-term effect on business results but which lie outside the customary span of variables that get integrated into investment decisions, irrespective of whether they are part of the research process.

The Opportunity for Long Horizon Investing and Enhanced Analytics

• Industry-wide focus on narrow financial indicators of corporate performance

• Diversity siphoned from investment decision making

• Alpha left on the table for investors who know better

• Widespread misallocation of capitalWith additional knock-on consequences

Enhanced Analytics for a New Generation of Investor

• Enhanced Analytics Initiative (EAI) Over $1 trillion under management Minimum allocation of 5% of brokerage commission Incentivises broader and longer-term perspective

• A new Generation of Investor Novel data in familiar and trusted format Required knowledge Appropriate models Greater salience

Sources of Alpha

• Existing extra-financial information overlooked R&D intensity Pro-shareholder corporate governance structures Minority shareholder rights Eco-efficiency Human capital management

• New extra-financial information priced in slowly Accruals as extra-financials Corporate governance

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

0.2

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36

Months

Ra

w R

etu

rns

Coming-into-Compliance Always-in-Compliance Never-in-Compliance

Corporate Governance as Exemplar

The Case for Diversity

• Fund manager experienceExpand set of variablesDeliver new perspective

• Radars retuned Relevant information

finding themSufficient diversity not

preordained

How Fund Managers Might Use Extra-Financial Factors

• Individuals Use a realistic model Apply filters Consult a checklist

• For organisations Join EAI Develop in-house capability Deliver data in usable form Encourage desired

behaviours

Equity Value

ROIC

Cost of Capital

Pricing

ProfitMargins

Growth

BrandPower

M&A

CorporateGov’nce

m

k

j

i

g

l

f

h

MinorityRights

ClimateChange

R&D

EcoEfficiency

Staff Training

A Partnership for Investing

• CEOs and CFOs Explain contribution of extra-

financials Enable comparison Communicate consistently

Equity Value

ROIC

M&A

CorporateGov’nce

MinorityRights

ClimateChange

R&D

EcoEfficiency

StaffTraining

e

e

e

e

e

e

e

e

• Unions Reject dogma Focus on systemic issues

• Trustees and consultants Develop indicators of short-termism Gather evidence Check quality of data Review models Build necessary resource

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The “Additional” Prize

• Permanent gains factored into higher asset pricesProductivity effectGrowth effectRisk effect

• Better alignment of investment processes with long-term needsEnd beneficiaries Investee companies

RED BLUE GREEN BLUE BLACK

YELLOW GREEN ORANGE GREEN RED

PINK BLACK BROWN YELLOW GRAY

BLUE RED GREEN PINK BROWN

ORANGE BLACK BLUE GREEN RED

Getting to Here from There

RED BLUE GREEN BLUE BLACK

YELLOW GREEN ORANGE GREEN RED

PINK BLACK BROWN YELLOW GRAY

BLUE RED GREEN PINK BROWN

ORANGE BLACK BLUE GREEN RED

Getting to Here from There

Conclusion

• We put the “extra” in “extra-financial factors”Leaving alpha availableMisallocating capital

• EAI addresses oversight at source– Redefines salience– Promotes diversity

• A new generation of investor emerging Informed partnershipAdditional prize

“When an investor systematically integrates all relevant variables into their

decision making there is no such thing as an extra-financial factor:

just enhanced analytics.”

Hendrik du Toit

The Lexicon of Investing

Seeing What We Expect to See

Corporate Governance as Exemplar

6.50%

7.00%

7.50%

8.00%

8.50%

9.00%

9.50%

10.00%

y-1 y y+1 y+2 y+3

Always-in-Compliance Coming-into-Compliance Never-in-Compliance