May 30, 2006
Applying an Ant Colony Mentality to Extra-Financial Factors and Enhanced Analytics
by Bill Baue
A report from the Universities Superannuation Scheme, a member of the Enhanced Analytics
Initiative, calls for diverse, community-wide advocacy of factoring extra-financials into research.
To illustrate the optimal strategies for producing valuable investment analysis, a recent
Universities Superannuation Scheme (USS) report directs readers' attention downward--to ants scavenging on the ground. See that one
veering off the beaten path? Rather than being constrained by such diversity of action, the ant
colony thrives on it, as it leads often enough to a mother lode (say, crumbs leading to a big
cookie) that would otherwise have gone undiscovered.
So too with the investment
community, which currently resembles lemmings marching to the drumbeat of quarterly earnings
reports. The Enhanced Analytics Initiative (EAI), of which USS is a founding member, encourages
greater research diversity by encouraging sell side analysts to cover so-called "extra-financial"
factors. EAI promises five percent of its brokerage commissions to the best research on
"intangibles" that are overlooked but can be material to financial performance--such as corporate
governance, executive remuneration, climate change, and other social and environmental issues. And
as with ant colonies, EAI wants the entire investment community to benefit, so it rewards only
research that is publicly released.
Consider this five percent allocation a crumb on the
way to the cookie: EAI firmly believes that extra-financial factors are financially material in the
long run. "Extra" in this sense does not mean "extraneous," but rather "additional" information
that can enhance investment returns.
"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," said Hendrik du Toit, CIO of UK-based Investec Asset Management, the newest EAI member.
Authors Raj Thamotheram of USS and James O'Loughlin of JOL Consulting extend the metaphor in recommending that
distinct actors in the investment community cooperate in advocating for the integration of
extra-financial factors into enhanced analytics.
Fund managers stand to gain by
identifying "alpha," or sources of financial outperformance, that are often "left on the table" by
traditional and current investment analysis. CEOs and CFOs stand to gain by stepping off the
treadmill of meeting quarterly forecasts that are inherently impossible for all companies across
the entire economy to fulfill. Trustees stand to gain by managing their beneficiaries' funds with
better long-term care. Even unions stand to gain by shifting from waging battles to achieve better
labor conditions to taking a more long-term perspective that recognizes positive labor conditions
as a source of investment value instead of a cost.
The report presents this "partnership
for investing" in its third section; it devotes its first section to advancing the case for
extra-financial considerations and enhanced analytics. The second section puts the meat on the
bones of the argument by presenting several case studies of diverse approaches to analyzing
Bernstein integrates research and development (R&D) into its valuations in researching the
pharmaceutical industry, a practice that led to tangible financial results.
surprisingly, given the long-term nature of Bernstein's research, it detected significant risk in
the safety profile of VIOXX one year in advance of the product's withdrawal from the market because
of serious cardiovascular side effects," states the report. "And, as far as EAI members are aware,
it was the only broker that lowered its price target on Merck, the manufacturer of VIOXX,
ahead of the dramatic fall in its valuation when the news leading up to the withdrawal broke."
Bank factors corporate governance into its analysis, identifying 50 different relevant elements
of corporate governance divided into four "pillars": board independence, shareholder treatment,
disclosure, and executive remuneration. Deutsche Bank has found that the top quintile of stocks
according to governance ratings financially outperformed the bottom quintile significantly since
Citigroup bucks the trend of
assessing country-level governance to determine which mining companies to invest in, instead
focusing on governance of the companies themselves.
"Our analysis suggests that risk is
more company-related, than country dependent," said Heath Jansen, director of metals and mining
research at Citigroup. "Two mining companies operating in the same country could have
substantially different discount rates based on; the commodities extracted, mine development, the
ability to control HSEE in operations and sustainable governance."
His team developed the
Citigroup Sustainable Mining Index (CSMI) to assess extra-financial factors in that sector,
focusing on commodities exposure, country exposure, mine development, health, safety, engineering,
and education (HSEE), and sustainable governance.
"Whilst the CSMI approach did not
engender any recommendation changes in the metals and mining sector, it did induce Citigroup to
lower its weighted average cost of capital assumptions for the large diversified miners of BHP, Rio, and Anglo, and this
increased its valuation estimate for those stocks in support of prior positive recommendations,"
said the report. "The approach also supported the firm's sell recommendation on Kazakmys and
flagged additional risks with the mining company."