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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 extra-financial factors.

Sanford Bernstein integrates research and development (R&D) into its valuations in researching the pharmaceutical industry, a practice that led to tangible financial results.

"Perhaps not 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."

Deutsche 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 2000.

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."


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