Long Horizon Investing and Extra Financial Factors

1. Long Horizon InvestingandExtra Financial Factors James O’Loughlin, JOL Consulting Ltd

2. Two Questions • Who put the “bop” in the “bop sh-bop sh-bop?” • Who put the “extra” in “extra financial factors?”

3. 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

4. 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

5. The Disconnect • Short-term and narrow focus • Earnings-based heuristics • Single period PE ratio analysis • Sophisticated analysis • DCF valuation models • Considered treatment of intangibles

6. Pattern Recognition

7. The Investor’s Task • Pattern recognition • See what we expect to see EPS • ‘Blindness’ Sales Growth Pricing Equity Value f • Salience • Tangibility • Measurability • Trustworthiness • Ambiguity aversion • Truncation m g ROIC Corporate Gov’nce l h k i j Profit Margins Cost of Capital M&A

8. Extra-Financials Defined 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. • 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

9. 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 capital • With additional knock-on consequences

10. 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

11. 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

12. Corporate Governance as Exemplar

13. The Case for Diversity • Fund manager experience • Expand set of variables • Deliver new perspective • Radars retuned • Relevant information finding them • Sufficient diversity not preordained

14. 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 Staff Training Brand Power Eco Efficiency Growth Pricing Minority Rights Equity Value f m g ROIC Corporate Gov’nce l h k i j R&D Profit Margins Cost of Capital Climate Change M&A

15. A Partnership for Investing • CEOs and CFOs • Explain contribution of extra-financials • Enable comparison • Communicate consistently e Staff Training e e Eco Efficiency Minority Rights e e Equity Value e e f e • Trustees and consultants m g ROIC Corporate Gov’nce • Develop indicators of short-termism • Gather evidence • Check quality of data • Review models • Build necessary resource l h k i j R&D Climate Change • Unions • Reject dogma • Focus on systemic issues M&A

16. The “Additional” Prize • Permanent gains factored into higher asset prices • Productivity effect • Growth effect • Risk effect • Better alignment of investment processes with long-term needs • End beneficiaries • Investee companies

17. Getting to Here from There

18. Getting to Here from There

19. Conclusion • We put the “extra” in “extra-financial factors” • Leaving alpha available • Misallocating capital • EAI addresses oversight at source • Redefines salience • Promotes diversity • A new generation of investor emerging • Informed partnership • Additional prize

20. The Lexicon of Investing “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

21. Seeing What We Expect to See

22. Corporate Governance as Exemplar