August 29, 2019

August 29, 2019 | Investments Insightz

Societal shifts as investment risks

What do Facebook, BHP, and Starbucks have in common? Or, put another way, what risk is most likely to drive change in each business?

What do Facebook, BHP, and Starbucks have in common? Or, put another way, what risk is most likely to drive change in each business?

Traditional investment analysis tends to underestimate the risks faced by companies today. From evolving consumer values, environmental issues, social media, and technology disruption, today's operating environment contains new risks that threaten the long-term status quo.

Underpinning all of these risks, at the most fundamental level, is a firm or industry's relationship with society. Every firm has a "societal licence to operate" or, put more simply, the permission that society gives to any corporate organisation to conduct its activities.

While invisible for most of the time, it becomes obvious by its absence when customers abandon brands, regulators punish bad practices, or governments introduce laws. The breakdown of these relationships – and the loss of this licence – is the primary way sustainability risks may undermine company fundamentals and stock prices in the future.

One only has to look at Facebook's defence of its platform in recent years over security and its role in elections, Starbucks' drive to showcase the value it brings to its wider stakeholders, and BHP's announcement that it would set targets and link executive compensation to cutting greenhouse-gas emissions for itself and their customers – to begin to see the importance companies are placing on avoiding a breakdown of relationships with larger society.

Industries with high impact on the environment and health are particularly susceptible to a change in their societal licence, especially through regulation. For other industries, the societal licence depends on the particular industry's cost and benefit to society.

Pharmaceutical executives are lauded for life-saving innovations but pilloried for raising drug prices. Extractive industries face scrutiny over the environmental consequences of their methods to monetise natural resources. The obvious benefits of energy supply and tax revenues must be weighed against a more holistic assessment of impact on societal licence.

In other areas, consumers change their behaviour as they adopt new values or are influenced by events. The successful IPO of Beyond Meat is one very visible example of where consumer choices, for plant-based alternatives in this instance, can positively drive valuations, at least in the short-run. On the other hand, incumbent food producers and soft drink companies have had to evolve and adapt as society's attitude towards sugar and obesity changes. Whether they represent part of the problem or part of the solution is a key question.

Manufacturers and retailers are praised for low prices but criticized for sending factory jobs to other countries with poor human rights. A more in-depth look at a company's supply chain and network can help to uncover areas of risk where a sea change in private and public perception of an industry could effectively remove its societal licence.

One group of companies that increasingly govern our lives and dominate investment portfolios are the “tech titans” - large internet and technology companies. Traditional company analysis reveals dominant market positions within industries, entrenched network effects, high margins and returns, fortress balance sheets and, in many cases, reasonable long-term valuations. No wonder they are popular investments. However, this approach overlooks a number of challenges in terms of company behaviour and how society is responding.

E-commerce companies pay low taxes and often low wages, which consumers appear willing to tolerate because the companies offer convenience, selection, and competitive prices. As long as society considers that an acceptable trade-off, then politicians and regulators will likely be cautious. If, however, consumers see tax avoidance as locally harmful or are upset by company treatment of its customers, employees or suppliers, then regulators could be emboldened.

Most recently, Amazon’s use of third-party merchants’ data triggered an EU antitrust investigation. Some of the largest tech firms have come under mounting pressure not only about how data is used to shut out rivals but over security breaches and social media's role in elections. Investors would do well to remember that in today's environment, a misstep could have severe consequences.

Patterns of regulatory attack are emerging, with a focus on the tech titans’ expansion into adjacent industries – and given tech dominance of personal data, almost every industry today appears to be adjacent. It is critical to consider which companies are abusing their near-monopoly positions.

The breakdown of relationships between companies, industries and society represents a threat to long-term fundamentals and ultimately returns. Consumers may reject a brand, talented employees may leave for a competitor, production may be crippled through accidents, governments may impose fines or remove licences to operate. The risks are real and appear to be rising. Investment judgement on these issues, as well as traditional financial analysis, will be key to generating positive differentiated long-term portfolio returns.

Author: Steve Wreford is a Managing Director and Portfolio Manager/Analyst at Lazard Asset Management, where he is a portfolio manager of the Zurich Investments Global Thematic Share Fund. 


Important information: The content of this publication are the opinions of the writer and is intended as general information only which does not take into account the personal investment objectives, financial situation or needs of any person. It is dated August 2019, is given in good faith and is derived from sources believed to be accurate as at this date, which may be subject to change. It should not be considered to be a comprehensive statement on any matter and should not be relied on as such. Zurich Investment Management Limited ABN 56 063 278 400 AFSL 232511 of 5 Blue Street North Sydney NSW 2060, nor any of its related entities, employees or directors (Zurich) give any warranty of reliability or accuracy nor accept any responsibility arising in any way including by reason of negligence for errors and omissions. Zurich recommends investors seek advice from appropriately qualified financial advisers. Zurich and its related entities receive remuneration such as fees, charges and premiums for the financial products which they issue. Details of these payments can be found in the relevant fund Product Disclosure Statement. No part of this document may be reproduced without prior written permission from Zurich. Past performance is not a reliable indicator of future performance. GINN FVHHKJ.00012.ME.036. DFOY-014862-2019

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