Total time: 19:47

0:00

Andy Poreda: Hi everyone, and welcome back to The Hitchhiker's Guide to ESG. Investing. I am Andy Poreda ESG, research analyst at Sage advisory. Today I'm joined by our president and chief investment officer Bob Smith, who is here to talk with us today about a very important topic that's dear to his heart, which is good governance. At Sage, in ESG investing it is important to look at the environmental, social issues, and the governance issues, but we really feel that the governance issue is not one that is necessarily focused on in the ESG landscape as much as it should be. Bob, you get a lot of questions about what is good governance, would you mind kind of breaking down what people should be looking at from a corporate perspective?

0:38

Bob Smith: Sure, Andy, and it is nice to be with you today to talk about a subject that is near and dear to my heart. You know, the world of ESG is a very complex world, very data heavy, lots of numbers, and lots of things to think about. So, very often for advisors, it's difficult for them to establish a general framework for how to think about management in the context of looking over many alternative companies and investment choices that they might wish to consider for clients. So today, I would like to review how we think about it, which is the five C’s of governance. What we try to do is to break it down into about five different ways of looking at what is governance with regard to any organization—whether it's corporate, whether it's in the public sector—and to give you some sense and notion of what are the big issues to be thinking about.

So first off, we all like to think about compensation. Compensation is part of the governance structure that we evaluate, because how people are incentivized and how they are compensated for their actions, their policies, the fulfillment of their responsibilities is really important to us, and it is an important part of understanding good governance. The other part of it is also the composition of the management. Composition of the management and the leadership structure of an organization is paramount. To really understand how the company is run, and who is running the company, and how long have they been there, where they come from? What are the policies and the directives that they essentially bring to bear on the organization, from the board, and from the senior management of the organization? The follow through on that is our next ‘C’, which is competency. We all assume that just because somebody is a senior manager that they must have professional competency, but I go back to the idea of, how many of us in life have looked at those above us and said, he doesn't know what he's doing, or she's just has no idea? Sure enough, that is where competency gets questioned. So, we also want to be looking at corporate competency in the sense of are they capable of doing what their job requires them to do? What are their professional capabilities? What it is their seasoning? What is their perspective? How broad and narrow is it in terms of the industry that they are in and the world that we live in? So, we want to study the competency of the management that we have in place. The next ‘C’ for us is going to be clarity. Are they transparent? Are they clear? Do they make everything that they should make available? Are they transparent about it in terms of their policies, and their methodologies for executing those policies? And, more importantly, the outcomes? Now, is this management very open, even about its problems? When it does have problems, are they quick to respond? Are they quick to make all the details available? We have seen time and time again, certainly in recent years, that not everybody is forthcoming. Management sometimes do try to hide important details from the various other stakeholders that are involved with their company. The last thing that I think is important in the five C's of governance is the consistency issue. One of the things we all like in life is a certain degree of predictability and consistency in all the things that we treasure in life. Nothing could be more true than a good management structure that is consistently applying its policies, consistently looking to improve, and consistently looking to take care of all the other stakeholders involved with the organization. So for us, when we think about how to look and judge what governance is all about in the realm of ESG, it is simply: let's look at the five C's – compensation, composition, competency, clarity, and then lastly, consistency. So, that is our framework for analyzing governance, and I think that for most advisors, it is a very clear, very nice, structured way of thinking about every organization that I look at, what are the big things I want to be thinking about when I am assessing governance in regard to a given organization?

5:07

Andy Poreda: Wow, that is a really interesting way to unpack this notion of good governance. But I think it might be good to give some examples to really showcase some of these details and companies that are actually successful in follow through of some of these topics and what that means to the company itself, both from a good perspective and another perspective. In terms of compensation, do we have a company that is a good example of one that is possibly tying their CEO’s pay to some sort of sustainability performance or other long-term outcome?

Bob Smith: Well, there are probably a whole bunch out there, but Andy, I know you have one in mind—I think Clorox is a good example. Why don’t you pick it up from there, because I know you have reviewed them?

5:50

Andy Poreda: Yeah. I do think Clorox is a great example of a company that has done a very good job of showcasing their sustainability intentions in their reporting by doing something that we at Sage think is great; to have an integrated annual report where your CSR (Corporate Sustainability Report) and your annual report your 10-K are combined into one. Another big thing that Clorox excels in is making sure that their CEO’s compensation is tied to some of their long-term strategies from a sustainability perspective. I think that they call it the “Ignite Strategy,” but they're actually figuring out targets of trying to reduce things like plastic usage, recycling material, and they're actually setting goals and then evaluating that performance, and their CEO is getting compensated on it. So, I think that is a good measure of a company to look at for a leader in that space.

6:43

Bob Smith: Sure. Well, as we are looking at compensation, clearly, you want to know how executives are being paid, how they are being incentivized. Are their incentives really tied to the benefit of all the other stakeholders in force? What are those goals and objectives? Are they clearly stated or identified? That idea of short-termism in terms of financial outcomes, and having compensation tied to that is a red flag for anybody who is trying to make an assessment of governance. We want those long-term positive outcomes, and we want that linked. We want to see that incentive built into the compensation structure for board members, as well as C-suite management. Right?

7:28

Andy Poreda: Absolutely, Bob. So that is a good coverage of the compensation. Moving on to the composition aspect, I do think this is a huge area of focus, and one that can easily be changed by a company at each annual shareholder meeting. I think when we're seeing even the Nasdaq just recently determining that they want two diverse board members on all their listed companies, I think looking at the board from that composition perspective is going to be a really important factor moving forward. That will include not just if they are a diverse board, but also is that board independent? What type of committees are there? Who has been on it? I think there is a lot of good factors in that board composition that we should be looking at. Dillard’s is one of those companies that when we're looking at who's going to be successful moving forward, I look at it and I see the struggles with them moving forward and adapting. I look at their board, and I see that their CEO and chairman are the same person, there is only one woman on the board, and the rest of the board is filled with family members. I think that in this day and age, I just don't see a publicly traded company, if you can really justify that kind of insular process for operating a dynamic company that has a lot of risks and opportunities. So, I think that for them as a shareholder, I would be concerned moving forward with a company like Dillard’s.

8:50

Bob Smith: Well, there is something positive to be said about family-owned businesses, but when you get to be as large as Dillard’s it is probably something that would be of concern to some folks. I think it's something that bears consideration when we're looking at issues of not only diversity, but also the ability to have independent thought amongst the board, who can think independently in on behalf of the stakeholders, and beyond the interests of the family. Let's talk about competency for our next ‘C,’ and the in the notion of how prepared is the management, how knowledgeable is the board? Do they come from backgrounds that are going to really augment the interests and support and grow the interests of the organization, because intellectually and educationally and experience-wise they really know what is going on within the industry and within the company? They are very familiar with the technology and with the various different products and services that they offer? So, is this something that we can get into as analysts in terms of ESG?

10:03

Andy Poreda: Definitely Bob, and I think anybody that looks at an annual proxy statement, you can really get a good feel from a competency standpoint whether or not these board members are matching the interests of the company. Their biographies and their stories are usually put on display for us to see. So, I really do think we can tell those good companies and bad companies. I just looked at Lockheed Martin as a story of this, their board, and the talent that's on there, they have past CEOs of other companies, they have three retired generals and admirals—that one makes sense. They have a former DHS Secretary that may end up being the Department of Defense cabinet member here in the future. They have board members that have been on other boards and been chairmen of boards in the past. So, I think the support network there, they understand Lockheed Martin as a business, and some of the opportunities and the risks. I really think that that talent level will help ultimately lead to better outcomes.

11:01
Bob Smith: Let's switch over to clarity, is the company being transparent in disseminating information in getting the ‘need to know information’ as we like to refer to it in ESG? Or are they creating a lot of informational fog? Are they avoiding? Are they ducking information that is pertinent to the stakeholders and important to the ongoing interests of the organization? Those are things I think that every ESG analyst is searching for when we look at corporate structures, and we look at governance structures within an organization. So, it might be interesting, just identify a good one and a bad one. So, let's start with a good example of a company that really provides pretty solid clarity.

11:52

Andy Poreda: Yeah, I think from a company perspective, we really like the name of transparency and communication, Nike. Nike was one of the first companies, especially in its industry, to put out a CSR (Corporate Sustainability Report), which is basically a sustainability report covering issues that people were concerned about from a stakeholder perspective. That's things like labor in contracted factories in places like China, which notably, is actually coming back up again, in the in the media as well with some lobbying, but we appreciated the fact that they were being very transparent as to where each of these factories were. Then also reporting all the question metrics from groups like SASB that are trying to get more information from these companies. So, I think Nike was a leader in that that CSR space. We really applaud them because others have now had to follow and match their level of transparency, which was great.

12:41

Bob Smith: That's an important part of it too, like you touched on there towards the end is the leadership factor. One of the things that we are always looking for is a very clear demonstration of leadership. Lord knows that life will always throw you curveballs every day, and there are difficulties that every corporate organization faces, but the fact is that when things do not go well, or even if they do go well, we want clarity; we want to understand what is going on. Those companies that are generally are the more most forthcoming we find have a high correlation to also being the high performers in their industry. So, when you see good clarity, good communication, good transparency of a company, in terms of all the things that you need to know, you're generally going to find that they're an industry leader.

13:30

Bob Smith: Let’s go to consistency. Everybody thinks that they have got good, consistent performers, but that is not always true. We find in our analysis in the world of ESG analytical review, that consistency counts. What we are looking for there is company decisions that are important and actions in terms of how they execute. Are they fairly predictable? Do they have a style, a culture, a clear and consistent application of decisions that are important to the long-term capital value of the organization? Those are things that we are going to be looking for and continue to look for every year. Let's talk about a good example of the right way to be consistent. I think the one name that that pops up in our mind is probably Apple. Is that right, Andy?

14:20

Andy Poreda: Yeah, I like the Apple story because everybody can look at Apple as a great success story over the past three decades. You either love Apple products or you hate them, but they are an essential part of American culture as we speak today. I really thought it was interesting and this is really kind of tells the power of the board. Anybody who has followed Steve Jobs and his success story, knows it was a very interesting ride. I looked at it and I saw the conviction of these board members at Apple that literally pushed out probably one of the most influential people in the world. They pushed him out of the CEO role in the company three different times based on what they as a board thought was best for the company. At the time it may have looked really controversial, but on three separate occasions they had to make the difficult decision to push out the founding member of the company. At the time, it may have looked controversial, but in the end, we look at where Apple is standing today as one of, if not the most valuable company in the world from a market weight perspective. You look at those decisions now and it obviously did not hurt. So, I really like that Apple story and look at how boards can operate as sort of independent and forward-looking entities.

15:32

Bob Smith: Yeah, I think everybody can applaud Apple and what they've done in terms of their brand, what they've done and what they've come to be known as in terms of their style, and their orientation, and again, their leadership. On, the other side of the coin, there are those who unfortunately, have problems with consistency. I think, in recent years, one of the poster children for that would be none other than good old Tesla. Maybe you might shed some light on that for us, Andy?

16:04

Andy Poreda: I look at Tesla, it's a great story because one week, it's going to be potentially the most valuable company ever, and then Elon Musk sends a tweet out and this company is basically going bankrupt. So, it is a really rocky ride when you are following Tesla. I think you look at that and it counteracts with Apple, which has been a very deliberate and consistent board. I think Tesla's board has not shown that leadership to rein in Elon Musk. I think if you look at Tesla, it's a great company and has a lot of potential to have a huge impact on society moving forward with revolutionary products that have tons of positive externalities; but in the end the relationship with Elon Musk, and the vulnerability that he provides, I think the board could be that calming force, and I don't think that they as a board have exerted that influence that they possibly could. It’s a difficult one for sure, when you have your founder and its ties to the company, but I think that's what separates a good company from a great company is making those tough decisions.

17:05

Bob Smith: Especially when you have such an illustrious leader like Mr. Musk, kind of a bull in a china shop. In terms of looking at governance, I hope our presentation today fulfilled the need that most people might have in terms of, how should I think about governance? What are the general factors that I want to be looking at? So, in reviewing it we say, the five C's are the pillars, if you will, of governance analysis, and there's lots of data that can go behind that. Today, we are not here to talk about numbers. What we're here to talk about is conceptually, how do I want to analyze an organization from a governance perspective? Because in our minds, you can't necessarily have really good environmental outcomes or social outcomes without having really good governance. Governance is an anchor for both good E, and good S within the ESG complex. So, if you are going to go out and start thinking about governance, let's not forget the five C's. For us, it is compensation, composition, competency, clarity, and consistency. If you just follow those five concepts, you'll really be able to get yourself a very good framework for how to analyze an organization and how to grasp and understand the quality of the ‘G’ within that particular company or organization that you're evaluating.

Andy Poreda: Thanks, Bob, for talking with us today. And thank you everyone for listening. For more information. You can find us at sageadvisory.com or on our Sage Advisory Instagram and LinkedIn pages. See you next time.

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