Brydon Review into UK Audit

January 4, 2020 Ben Yeoh

"Language matters." so begins the Sir Donald Brydon Review into UK Audit.

In parts touching on the philosophical, Brydon suggests:

"Audit is not broken but it has lost its way and all the actors in the audit process bear some measure of responsibility."

Recommendations:

• A redefinition of audit and its purpose

• The creation of a corporate auditing profession governed by principles

• The introduction of suspicion into the qualities of auditing

•The extension of the concept of auditing to areas beyond financial statements

• Mechanisms to encourage greater engagement of shareholders with audit and auditors

• A change to the language of the opinion given by auditors

• The introduction of a corporate Audit and Assurance Policy, a Resilience Statement and a Public Interest Statement

• Suggestions to BEIS' work on internal controls and clarity on capital maintenance • Greater clarity around the role of the audit committee;

• A package of measures around fraud detection and prevention • Improved auditor communication and transparency

• Obligations to acknowledge external signals of concern • Extension of audit to new areas including Alternative Performance Measures

• The increased use of technology

Brydon quoting Karthik Ramanna “I know of no better system than market capitalism to sustain liberty and create prosperity – and market capitalism cannot function without a robust audit function. If we do not save auditing, we cannot save capitalism.”

And on fund managers.... " I was also rather underwhelmed during the Review by the interest in audit shown by some of the portfolio managers with whom I spoke. Few appeared to read the audit report thoroughly and several took the view that it was enough to know whether or not the auditor had given an unmodified opinion."

I do note, I did not speak to Brydon but have tangential advisory interests through being on an advisory group for IASB and for FRC.

Review can be found here.

The dawning of Japanese Corporate Governance

June 20, 2018 Ben Yeoh

Source: Board Independence graph is Yanagi's book quoting ISS survey 2012-13

I recently finished a positive stewardship engagement with a Japanese company on the nature of independent directors. ESG ignored 10 years ago, is increasingly in focus in Japan. In my view, this trend is set to continue.

One resource to examine in this area is Ryohei Yanagi’s new book on corporate goverance in Japan (Amazon link here). Yanagi has a book event in London 4 July 2018 (link to event here).

Yanagi examines the Ito review (cf UK Kay review, a blog on Kay here), the corporate governance and stewardship codes in context of Abe’s reforms, and gives the historic background of why Japanese corporates are managed and governed like they are today.

Source: the RoE (Return on Equity) chart is based on RoE average primary index of each country (cap weighted), on 4Q (2004-2013( by Bloomberg data, from Moving the Mountain study group, 2014 from Yanagi (2018)

He discusses RoE (Return on Equity) and RoE - cost of capital spreads.

Since the work of Stern Stewart and others on EVA (Economic Value Add) from the 1990s and before (see a background paper here) which focus on Return on Invested Capital (or for some in modern day expressions Cash Flow Return on Investment) over some assumption of cost of capital, this thinking has been a dominant feature in US and EU corporate thinking and finance. Less so, seemingly in JP corporates.

Yanagi then synthesises this with ESG and intangibles and coins a concept of RoESG.

Yanagi suggests many Japanese corporates view some of their intangible ESG/CSR management as good (although again one can debate on reporting on it). (I also think many non-Japanese investors may not concur with what Japanese manager tout on CSR)

He then suggests that intangible/ESG management and management of RoE are two lens which are not opposed – in fact almost could be joined more symbiotically.

Not an entry level book, it draws practical thinking about how to look at financial and non-financial metrics for corporates and investors alike and roots it in the historic and cultural context of Japan.

When a board can't detect fraud...

February 7, 2018 Ben Yeoh

I’m still utterly amazed at large company fraud. Christo Wiese owns 23% of Steinhoff and was Chair, and didn’t know anything about it at Steinhoff. Highlights to me that choosing the CEO is still one of the most important if not the most important job of a board.

“Normally when you’re in a business, and you’re responsible, you can see the problems coming, you’re aware of them,” Mr Wiese said. “This came like a bolt out of the blue.” “I can only say that cleverer people than this board have been duped before by people committing fraud,” he added. “To detect fraud in a company is an extremely difficult if not impossible task and it becomes more difficult when, as is alleged in this case, the CEO is directly involved.”

Jan 31, FT article here and Dec 2017, Bloomberg article here

Also, highlights the problems the board has if it can't assess what management are showing them. In the light of the UK's Carillion failure, its board have been given a hard time too.

Blackrock CEO supports ESG and Long-Term in 2018 Letter

January 17, 2018 Ben Yeoh

Larry Finks 2018 Letter to CEOs is titled “Sense of Purpose” he writes:

“We also see many governments failing to prepare for the future, on issues ranging from retirement and infrastructure to automation and worker retraining. As a result, society increasingly is turning to the private sector and asking that companies respond to broader societal challenges. Indeed, the public expectations of your company have never been greater. Society is demanding that companies, both public and private, serve a social purpose. To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.

Without a sense of purpose, no company, either public or private, can achieve its full potential. It will ultimately lose the license to operate from key stakeholders. It will succumb to short-term pressures to distribute earnings, and, in the process, sacrifice investments in employee development, innovation, and capital expenditures that are necessary for long-term growth. It will remain exposed to activist campaigns that articulate a clearer goal, even if that goal serves only the shortest and narrowest of objectives. And ultimately, that company will provide subpar returns to the investors who depend on it to finance their retirement, home purchases, or higher education.”

My personal view is that reflects close to a consensus view amongst thoughtful long-term investors and those interested or practicing a sustainable or integrated ESG part of their investment process.

However, I do not believe that this is the predominant line of investment practice in the assessment management world. I have no direct data on this, it’s culled from experience and anecdote. The reasons are multi-factorial compounded by incentive structures, short-term pressures and job career risk. A lot of what it means to be human is not initially geared for long-term sustainable thinking. Perhaps this will be humanity’s

downfall.

Under: A new model for corporate governance, Fink suggests: “ In managing our index funds, however, BlackRock cannot express its disapproval by selling the company’s securities as long as that company remains in the relevant index. As a result, our responsibility to engage and vote is more important than ever. “

“…The time has come for a new model of shareholder engagement … companies have been too focused on quarterly results; similarly, shareholder engagement has been too focused on annual meetings and proxy votes. If engagement is to be meaningful and productive – if we collectively are going to focus on benefitting shareholders instead of wasting time and money in proxy fights – then engagement needs to be a year-round conversation about improving long-term value.

“….: a company’s ability to manage environmental, social, and governance matters demonstrates the leadership and good governance that is so essential to sustainable growth, which is why we are increasingly integrating these issues into our investment process.

Companies must ask themselves: What role do we play in the community? How are we managing our impact on the environment? Are we working to create a diverse workforce? Are we adapting to technological change? Are we providing the retraining and opportunities that our employees and our business will need to adjust to an increasingly automated world?”

FT’s Authers comments: “CEOs who think this is politically correct claptrap (there must be plenty) can of course ignore him. They can be safe in the knowledge BlackRock is not going to sell, whatever happens”

(Truly active) managers oft scoff at passive managers ability to engage. 40 ppl engaging 4,000+ companies, is not 10 ppl engaging with 50 cos.

Passive managers remain skeptical of how many active portfolio managers are effectively engaging.

But as Dimson et al. Active Ownership academic study implies +ve stewardship is good for multiple stakeholders: employees, company, shareholders environment…

Long-term stewardship should be a win-win for All.

But as my earlier post on actual effectiveness and mainstreaming sustainability, where we can see Blackrock itself only voted in favour of Climate Change proposals for the first time in 2017 and then on very few (2%) of climate proposals, one could argue we still have some way to go.

There are also reasonable arguments that can be made suggesting that this is so far rhetoric which might not be supported by the current voting record. Although others would note it is complicated and that much good engagement can happen regardless of vote.

Link to climate proposals post

Link to BlackRock CEO 2018 Letter

Link to Active Ownership paper here: H/T Xi Li, Elroy Dimson and Oğuzhan Karakaş https://www.thendobetter.com/investing/2017/10/16/active-ownership-academic-study

If you'd like to feel inspired by commencement addresses and life lessons try: Neil Gaiman on making wonderful, fabulous, brilliant mistakes; or Nassim Taleb's commencement address; or JK Rowling on the benefits of failure. Or Charlie Munger on always inverting; Sheryl Sandberg on grief, resilience and gratitude or investor Ray Dalio on on Principles.

Cross fertilise. Read about the autistic mind here.

Active Ownership. Academic Study.

October 16, 2017 Ben Yeoh

From Active Ownership, by Dimson et al. (see end for notes)

“Active Ownership” by Elroy Dimson , Oğuzhan Karakaş and Xi Li - this paper, in my view, suggests that successful active engagement in a collaborative and constructive manner on material ESG concerns improves the fundamentals of a company and also increases stock returns.

I differentiate this type of engagement with what one typical sees from “hedge-fund activists” or where board proxy fights occur; and where media engagements and open letters are used (although that type of activism has also seen positive returns see Klein and Zur, 2009).

Starting with the conclusions: “How does the market react to ESG activism? We find that ESG engagements generate a cumulative size-adjusted abnormal return of +2.3% over the year following the initial engagement. Cumulative abnormal returns are much higher for successful engagements (+7.1%) and gradually flatten out after a year, when the objective is accomplished for the median firm in our sample. We do not find any market reaction to unsuccessful engagements. The abnormal return patterns and magnitudes are similar for the subsamples of CG and ES engagements.4 This suggests the existence of a threshold for success to be pursued and achieved for both types of engagements. We then examine the cross-section of abnormal returns (controlling for industry and year fixed effects) and find that the positive market reaction to successful engagements is most pronounced for the themes of corporate governance and climate change. For these themes, the cumulative abnormal return of an additional successful engagement over a year after the initial engagement averages +8.6% and +10.3%, respectively.”

Then:

“To investigate the sources of the positive market reaction to successful engagements, we take a difference-in-differences approach and examine the subsequent changes in target firms’ operating performance, profitability, efficiency, institutional ownership, stock volatility, and governance after successful engagements relative to after unsuccessful engagements. We observe significant improvements in all these measures (i.e., an increase in firm performance, investor base, and governance, and a decrease in stock return volatility) following successful engagements, as compared to the unsuccessful ones.

Particularly focusing on the ES and CG subsamples, we first find that the return on assets and the ratio of sales to the number of employees improve significantly one year after successful ES engagements, as compared to the unsuccessful ones; but such improvements are less pronounced for successful CG engagements. These findings support the view that successful ES initiatives enhance customer and employee loyalty. Second, we observe an increase in shareholdings by the asset manager, pension activists, and SRI funds one year after successful ES engagements; but such an increase is not apparent for successful CG engagements. These results support the view that ES initiatives generate a clientele effect among shareholders. Third, we find improvements in the corporate governance structure of targeted firms, as measured by the Bebchuk, Cohen, and Ferrell (2009) entrenchment index, two years after successful engagements on all ESG issues. This suggests that good ESG practices signal improving governance quality.

And to conclude:

“We conclude that environmental, social, and governance activism of the type that we study

improves social welfare to the extent that it increases stakeholder value when engagements are successful and does not destroy firm value even when engagements are unsuccessful. We note that, after successful engagements (particularly on ES issues), firms with inferior governance subsequently improve their governance and performance. Our interpretation is that active ownership attenuates managerial myopia and hence helps to minimize intertemporal losses of profits and negative externalities (see Benabou and Tirole 2010). This approach is differentiated from other styles of shareholder action, particularly hedge fund activism. Responsible investment initiatives are less confrontational, more collaborative, and more sensitive to public perceptions; yet they achieve success.”

The full methodology and discussion is in the link SSRN here (further bibliography in that paper to studies on the full range of stewardship to activism) .

An overview of several Active Ownership studies is given by Share Action here.

Summary slides given by Dimson on this paper are here.

If one puts this work together with the work on the outperformance of Global Equity managers described here, one can start to build a defense of Active Management; where John Kay would argue Active Managers should compete on style and philosophy in any case.

If you'd like to feel inspired by commencement addresses and life lessons try: Ursula K Le Guin on literature as an operating manual for life; Neil Gaiman on making wonderful, fabulous, brilliant mistakes; or Nassim Taleb's commencement address; or JK Rowling on the benefits of failure. Or Charlie Munger on always inverting.

The chart above figure plots the cumulative monthly abnormal returns (CARs) around the initial engagements from one month prior to the engagement month to 18 months afterward. The chart examines the entire sample Each CAR is decomposed into the CAR for successful engagements (i.e., those that achieved milestones) and the CAR for unsuccessful engagements. For each event month, authors calculate the average abnormal return from holding an equally weighted portfolio of all target firms that initiated engagements in month 0. The stock returns are adjusted for Fama-French decile size-matched returns. The stock returns are winsorized at the 1st and 99th percentile levels before calculating the average CARs.

$5m prizes for new global governance ideas

August 7, 2017 Ben Yeoh

$5m prize awards for new ideas in global governance. This competition is a quest to find new models of global cooperation capable of handling global risks. It will award US$5 million in prizes for the best ideas that re-envision global governance for the 21st century.

"Be part of the effort to safeguard our world for future generations. Be part of the global conversation. Help to change the shape of things to come."

So, peeps, enough complaining. Start thinking and doing!

Have some big ideas and put them out there, deadline until end of September 2017 now (it has been open since November 2016), but that's still quite enough time to put something down. Apply here and FAQ. Even if not maybe it will get you thinking!

There are plenty of resources on the Foundation's website. Here's the founder's letter.

Here are current ideas in global governance

Here are a series of solutions and ideas the world has had.

A summary of the Foundation is below:

" The Global Challenges Foundation aims to incite deeper understanding of the most pressing global risks to humanity - and to catalyse new ways of tackling them. Founded in 2012 by the Swedish financial analyst and author Laszlo Szombatfalvy, GCF is based on the belief that global challenges require global solutions and new forms of international cooperation are urgently needed in order to secure acceptable living conditions for future generations.

GCF’s approach is rooted in the risk analysis employed by Laszlo Szombatfalvy (wiki) during his five-decade career as an exceptionally successful investor. This objective, scientific approach led him to conclude that the impacts of the great challenges of today – especially climate change, large-scale environmental degradation, violent conflict, extreme poverty and continued rapid population growth – are being gravely underestimated by political and business leaders, who are too often influenced by short term interests. "