Firms of Endearment Inspires New Investment Strategy
Interview by Raj Sisodia with Rick Frazier, founding partner of Concinnity Advisors, LP
Acknowledging the contributions and support received from friends and colleagues was one of the most satisfying writing tasks for the authors of Firms of Endearment. At about the same time the book was published, three of those contributors, Peter Derby, Jeff Cherry and Rick Frazier, devoted themselves to the idea of creating investment portfolios comprised of firms guided by a multi-stakeholder operating system, or “firms of endearment.” In this interview, Rick Frazier provides an update on the status of their journey.
Raj: You guys have been at this for quite some time Rick so your commitment can hardly be questioned. Are you also being fueled by a higher purpose?
Rick: It’s been about six years now and along the way we faced a good number of challenges. So it probably would have been impossible to stay the course if we didn’t feel purposeful in creating this business. A good deal of our staying power came from our belief that capitalism is the bedrock for reducing poverty and increasing living standards. So we think it’s critical for capitalism to be practiced in a way that makes it more attractive and more defendable. And companies guided by a multi-stakeholder operating system are setting the example. They’re showing that you can create wealth for shareholders without neglecting other stakeholders. Our objective is to prove that these companies are worthy of greater investor support.
Raj: So you set out to create investment products that would allow investors to provide that support.
Rick: That’s right. We’ve always envisioned the possibility of a virtuous cycle of sorts whereby companies realize lower capital costs as more investors reward them for operating this way, which in turn should influence more companies to practice capitalism in this manner. And when I say investors I mean institutional investors since we think they have more capacity to change capitalism’s reward system than any other stakeholder.
Raj: How confident are you that this type of virtuous cycle will materialize?
Rick: Well, on the corporate side of the equation we’re convinced that a multi-stakeholder operating system is becoming less of an option. All the market forces that make this so, many of which were described in Firms of Endearment, are just too powerful to ignore. Clearly, what we expect from the companies we buy from, work for and let operate in our communities is changing. So this new marketplace reality is requiring companies to adopt a multi-stakeholder operating system ahead of any widespread investor demand that they do so.
But obviously the pace of adoption would accelerate if investors provided more capital to firms that do and less to those that don’t. And maybe there’s cause for some optimism on this front in light of the whole socially responsible and better governance movement. But understandably most institutional investors still need to care more about returns than anything else.
So at the end of the day investors need strong evidence that they’ll be rewarded if they invest in companies guided by a multi-stakeholder operating system. Our job is to show they don’t have to make a trade off…that they can make the returns they need and also influence the way capitalism is practiced. If we do that, the virtuous cycle we envision has a chance.
Raj: How good do the returns need to be? Will you be held to a higher standard since you’re trying something new?
Rick: I think we need to be among the top performing actively managed funds to be taken seriously. I don’t know if we’ll be held to a higher standard. I suppose we might by those who view our investment approach as a bit unconventional.
Raj: How long have you actually been investing and what is your return performance?
Rick: We’ve been investing in U.S. companies for over three years now and our performance is about where we think it needs to be. We’ve always felt confident that a multi-stakeholder operating system ultimately boosts bottom line financial performance. We’ve seen it first hand in our previous work as consultants. So we didn’t think it was a big leap to expect stock prices to eventually track with that performance. And of course the long-term returns of companies featured in Firms of Endearment provided more fodder for creating an investment strategy based on that assumption.
Raj: How many U.S. public companies do you think are truly guided by a multi-stakeholder operating system?
Rick: We don’t know for sure since we haven’t evaluated all U.S. companies and probably never will. Your use of the word “truly” is the key though. If you plucked a random sample of fifty names from the S&P 500 and read each of their websites, you might conclude that as many as half or more of them have adopted it. My guess is that only around five percent are really achieving the requisite concinnity though.
Raj: We used the term concinnity in the book. Is that why you selected it as the name of your firm?
Rick: Yes, we shamelessly confiscated it. It’s a great word and I didn’t know what it meant until I saw it defined in the book. We chose it because it reflects what multi-stakeholder minded companies achieve and it’s also descriptive of our integrative research process.
Raj: How does your approach differ from socially responsible investing?
Rick: Socially responsible investing comes in many forms. I think we line up well with most SRI minded investors. Our basic premise is that regardless of how you define SRI, the likelihood that companies will meet the expectations embedded in that definition largely depends on whether they’re guided by a multi-stakeholder operating system.
Raj: How much emphasis do you place on a company’s philanthropic actions?
Rick: We take a neutral position. Philanthropy is grounded in the notion of giving something back, which implies you took something in the first place. We’re more interested in companies that add value for all stakeholders as a matter of course. But as it turns out though, it’s rare to find a company operating with a multi-stakeholder mindset that doesn’t also have a strong charitable bent. As I recall, you made a similar observation in Firms of Endearment.
We like the way Peter Drucker separated social responsibilities into social impacts, or what business does to society and social problems, or what business can do for society. Addressing or eliminating negative social impacts is something all businesses should try to do. Our take is that companies guided by a multi-stakeholder operating system are simply more likely to do that. We don’t penalize companies for choosing not to address a social problem, but we do penalize them for not addressing social impacts.
Raj: You mentioned that you faced a number of challenges on this journey. What was the greatest challenge you needed to overcome?
Rick: That’s difficult to answer. Several choices come to mind, not the least of which was starting this venture just as the financial crisis was unfolding. But I’d have to say it was the development of the investment research process. It was an exercise in humility that spanned a couple of years.
Raj: I’m surprised to hear this was such a challenge. You’re one of the most qualified people I know when it comes to assessing the multi-stakeholder model. What made it so difficult?
Rick: Well our whole accounting and reporting apparatus is designed to give investors information about tangible assets. Which is really crazy when you think about it since intangible assets account for 80% of the market cap of S&P 500 companies. And nearly everything we needed to evaluate was an intangible asset. So we had to build an information system from scratch.
Raj: But at least you knew what you wanted to look for right?
Rick: Yes that’s right. And that was also part of the problem. We knew precisely what to look for as a result of our prior consulting experiences when we could thoroughly assess on-the-ground realties within companies. How finely tuned the stakeholder listening systems were. What the culture was like. How employees felt about working there. The quality of relationships with customers and suppliers and so on. So that was our ideal benchmark and it was a very high bar.
The challenge was how can we assess what’s really happening inside these companies without actually being inside? We felt blind and ill equipped at first, but you’re right. Since we were never confused about what to look for, we felt qualified to at least have a go at it. A couple years later we finally felt we had something that allowed us to select companies with some measure of confidence.
Raj: Can you describe that something without giving away too much of your secret sauce?
Rick: Our research process is basically a proxy for no longer being able to assess a company from the inside. But that doesn’t mean every piece of information we use is a proxy in and of itself. For example, we don’t use proxies for determining how customers feel about a company. We can still determine that directly as outsiders. On the other hand, our analysis of employee sentiment does require proxies, as does our analysis of corporate culture.
I’ll quickly give you an outline of what we do. The first stage is a screen that produces a universe of companies that seem worthy of further investigation. We use about 40 different information sources that recognize companies for achieving certain outcomes that we expect from firms guided by a multi-stakeholder operating system. A couple examples are firms recognized as being ethically sound or great places to work. The companies receiving the highest scores based on our weighting system are then evaluated in our composite analysis.
The composite analysis incorporates data, ratings and insights from about twenty different specialists who provide assessments associated with specific stakeholders. It also integrates ESG [Environmental, Societal, Governance] ratings from multiple ESG ratings providers. In a nutshell the main blocks of analysis are culture, supplier relationships, employee relationships, customer relationships, community relationships, intangible asset management, management integrity and fundamental analysis. I’m skipping over a lot of detail here. It would be too much territory to cover if I started diving in.
So the composite analysis views each company through a number of lenses and a company needs to look pretty good across all those areas to make it into the portfolio. The finalists are then poured into a quantitative model for portfolio construction and risk management. And then the whole process is repeated every year.
Raj: Since you use a quantitative model, does that mean you’re offering a quantitative investment product?
Rick: I think David [Wolfe] said it best when he described it as more of a whole-brained investment strategy. About 70% of our performance is attributable to the names selected by the research process and about 30% is due to quantitative portfolio management techniques. David always cautioned us to not let the quantitative drive out the qualitative—especially the pesky human driven intangibles. He kept urging us to hold on to a more holistic view and I think we have.
But it wasn’t easy. Wall Street overall has a decidedly left-brained bent—quant jocks especially. So when you start talking about intangible investment criteria like culture, customer loyalty, employee commitment, corporate reputation, let alone values and trust, you don’t exactly ooze with credibility in their eyes. But I think this is changing.
Raj: Are you suggesting Wall Street is becoming more right-brained? I must have missed that development.
Rick: Not by leaps and bounds and certainly not quickly, but there are some telltale signs of a subtle shift. To some degree I think it’s happening out of necessity. I think the credit crisis exposed the limitations of overreliance on quantitative techniques. Corporate risk managers are now starting to explore how they can combine qualitative components with quantitative techniques to better manage risk. They may even be starting to wonder whether organizational culture is important to the mix. One could argue they’re a little late to that party, right?
Another sign is that more quantitative investment analysts are looking at how to integrate intangible indicators with quantitative investment techniques. Again I think this is born from necessity. They’ve all been slicing and dicing the same 20% pile of tangible asset information for a very long time.. At this point it seems like they’re all trying to squeeze alpha blood from the same information rock. Meanwhile, the intangible asset information pile that makes up about 80% of corporate value is still largely virgin soil.
Raj: So your analysis is mostly focused on the 80%?
Rick: Yes, mostly, and that’s because a multi-stakeholder operating system is by its very nature an intangible asset. And it’s also because we recognize that corporate financial performance and economic prosperity increasingly come from intangible assets.
But by no means do we claim to have completely cracked the intangible asset code. The most we dare say is that we’re at least seeing shapes and shadows in areas that most analysts overlook entirely. We look at financial information as well, but only after a company has been qualified as multi-stakeholder proficient.
What sets us apart I think is that regardless of how attractive a company’s financial metrics or ratios might be, it won’t necessarily make our cut because it also matters to us how they achieve it. Is it at the expense of other stakeholders? Is it based more on becoming expert at the quarterly earnings game? Are they sacrificing long-term performance on the altar of short-term earnings?
We’ve never really understood why qualitative factors aren’t considered part and parcel of fundamental analysis. I mean what could be more fundamental to a company’s ability to create future cash flow than customers who keep buying or employees who give their best effort? This is the upstream stuff that has more leading indicator potential. The financials are always laggards by comparison.
Raj: You mentioned that the research process begins anew or is refreshed every year. I assume this means some companies could be dropped from your portfolio after a year. Does this mean in some cases you’re a short-term investor?
Rick: Keep in mind that hanging on to a stock for a year these days means you’re a long term investor. The bulk of our names have been in the portfolio from the very beginning. But they all need to qualify again each year.
We’re a long-term investor so long as a company continues to demonstrate a commitment to the multi-stakeholder operating system. We do have some annual turnover mostly because every year we increase the number of names that get put through the composite analysis. This means we’re capturing some new names that score better in the composite analysis than previous years names. And some names keep getting better each year to the point where one year they might leap past some names currently in our portfolio.
Raj: How much does executive compensation influence your view of whether management will safeguard the long-term health of the business?
Rick: We do incorporate opinions from specialists who evaluate executive compensation. But in our view, once you get past the likes of Whole Foods, Costco and a handful of other exemplars on this issue, there’s a big gap and then everybody else pretty much lands in the same bucket.
Most of the calls to fix executive compensation seem like tweaking at the margins to me. Until we get serious about ditching compensation systems that are mostly driven by short-term earnings and stock prices, we shouldn’t expect much to change. I agree with those who think there’s a fundamental flaw with the theory that underlies today’s compensation systems. I know former IBM CEO Sam Palmisano recently argued as much in an interview he did with Michael Useem at Wharton. And Roger Martin [Dean, Rotman School of Management, University of Toronto] has been making this case for at least a decade. And Sumantra Ghoshal soundly discredited corporate governance based on agency theory in a paper you sent to me several years ago.
Raj: That paper was Bad Management Theories Are Destroying Good Management Practices.
Rick: That’s right. The point is that some very smart people have weighed in on this, but chances are we’ll be living with what’s now in place for quite some time. We’ll see. But let’s face it, everybody knows something is way out of whack when a CEO makes more in a day than the average worker makes in a year.
Raj: In Firms of Endearment we made an effort to profile companies that find a way to avoid layoffs during downturns. In one of our previous phone discussions you mentioned the impressive record of SAS Institute for avoiding layoffs. Do you evaluate a company’s layoff history or policies in your analysis?
Rick: I loved the Southwest Airlines example in the book where you describe how it was the only major airline that didn’t lay people off immediately after 9-11. Let’s go back to that virtuous cycle we discussed earlier. What if institutional investors started gobbling up Southwest stock after learning the company was determined not to lay people off. That was a great opportunity to send a message that if you take a long-term view, you’ll be rewarded with lower capital costs. If Southwest’s stock price held up while all other airlines announcing layoffs slid lower, that would have sent a powerful message. And here’s the thing…the more workers an airline laid off, the longer it took for their customers to return. But even now you can find analysts grumbling that Southwest pays people too much…that their labor unit costs are too high.
So look, on the one hand we do seek out executives who appear to take a long-term, holistic view of the enterprise and its place in society. But if we only invested in companies that never lay people off, we wouldn’t have much to choose from. We realize there are times when survival depends on cutting back. But when customers are temporarily unable to pay during a downturn, we might view a layoff as shortsighted and not worth the price of the pain it inflicts. But above all, the main thing we look for is whether leaders share in the hardship of layoffs.
I remember being in Pittsburgh about 15 or 20 years ago and reading a newspaper article about the CEO of Heinz paying millions for a diamond ring that he bought for his wife. In another section of the paper was an announcement of layoffs at one of the Heinz plants. I’ll never forget that. I mean nineteen and twenty-year-old corporals implicitly understand that no one will respect them unless they lead by sharing in the hardship. Why is this simple truth so difficult to understand for a 50-year-old executive with above average intelligence, a couple degrees and years of experience?