The term “ESG” is a multifaceted one, covering so many different topics at once. Analogous to the fundamental-based valuation of shares, a one-dimensional approach falls far short of the mark. Therefore, multi-dimensional thinking is necessary to obtain as comprehensive a view of a company as possible. Rigid guidelines for assessing or classifying a company do not sufficiently reflect the realities of economic diversity and the distinctive characteristics of some companies.
Although quantifiable progress, for example in achieving greenhouse gas reduction targets, can still be measured and documented in figures, a primarily numbers-based assessment of good corporate governance is much more difficult, error-prone, and ambiguous. How one defines good corporate governance is actually in the eye of the beholder. When it comes to family-run companies in particular, there are many different views on good corporate governance.
German law provides for the well-known separation of powers between management, the supervisory board, and the Annual General Meeting. When it comes to the Supervisory Board, which monitors management, its composition is a decisive factor. Are there independent, critical thinkers with a wealth of experience? Or are they merely yes men appointed at the pleasure of management? Multiple mandates are all too common, particularly in large corporations. This often means that a diligent examination of the multifaceted problems within large companies is not guaranteed.
For our team, which focuses on German and European equities, management qualities have always been the most important criterion for an investment after valuation aspects. The assessment of corporate management is part of the DNA of our investment approach. Qualities such as honesty, trustworthiness, transparency, a pinch of conservatism, but also the ability to take criticism are important to maintain the integrity of a listed company. Management is legally obliged to act as an intermediary between all stakeholders. This makes a thorough analysis of whether management’s objectives are in line with those of the shareholders all the more important. A first indication of this can be found by looking at the long-term financial incentive mechanisms of management remuneration. Ideally, even a non-shareholding management should act in an entrepreneurially sustainable manner, as if it owed the company. However, an often-overlooked idea in board rooms is that management are actually only the employees of the company’s owners – i.e. the shareholders.
In terms of the institution of the Annual General Meeting, it is important to note the role of large shareholders and their involvement in these companies. This is one of the reasons why family businesses often receive widely differing ratings from various external rating agencies. However, it is precisely family businesses that we consider to be the more sustainably-oriented companies. This is because short to medium-term optimisation of remuneration over the term of a management mandate is not the main focus there. Instead, responsible family businesses think in terms of generations. The reputation and maintenance of the life work of the family is of paramount importance to them. Ultimately, this attitude forms the foundation for sustainable success. Following the same pattern, their external relationships are also geared towards this enduring success. The focus on the long-term well-being of the company, including shareholders, employees and other stakeholders, contributes to greater consistency in corporate governance, as well as the preservation of, and increase in, value. Fewer balance sheet structure optimisations mean that expenditure for future growth via research and development or expansion investments can be financed continuously, even in times of crisis. Inorganic growth sprees, as practised by some large corporations, could jeopardise this very flexibility.
The major challenge in family-run businesses is succession - the smooth transition from one generation to the next. Everything must be in place for an orderly transition. This is one of the risks of investing in family businesses. These overarching issues are also explored and validated in our numerous meetings. In addition, as shareholders, the active exercise of our voting rights at Annual General Meetings is of great importance to us and we have been exercising these rights conscientiously and in a fiduciary manner for years.
A prerequisite for inclusion in our funds is a face-to-face meeting with a top-tier company representative. After investment by the fund, regular updates - whether virtually, in person at our offices in Frankfurt, at conferences or at the company itself - are just as much a part of the process, in some cases even taking place several times a quarter. Above all, we maintain very close contact with the top 10 companies in our focused portfolios. An active dialogue about current business developments, the strategic development of the companies, and sustainability aspects is essential.
In general, a more nuanced approach to governance is needed when dealing with small to medium-sized companies. Understandably, these companies often do not have the extensive capacities to build up their own infrastructure to address numerous issues related to controlling and communicating sustainability aspects. For this reason, they often unfairly fall through the rigid, quantitative-oriented grid of the large rating agencies and are given lower ratings by them. However, this is precisely where we take action, get involved and form our own opinion through direct dialogue. This differentiated assessment of companies fits perfectly with our bottom-up stock-picking approach.
A more in-depth integration of ESG into our investment process has brought with it, in addition to the continued high ranking of the governance section, a deeper focus on environmental and social issues. Nevertheless, the consideration of these aspects was already part of our fundamental company assessment. Questions about employee turnover, risks from environmental issues or how the company deals with its own employees were standard practice. We decided to obtain data from Sustainalytics as an additional component in the decision-making process to gain further information and insights before making our purchasing decisions. This provides us with a more complete picture of our companies. Translating this knowledge into long-term outperformance is one of the key differences and advantages of active fund management over passive investment strategies.
Authors: Olgerd Eichler, Evy Bellet, Alexander Dominicus, Alexander Lippert
The Team manages the MainFirst Top European Ideas Fund and the MainFirst Germany Fund.
