Laurence Fink, the Chair and CEO of BlackRock, has issued his annual letter to public companies, entitled A Sense of Purpose. As in prior years, Fink advocates enhanced shareholder engagement and a focus on long-term strategy development. (See this PubCo post and this PubCo post.) What’s new this year is that he is also advocating that companies recognize their responsibilities to stakeholders beyond just shareholders—to employees, customers and communities. Holy smokes, Milton Friedman, what happened to maximizing shareholder value as the only valid responsibility of corporations?
Some academics have maintained that, during the booming economy of the decades after World War II, the interests of companies and a broad range of constituencies were in sync. During that period, many companies acknowledged their responsibilities to balance profits and the interests of employees and the community. The shift to shareholder primacy has been widely attributed to the development of the “shareholder preeminence theory” by the Chicago school of economists, beginning in the 1970s, with economist Milton Friedman famously arguing that the only “social responsibility of business is to increase its profits.” Subsequently, two other economists published a paper characterizing shareholders as “‘principals’ who hired executives and board members as ‘agents.’ In other words, when you are an executive or corporate director, you work for the shareholders.” (See this PubCo post.)
Fink begins by celebrating the great upward climb of equities in 2017, but tempers that acknowledgement with a recognition that it has been accompanied by a simultaneous increase in
“popular frustration and apprehension about the future….We are seeing a paradox of high returns and high anxiety. Since the financial crisis, those with capital have reaped enormous benefits. At the same time, many individuals across the world are facing a combination of low rates, low wage growth, and inadequate retirement systems….For millions, the prospect of a secure retirement is slipping further and further away—especially among workers with less education, whose job security is increasingly tenuous. I believe these trends are a major source of the anxiety and polarization that we see across the world today.”
Governments, in Fink’s view, have not been up to the task, with the result that “society increasingly is turning to the private sector and asking that companies respond to broader societal challenges…. 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.” [Emphasis added.]
What does that mean in practice? According to Fink, among other things, a company should consider its role in the community, its management of its environmental impact, its efforts to create a diverse workforce, its ability to adapt to technological change and take advantage of new opportunities, its retraining programs for employees in an increasingly automated world and its efforts to help prepare workers for retirement. But these goals are not just goals in and of themselves; they have a larger purpose. In the absence of “a sense of purpose,” Fink contends, echoing the title of this year’s letter, companies will simply “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.”
Why the intensified interest in this topic? With the growth in index investing, Fink argues, asset managers’ responsibilities of engagement and advocacy have increased, given that asset managers cannot simply sell the shares of companies about which they have doubts if those companies are included in index funds. “In this sense,” he maintains, “index investors are the ultimate long-term investors.” (See this PubCo post.) Fink then calls for a “new model of shareholder engagement – one that strengthens and deepens communication between shareholders and the companies that they own.” Instead of focusing only on annual meetings and proxy votes, “to be meaningful and productive… engagement needs to be a year-round conversation about improving long-term value.” To that end, BlackRock is expanding its investment stewardship team.
In the past, BlackRock has frequently put its vote where its mouth is, having voted in favor of proposals for board diversity (see this PubCo post) and climate change reports (see this PubCo post). In its Investment Stewardship Report for Q2 2017, BlackRock indicated that, in the second quarter, it supported eight out of nine shareholder proposals that requested the adoption of a policy on board diversity or disclosure around plans to increase board diversity. BlackRock indicated that board gender diversity “is important from a sustainable investment perspective given that diverse groups have been demonstrated to make better decisions. In the board context, this appears to be because they are better able to consider, where appropriate, alternatives to current strategies—a proposition that can ultimately lead to sustained value creation over the long term.”
For Fink, the focus of that engagement, as in the past, is on each company’s strategy for long-term growth:
“I want to reiterate our request, outlined in past letters, that you publicly articulate your company’s strategic framework for long-term value creation and explicitly affirm that it has been reviewed by your board of directors. This demonstrates to investors that your board is engaged with the strategic direction of the company. When we meet with directors, we also expect them to describe the Board process for overseeing your strategy. The statement of long-term strategy is essential to understanding a company’s actions and policies, its preparation for potential challenges, and the context of its shorter-term decisions.”
Although each “company’s strategy must articulate a path to achieve financial performance,” critically, Fink advocates that, to sustain a company’s financial performance, the company “must also understand the societal impact of your business as well as the ways that broad, structural trends—from slow wage growth to rising automation to climate change—affect your potential for growth.” In effect, Fink is arguing that attention to corporate social responsibility is inherently linked to and inseparable from sustainable financial performance. (Does that mean there’s no collision—no collision!—between these two theories, but there is collusion?… Sorry, I hate puns too, but I just couldn’t help it.)
As discussed in this PubCo post, a recent study found that inclusion of corporate social responsibility metrics as performance targets in executive compensation arrangements mitigates “corporate short-termism and improves business performance,” including significant increases in firm value that foreshadowed a “large and statistically significant” increase in operating profits that materialized within three years. The study authors contended that inclusion of CSR performance targets “enhances the governance of a company by incentivizing managers to adopt a longer time horizon and shift their attention towards stakeholders that are less salient, but contribute to long-term value creation.” These CSR factors can improve long-term value creation “because in the long term, social and environmental issues become financial issues.”
Articulation of long-term strategy is particularly important because, in Fink’s view, the failure to adequately articulate a long-term strategy is a central reason for the rise of activism and “wasteful proxy fights.” That’s not to say that all hedge-fund activism is a waste of time—Fink advises that when these activists bring valuable ideas to the table, companies should not wait until a proxy proposal emerges, but engage early and include shareholders like BlackRock as well as other stakeholders. (See this PubCo post for a discussion of a McKinsey study promoting alliances with long-term institutional investors as a way to blunt the effects of short-termism.) In that regard, Fink advocates that each company’s strategy statement should also “explicitly recognize possible areas of investor dissatisfaction.”
A company’s strategy will necessarily evolve over time as new issues arise. One example is the effect of the new tax bill. Fink encourages companies to explain to investors how the new tax law changes will affect their long-term strategies. For example, he suggests, if companies do not explain how they will use their increased after-tax cash flows to create long-term value, they may well be targeted by hedge-fund activists to use the increased cash flows for short-term purposes, such as stock buybacks.
With regard to boards, Fink continues to emphasize the importance of diversity, both as a way to avoid “groupthink” and to facilitate identification of new opportunities. Fink also stresses that directors should “assume deeper involvement with a firm’s long-term strategy. Boards meet only periodically, but their responsibility is continuous.” They are critical to
“helping a company articulate and pursue its purpose, as well as respond to the questions that are increasingly important to its investors, its consumers, and the communities in which it operates. In the current environment, these stakeholders are demanding that companies exercise leadership on a broader range of issues. And they are right to: 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.