Knock-On Effects
Knock-On Effects |
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Instant global communication and the immediacy of social media can leave a company’s reputation in tatters within hours. For this reason, we believe it is important to identify and understand any material reputational issues – including environmental and social – that might impact the sustainability and direction of future returns for the companies in which we invest.
As we explained previously in “ESG Scores: Comparing Apples to Oranges,” we do not use scores to determine potential ESG considerations, but prefer to consider each company (and any environmental or social factors) individually as part of our fundamental stock selection process. We believe the key is to concentrate on material risks that can have a significant impact on the fortunes of the company. While we take a bottom-up approach to assessing companies, there are common issues that we see within sectors.
PRICING MATTERS
An obvious material concern in the health care sector, for example, is U.S. drug pricing, which has captured the headlines and been used as a campaign tool. Even though prescription drugs account for only 10% of U.S. health care expenditure, politicians have seized upon the issue, amplifying the social consequences for companies.1 We monitor the risk of negative headlines about drug prices for the health care sector and individual companies within it. There are some health care companies – notably high-quality medical equipment companies – that have managed to sustain high returns on capital without relying on excessive pricing. Big data, for example, is emerging as an effective way to help hospitals to reduce costs by understanding population health trends. On the other hand, this increases the risk of data security issues.
PRIVACY, PLEASE
Portfolios aiming to grow capital and reduce downside participation need to tread carefully along the fault lines of digital ethics. Rapid data-driven technological change is transforming how we live and work. Should governments eventually decide to seriously curb the flow and use of personal data due to political and social concerns (fake news and election meddling, social media/smartphone addiction, privacy), this would damage business models reliant on monetizing it (see a certain social media giant’s problems with U.S. Congress, the U.K. government and the European Union [EU]).
Fines for breaches of data privacy can hurt companies in any sector but primarily in information technology, health care and financials (e.g., health insurance). The EU’s GDPR regulation has exponentially increased potential fines, especially for highly sensitive data like health records. Companies could be caught unprepared for this completely new risk. Additionally, bigger companies represent a bigger ‘threat surface’ for cyberattacks unless they invest.
However, this could present an opportunity for large cloud providers if they can prove to clients that data security in the cloud is better than in on-premise storage. The security of customer data held by corporations, privacy issues relating to how data is being monetized and cyberthreats are leading to increased spending on security software. These evolving trends will open up new markets, new risks and potential opportunities. We invest in companies that we believe are more likely to benefit from these material opportunities and avoid those who rely on the monetization of data as the driver of revenues.
CHANGING TASTES, CHANGING FORTUNES
We avoid owning consumer staples companies where management is failing to position their firms for future consumer demand – for example, U.S. food companies. As an industry, food manufacturers face multiple and fast changing challenges. If management is short-sighted about changing tastes, then their company will struggle. Take the increased interest in healthy eating, and the desire for food with recognizable, more natural ingredients. This has led to consumers concentrating their shopping on the outer aisles of supermarkets, where the fresh, natural and whole foods are stored and avoiding the middle aisles that are home to more processed food items. Failure to adapt resulted in the top 25 U.S. food and beverage companies losing $18 billion in market share over a five-year period, according to Fortune (2015).
We want to understand the return drivers behind every stock we own. When we discover issues that are material – especially when they have knock-on effects that could jeopardize the sustainability of a company’s long-term returns on operating capital – we look deeper, and we engage.
RISK CONSIDERATIONS
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market value of securities owned by the portfolio will decline. Accordingly, you can lose money investing in this strategy. Please be aware that this strategy may be subject to certain additional risks. Changes in the worldwide economy, consumer spending, competition, demographics and consumer preferences, government regulation and economic conditions may adversely affect global franchise companies and may negatively impact the strategy to a greater extent than if the strategy's assets were invested in a wider variety of companies. In general, equity securities' values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. Option writing strategy. Writing call options involves the risk that the Portfolio may be required to sell the underlying security or instrument (or settle in cash an amount of equal value) at a disadvantageous price or below the market price of such underlying security or instrument, at the time the option is exercised. As the writer of a call option, the Portfolio forgoes, during the option's life, the opportunity to profit from increases in the market value of the underlying security or instrument covering the option above the sum of the premium and the exercise price, but retains the risk of loss should the price of the underlying security or instrument decline. Additionally, the Portfolio's call option writing strategy may not fully protect it against declines in the value of the market. There are special risks associated with uncovered option writing which expose the Portfolio to potentially significant loss.
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