The economics of geopolitics
Trade war escalation and stalled Brexit negotiations have boosted investment risk and market volatility. Our panelists discussed the geopolitical landscape and how it's influencing investment decisions.
In August 2019, Business Roundtable issued a statement on the “Purpose of a Corporation”¹ and redefined its longstanding position that corporations exist principally to serve shareholders. Instead, the association of CEOs of leading U.S. companies emphasized the need to benefit all stakeholders: customers, employees, suppliers, communities and shareholders. The reactions were immediate and occasionally extreme, with many questioning the implications for capitalism or arguing that the statement merely served to entrench management teams. We met with Brad Klapmeyer, CFA, portfolio manager of the Ivy Large Cap Growth Fund, to review the details and the potential impact on business, industry analysis and corporate governance.
Q: Business Roundtable incited a flurry of press reactions with its latest statement, ranging from “this is simply rhetoric” to “this is the death of capitalism.” What’s your reaction to the new definition?
Klapmeyer: The list of corporations that are signatories includes many of the world’s best companies. That tells me there has to be something in this pronouncement that we must consider as fundamental investors. I think there is a lot of importance in the things they said and we need to recognize it as we consider each element.
Q: Let’s dig into the five specific tenets of the statement and consider them one at a time. The first is: Delivering value to our customers. We will further the tradition of American companies leading the way in meeting or exceeding customer expectations. As a fundamental investor doing daily bottom-up research to identify strong businesses, what’s your reaction to the idea that delivering value to the customer is a key corporate responsibility?
Klapmeyer: Consumer-facing products are the easiest to understand in this context. However, if you reverse the thought and ask how that ultimate value to the customer is created, then you can uncover the fundamental components required. Key inputs in delivering value to customers include a strong investment in research and development (R&D), helping to generate innovation and diversity of ideas. The ultimate value of a product would be realized by the customer, and the company would benefit through profitability and strong returns. It’s key to understand how these things are connected.
We see it in the footwear industry, where there is massive innovation on direct to consumer sales, and there are software and health care companies that drive significant innovation and generate strong profitability and returns. On the other side, I covered the pharmaceutical industry for years. There was a period when certain specialty pharmaceutical companies were pursuing financial engineering and driving earnings through mergers and acquisitions. We began to ask, “What is the ultimate value those companies bring to consumers through that sort of activity?” We found out that they weren’t investing in R&D. They were buying drugs, raising the prices and investing zero in R&D and innovation. Those companies eventually were exposed for what they were. They were providing no ultimate value to consumers. These are proof points that show how focusing on delivering value to consumers has tangible benefits to the sustainability and profitability of a business.
Q: The second tenet is: Investing in our employees. This starts with compensating them fairly and providing important benefits. It also includes supporting them through training and education that help develop new skills for a rapidly changing world. We foster diversity and inclusion, dignity and respect. Does this seem consistent with your approach of seeking high-quality companies with strong business models or is this at odds with being able to deliver value to shareholders?
Klapmeyer: I think it becomes more meaningful in linking this statement to things that can be described through fundamental components. Investing in employees is taking consideration of employee turnover, employee productivity, the ability to attract talent — those are all key conversations we have with companies when we’re doing deep fundamental research. I think it would be difficult to say these attributes aren’t integral to the durability of the company. One of the things we worry about, for example, is the “talent bench.” If the CEO leaves or if the head of R&D leaves, who’s on the team to step up? Is external top talent attracted to work at that company? These are crucial conversations to have when conducting deep fundamental research.
I would say this lends itself to a bigger discussion around corporate governance, and it also weaves into compensation discussions and fair wages. For example, you must ask whether all employees feel like they’re being adequately compensated and valued by the company. This could influence employee productivity. I believe one could easily argue that investing in employees starts with the actions of executives — leading by example — which lends itself to a deeper discussion on corporate governance and executive compensation practices.
Q: There is always that tension between running the business for the profit-and-loss (P&L) statement — and in the short term a business can drive profits by not investing for growth — and investing for growth to create competitive advantage. If it’s a talent-driven business, it would be problematic if management was not investing in a deep bench.
The third tenet is: Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions. Is that at odds with serving shareholder value? Some might argue that a major company should exert its customer power and squeeze its suppliers for margin. How can dealing fairly with suppliers serve the bottom line?
Klapmeyer: I believe a strong collaborative and trusted relationship with your suppliers is paramount for any company. As an example, I covered the auto manufacturing industry for several years. Those manufacturers don’t build many of the components that go into each vehicle; auto suppliers do. Components including the suspension, electronics, powertrain, seats — all can be engineered and innovated by the supply chain. The auto manufacturers are leaning heavily on the relationships with their suppliers to provide innovation, logistics related to the components and just-in-time supply management.
I once visited a manufacturing plant in Texas. It was what I would call a new-age plant from a Japanese automaker. This auto manufacturer was well ahead of domestic automakers at the time in terms of manufacturing productivity. You would see an ecosystem of suppliers around that manufacturing plant, where a red leather seat with white trim was being introduced into the manufacturing facility at the exact time a truck coming through needed a red leather seat with white trim. That is not something you can execute productively if you do not have excellent supplier relationships. It must be a trusted relationship and those take years to cultivate. In doing our fundamental research, those are things we should be able to discover and understand because they have a real, lasting impact on profitability and durability of businesses.
Q: That example highlights that there are businessmodel specifics related to each of the tenets in the Business Roundtable statement. But it is nuanced. Management teams need to act on these things in ways that can serve their businesses and can drive their bottom lines.
The fourth tenet is: Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses. What’s your reaction to the idea that companies should be welcomed and seen as positive actors in their communities?
Klapmeyer: I think this can even take a broader lens. People often look at sustainability metrics and wonder how emissions, waste and recycling relate to analyzing a business. An example for me comes from a transportation company I recently visited. This company runs a large trucking fleet, so it’s required to burn a lot of fuel in operating the business. Understanding fuel economy is integral to its business because it is a sizeable cost component of running the fleet. The management team wants to improve fuel economy as much as it can and supports natural gas trucking and electric vehicle trucking. The potential efficiencies that come from these technologies in the form of fuel-cost savings and productivity are important to the company’s competitiveness in a fragmented industry. However, we can’t lose sight of the fact that these business directives also align with lowering emissions and waste, and thus link protecting the environment to real business drivers.
The other thing this trucking company is doing for the community more broadly is taking steps to improve its safety record. Something the company doesn’t get recognized for is the requirement of hair-follicle drug testing for drivers, rather than urinalysis. It is a much more stringent test that is not required, but management believes there’s a real safety aspect to it. In the longrun this should improve relationships with shippers and position the company as a trusted, safe source of transportation and improve road safety. This also has ramifications on insurance costs related to a lower number of accidents. There are real public relations and P&L considerations in how a company works with communities and protects the environment.
Q: From a bottom-up view of understanding the fundamental drivers of a business, would you say looking for sources of competitive advantage and looking at the management to understand what has matured in the business as well as whether it’s being managed effectively — are those ingrained in how you look at identifying business quality?
Klapmeyer: Yes, if you think about that specific example in the transportation industry, there are reasons a lot of these companies aren’t sustainable business models and there is massive fragmentation in the industry. There must be long-term planning around employee engagement, continued innovation — especially innovation that requires partnering with suppliers — and ultimately a focus on the quality and desirability of the product they are bringing to customers. You can connect all these dots and find some companies do this exceptionally well and it’s a focus for them. Ultimately the same metrics that you would look at fundamentally show up both in sustainability and profitability.
Q: The final tenet is: Generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. We are committed to transparency and effective engagement with shareholders. I think Business Roundtable is saying that — the customers, employees, suppliers, communities, shareholders — each of those stakeholders is important in different ways to different business models. It is not a one-size-fits-all approach. By proactively managing those relationships in a way that can serve the business franchise, reputation and competitive advantage, the company has the potential to deliver better levels of profit over the long term. It may be that a long-term view is the key versus a short-term financial engineering approach. In the short term, those costs and benefits don’t show up. But over the long term we think they will come home to roost.
Klapmeyer: Agreed, I think you said it very well.
Q: As a fundamental investor looking to deliver returns, you don’t seem to believe that the new statement from Business Roundtable is turning capitalism upside down.
Klapmeyer: Not at all. We’re already looking at specific companies in terms of how they treat their suppliers, how they engage with their workforces, what their talent pools are like and whether they are polluting their communities. These things are embedded in our fundamental research process and how we conduct due diligence on a company.
I also have the sense that there is a real opportunity for Ivy to do something different as it relates to sustainability. In my view, we have longstanding, solid relationships with companies because we’ve been good, long-term shareholders and they have welcomed this discussion with us. I think you’ll find that many companies achieve sustainability effectively. We can learn from them and they can learn from us, but there are also many companies that don’t know what they’re doing right or wrong. It’s not because they are ignoring these issues or running the business incorrectly. It just hasn’t been the focus.
We can engage with those companies more deeply and help steer their businesses in a direction that not only makes them better corporate citizens, but also enhances growth and profitability and helps them create more sustainable and durable business models. We focus on the strength of the business and we think all these things ultimately get us there. The practices detailed in the Business Roundtable statement are intended to make good businesses better. We believe we can create value for shareholders by actively participating in this effort.
The opinions expressed are those of Ivy Investment Management Company and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Ivy Investment Management Company and Ivy Distributors, Inc. are not affiliated with or members of Business Roundtable.
1 - Business Roundtable: “Statement on the Purpose of a Corporation,” August 2019.
Risk factors: Investment return and principal value will fluctuate and it is possible to lose money by investing. Investing in companies involved primarily in a single asset class (large cap) may be more risky and volatile than an investment with greater diversification. These and other risks are more fully described in the Fund’s prospectus.