Opinion: What corporate purpose actually means – and how investors can assess it

15 Oct, 2020 18:47
source: Alex Edmans 

Singularity Financial Hong Kong October 15, 2020 – What corporate purpose actually means – and how investors can assess it

About this author: Alex Edmans (@aedmans) is Professor of Finance at London Business School and Academic Director of the Centre for Corporate Governance. He is also the author of “Grow the Pie: How Great Companies Deliver Both Purpose and Profit”. This article was originally published on Principles for Responsible Investment.


Corporate purpose is one of the buzzwords of the day. In 2018, BlackRock CEO Larry Fink wrote to business leaders that “society is demanding that companies, both public and private, serve a social purpose.” The importance of purpose has further risen in the pandemic, with politicians, the media, and the public demanding that companies serve wider society, rather than only shareholders.

But this enthusiasm is rarely accompanied by a clear definition of what the word “purpose” actually means. It’s commonly used as a synonym for “altruism”. Indeed, the Business Roundtable’s much-heralded Statement on the Purpose of a Corporation states that purposeful companies “share a fundamental commitment to all of our stakeholders”, which include customers, employees, suppliers, communities, the environment, and shareholders.

However, that’s not what the word “purposeful” actually means – it means focused and targeted. A purposeful meeting is one with a clear agenda; if I do something on purpose, I do it deliberately. The Cambridge dictionary defines “purposeful” it as “showing that you know what you want to do”. (Of course, the purpose must benefit society – a clear agenda to sell cigarettes would not be a valid purpose.)

In a recent book, “Grow the Pie: How Great Companies Deliver Both Purpose and Profit”, I define purpose as “why a company exists – who it serves, its reason for being, and the role that it plays in the world”. The answer to these questions must be focused, for two reasons. The first is that a clear purpose helps a company evaluate tough trade-offs. A purpose to serve customers, employees, suppliers, communities, the environment and shareholders sounds good, but sweeps the reality of trade-offs under the carpet. In reality, business leaders need to make decisions that help some stakeholders but hurt others. If an energy company shuts down a coal-fired plant without a transition plan, this can benefit the environment at the expense of employees. A purpose that gives equal priority to all stakeholders is a meaningless PR statement: It provides no guidance to CEOs on how to navigate difficult decisions, or to investors on what they should hold CEOs accountable for.

The second is that the academic evidence on the business case for responsibility is much more nuanced than commonly portrayed. In a recent Wall Street Journal article, Al Gore and David Blood claimed that “voluminous research has conclusively shown that businesses properly integrating ESG factors into their plans are typically more successful and profitable”. These claims are often accepted uncritically due to confirmation bias – the temptation to accept evidence that supports what people would like to be true. But the evidence is much more mixed. Khan, Serafeim, and Yoon (2016) found that companies that perform well on all stakeholder issues don’t beat the market. However, those that perform well on material stakeholder issues – those that are critical to their business model – and scale back on immaterial ones, outperform by 4.8% per year.

The implications for both executives and investors are profound. Starting with executives, a purpose statement must be focused: it’s as much about knowing what not to do as what to do. The pandemic has highlighted the importance of such discernment, as companies have had to scale back desirable initiatives to concentrate on critical ones. Unilever has suspended some water conservation and sustainable farming initiatives; Ford has cancelled an electric car project.

Relatedly, it’s not a company’s responsibility to solve all of the world’s problems. Some leaders may shy away from purpose – the magnitude of social challenges (climate change, inequality, resource depletion, and now the pandemic) is so daunting that they can’t address all of them, so they default to focusing on profit. But they don’t have to. The book discusses two principles to guide a leader on what stakeholder issues to prioritize: those that are most material to the company’s business (the principle of materiality) and that the company has particular expertise in addressing (the principle of comparative advantage).

As a result, purposeful companies shouldn’t swing in the wind and jump on whatever issue happens to be the order of the day – last year it was climate change, this summer it was racial diversity. Both of these issues are clearly important, and companies should take them seriously. But, depending on materiality and comparative advantage, they may have even more important priorities.

Moving to investors, the apparent trade-off between purpose and profit is not a false dichotomy – but only if purpose is correctly defined. Some evaluate companies in a box-ticking manner, where the more stakeholder boxes you tick, the better. But if a company is ticking every box, it may be forgetting about shareholders. CEOs may have private incentives to overinvest in stakeholder issues, even if they are not material, to boost their public image.

The principles of materiality and comparative advantage can guide not only stock selection, but also engagement. A CEO may be unable to objectively assess whether a line of business satisfies these principles, if it’s always been part of the company. An investor can provide an outside perspective. Brav, Jiang, Ma, and Tian (2018) found that shareholder activism improves innovation by spurring firms to sell patents unrelated to their technological expertise, and instead to concentrate their R&D efforts on their comparative advantage. Investors can similarly challenge management on the stakeholder issues they choose to focus on. Potential questions to ask are: “how do you manage trade-offs between different stakeholders?” and “how do you decide which investments in stakeholders to turn down?”

Assessing whether a company is truly purposeful is very difficult. Investors need to evaluate ESG metrics within a company’s strategic context, and engage in boots-on-the-ground conversations with management. Rather than making responsible investing unappealing, this complexity makes it more attractive. If it simply involved using publicly-available data sources to tick boxes at arm’s length, responsible investing could be undertaken by computers running smart beta funds and the would be no need for active management. A nuanced definition of purpose is unlikely to be priced by the market, and so investors that develop expertise in assessing it can outperform even in a world of big data and artificial intelligence.

Original Source: https://www.unpri.org/pri-blogs/what-corporate-purpose-actually-means-and-how-investors-can-assess-it/6556.article#.X4WiMtzwuOo