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Profitable Ways of Looking Beyond the Balance sheet (and what might get in the way)

Investors struggle to assess expenditure on ideas, patents, software, corporate culture and brand strength.

By Alex Edmans 25 May 2016

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Yet in today’s knowledge-based economy intangible investment is precisely what differentiates one company from the next and gives competitive advantage. Companies neglect it at their peril. Whereas British firms used to be leaders in the chemical, electronics and electrical engineering industries, a lack of investment in R&D thirty years ago may well be a reason why today there are only two hi-tech firms in the FTSE 100. (1) 

And it’s not just in action decisions that intangible investment is invisible. It’s also frequently unseen in financial reports and undervalued by the stock market. Although the UK has experienced a boom in start-ups, few have scaled up. Apprehensive that money spent on intellectual property or brand – often twice as much as on tangible assets – will go unacknowledged in the share price, they’re wary of IPOs.  This prevents them from raising capital vital for developing into sustainable, value-generating enterprises.

Furthermore, the positive results of intangible investment take time to show up in a company’s profits. My research indicates that it typically takes 4 to 5 years for investment in employee wellbeing to be reflected in a company’s share price. (2) If a shareholder’s strategy is to invest only where financial benefits can be immediately gauged and quickly recouped then they’ll shy away from companies rich in intangible assets, especially in the short run. 

Promoting intangible investment requires lengthening the horizon of performance measures, encouraging large, informed shareholders, and revising accounting standards to define and quantify intangible investment.

Taking your eye of the profit ball

It feels counter-intuitive but it’s possible that by not focusing solely on profit you may end up being more profitable.  Traditionally the role of the company has been viewed as either to make a profit or to serve a purpose. Achieving one of these goals was thought necessarily to be at the cost of the other – money spent on employee wellbeing, the environment or innovation was seen as taking profits out of shareholders’ pockets.  But are the interests of different stakeholders really so distinct and different? 

I discovered that for those companies listed in the Fortune 100 Best Companies to Work For in America employee satisfaction was linked to future stock returns. Offering their employees higher pay and a positive work environment meant that profits for these companies followed as a matter of course (3). John Kay, founding director of Oxford’s Said Business School, suggests that the best way to achieve goals is by obliquity - pursuing them indirectly (4).  It may make business sense to resist looking at the bottom line before making every decision and to concentrate instead on a different overarching aim. Indeed, if a football manager pays individual players according to the number of goals they score, they may shoot on sight, leading to fewer goals being scored.  

This means focusing everyone - customers, employees, suppliers, investors and communities – on attitudes and aims that may not be represented in a company’s balance sheet today but that will reap financial and societal rewards in the future.  Creating this alternative meaning for your company’s direction doesn’t have to mean sacrificing profits, it just means you arrive at them by a different route. 

At Apple Steve Jobs strove for perfection. He set out to excel in design and innovation, and to delight customers.  As a result, people rushed to buy iPods, iPhones and iPads. Huge profits followed.  

Sam Walton declared, ‘If we work together, we'll lower the cost of living for everyone...we'll give the world an opportunity to see what it's like to save and have a better life.’ This collaborative approach of sharing the benefits of price reduction with as many people as possible made Walmart the largest retailer in the world.

Finding yourself - Corporate Purpose  

Apple and Walmart identified their intrinsic reason for existing – their Corporate Purpose. Making a profit, their extrinsic reason for existing, came as a by-product  -albeit a vital, substantial and very welcome one.
Corporate Purpose ‘glues’ together customers, employers, suppliers, communities, and investors in a common cause that determines goals and strategy. Although in theory contracts specify exactly what each stakeholder contributes and what they can expect in return, in practice they’re incomplete. They assume that everyone has the same interest in a particular outcome and is working to the same timetable but that’s not always the case - employees move on, shareholders buy and sell, CEOs come and go, suppliers change.  

Corporate Purpose aligns all these stakeholders, motivating them to go beyond the call of duty and create more value for the firm. An employee might voluntarily mentor junior colleagues or give exceptional customer service. A shareholder, understanding a company’s ambition, may recognize that initially costly – and sometimes idiosyncratic - innovation may be valuable in the long term and so hold onto their stock. 
Shared purpose drives relationships and generates trust. Trust results in value creation and increased benefits for all stakeholders.

Removing obstacles

So why isn’t Corporate Purpose more widespread?  The main problem is that the current UK business ecosystem rewards short-term behaviour.  Such shallow soil isn’t suited to cultivating long-term objectives like intangible investment and Corporate Purpose.

Dispersed investors

Companies often have fragmented shareholder bases with many investors – both individuals and pension funds - each of whom holds a relatively small number of shares.  Without sufficient ‘skin in the game’ it’s not worth their while to look closely at what a company does. Instead they concentrate on readily available short-term financial figures.  

This increases managerial myopia - focusing on the current profit target and spending valuable time steering market expectations. In 2014 the Financial Services Authority scrapped the requirement for listed companies to publish quarterly results.  It was a good first step towards encouraging companies and their investors to focus on the longer strategies required for sustained growth but further reform is still needed.
One solution is to encourage blockholdings, perhaps by reducing the disclosure requirements when shareholders acquire large stakes. Having a larger shareholding encourages investors to be engaged owners who anchor companies in times of change rather than sell up at the first sign of stock price wobble. 

Notice that short-term behaviour by managers is not necessarily a consequence of short-term trading by investors.  Hillary Clinton has proposed a higher capital gains tax rate on shares held fewer than two years, and the “Loi Florange in France” gives additional voting right to investors that hold stock for more than two years. The mistaken belief is that short-term investors sell if a firm’s short-term profit is low, thus forcing a CEO to focus more on short-term profit. However, a firm’s short-term profit is public information – it’s already in the stock price, and so an investor has no incentive to trade on it. Instead, short-term investors have incentives to gather information on a firm’s long-run value, since it’s not in the stock price. They will sell shares of firms that are seemingly profitable but at the expense of long-term purpose. In contrast, Volkswagen had long-term shareholders, who never sold, and thus allowed management to get away with unethical behaviour. 

CEO Incentives

Like football managers, CEOs are often fired if they don’t deliver fast results. Their remuneration is dependent on rapid returns.  Pay and bonuses reflect the previous twelve months’ performance and allocated shares and options vest after relatively short periods (tempting some unscrupulous managers to cut investment and advertising in order to boost earnings so they can cash out at a high price). Restructuring incentives according to their company’s five-year performance encourages decisions that will nurture growth in years beyond a CEO’s relatively short tenure (5). 

Look to the horizon

As individuals we thrive by looking beyond daily routines and broadening our horizons.  Companies are no different. Our knowledge-based economy requires continual reinvention and innovation, enterprises that thrive in environments based on trust and collaboration.  Establishing a Corporate Purpose is a necessary strategy to unite and motivate different stakeholders to think long term and work towards a common goal.

Corporate Purpose is not fluffy management speak.  Neglecting it has a severe financial impact estimated to cost British companies in excess of £100 billion a year (6).  That should be reason enough for a firm to make expressing Corporate Purpose a fundamental part of its daily operations and include it in financial reporting. 

Of course any statement of Corporate Purpose is an aspiration.  Words must be backed by deeds and sometimes we will fall short. 

But just because we can’t be perfect all of the time doesn’t mean we shouldn’t try.

(1) ARM and Sage

(2) Edmans, A. (2011) ‘Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices’, Journal of Financial Economics 101, 621–640; Edmans, A. (2012) ‘The Link between Job Satisfaction and Firm Value, with Implications for Corporate Social Responsibility’, Academy of Management Perspectives 26, 1–19. 

(3) Edmans, A. (2011) ‘Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices’, Journal of Financial Economics 101, 621–640; Edmans, A. (2012) ‘The Link between Job Satisfaction and Firm Value, with Implications for Corporate Social Responsibility’, Academy of Management Perspectives 26, 1–19. 

(4) Kay, John, Obliquity, Profile Books, London 2010

(5) The average CEO tenure at the world’s largest 2500 companies is between 4.2 and 5.6 years. Strategy&/PWC (2015) ‘2014 Study of CEOs, Governance and Success: The Value of Getting Succession Right’, http://www.strategyand.pwc.com/media/file/2014-Study-of-CEOs-Governance-and- Success.pdf. The lower (higher) figure refers to the median tenure of CEOs who come in after a forced (planned) succession.

(6) Big Innovation Centre, ‘The Purposeful Company Interim Report’, May 2016

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Comments (5)

cagbakwuru978 1 years, 5 months and 20 days ago

In any Profit oriented Business venture profit margins are understandably considered key factors and most priorities to Growth.

Jean Létourneau 1 years, 5 months and 23 days ago

To make a knowledge economy work, you need a knowledge informational infrastructure to support it!

Jean Létourneau 1 years, 5 months and 23 days ago

To make a knowledge economy work, you need a knowledge informational infrastructure to support it!

Jean Létourneau 1 years, 5 months and 23 days ago

Interesting article! Thank you!

Jean Létourneau 1 years, 5 months and 23 days ago

Interesting article! Thank you!

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