Sunday brunch: diversity that makes a real difference
Or - the importance of the swim leg in a triathlon
Diversity in workforces, quite rightly, gets a lot of attention. Both from a values perspective and in terms of financial value creation. You will have all read ‘research’ that claims to show that more diverse workforces make for better businesses. And this appeals intuitively. It makes sense that a more diverse workforce can look at problems and challenges differently, and by doing so come up with new and often better solutions. Its a key aspect of innovation. And innovation is good for business. And hence the argument goes diversity is also good business.
But is it always true?
Unless we understand what constitutes Diversity, Equity and Inclusion (or DEI for short) in practice, we cannot really know whether our actions are increasing it. And perhaps most importantly, whether it is having a positive impact, both financially and from a social perspective.
What constitutes 'good performance' is not as straightforward as people think, particularly when it comes to stock returns.
In earlier blogs we discussed some excellent research by Alex Edmans (London Business School), Caroline Flammer (Columbia University) and Simon Glossner (Federal Reserve Board) looking at Diversity, Equity and Inclusion (DEI).
They sought to identify what the determinants of a DEI environment in the workplace are and then looked at the consequences of that environment on performance, valuation and stock returns. We discussed their findings in an earlier Quick Insight.
They found, for example, that there was a positive association between high DEI and all but one of the eight measures of future profitability studied and a positive link to future earnings surprises. However, they found no evidence of a link between DEI in a firm and its stock returns, all else being equal. We'll come back to that in a moment.
That is not the most interesting bit.
They challenge the common view on what DEI actually is. That's a good thing. It means we can focus on the right actions. It means we can design workplace policies and approaches to improve DEI in the workplace. I discussed that in a Perspective 👇🏾
Their piece stimulated some other thoughts, and this is where we come back to their finding on stock returns. If there is no link between DEI and stock returns, from a purely investing perspective, should we care whether a firm has a positive DEI culture?
Let's look at that...
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The important foundation of the swim leg
A triathlon comprises three legs - a swim, a cycle and a run with the transition between each leg often seen as the 'fourth leg'.
My colleague Sandy learnt a pretty important lesson about cold water shock doing his first triathlon back in 2012. It was in St. Neots during the first week of May with the swim leg in the River Ouse. It was a brisk 9 degrees Celsius (48 degrees Fahrenheit). He reasoned that the water would be f-f-fairly cold too and that the least time he spent in there the better. So he decided to get in the water just before the gun went off.
He never made that mistake again. The cold water shock meant that after the first nine strokes (with no breathing) he was essentially a bobbing mass and the swim leg took him more than double the time it should have. For half of the following cycle leg, he had numb lumps for legs.
So the swim leg is important.
But, is it what determines overall success in the event?
Well, not really. A study of Ironman triathlons over the competition's first 40 years found that the biggest improvements for elite competitors came during the cycling stage. That was the biggest correlation to the overall result.
However, Sandy can tell you from his own experience that your approach to all components is important. A steady disciplined approach to the swim can really set you up for the cycle leg with your body warmed up and the mind in a zen-like state. That can sometimes mean avoiding the 'washing machine' at the start and ultimately letting the eager swimmers come out of the water ahead of you.
Of course, the cycle leg being the longest from a time perspective, is where he could make the most difference, but the swim was pivotal to get right to ensure he was best prepared for the other legs. A solid foundation.
We haven't found any studies that show a direct correlation between swim leg performance and final triathlon result. However one thing we do know. It is extremely difficult to do a triathlon if you don't know how to swim.
There are some parallels here with how we consider stock returns and the link (or apparent lack of it) with DEI.
Stock returns - what determines the price of a stock.
When Sandy had new summer interns on the desk he would always ask them early on what they thought determined the price of a stock. And he would typically receive the textbook answers such as "it is the present value of future cashflows discounted to today using an appropriate discount rate" or "it is the earnings times an appropriate earnings multiple" etc. His reply, which was often met with the kind of look you give your worst enemy was "it is whatever the next person is prepared to pay for it."
In many cases that is based on discounted cashflow methodologies but sometimes the focus is on other things.
Sandy used to be a technology specialist salesman back in the mid-2000s, when the semiconductor stocks were 'easy to trade'. It was just a case of looking at the Book-to-Bill ratio - how much bigger or smaller was the dollar value of orders relative to what had been effectively invoiced). A move above one was a good indicator that forward looking demand was good and the stock would trade up. Similarly in the media space, to gauge the moves in the advertising stocks we would look for the second derivative in advertising revenue growth to pass through zero - i.e. that when the rate of growth in advertising revenue growth starts to accelerate or decelerate.
Of course the above was quite simplistic and whilst it seemed to hold at the time for short term moves, there were many other things that determined a stock price move and ultimately stock returns.
What does any of this have to do with DEI?
Whilst Edmans's, Flammer's and Glossner's research found no evidence of a link between DEI in a firm and its stock returns (all else being equal), they did find a positive association between high DEI and measures of future profitability. Ultimately that is one of the building blocks and components. So creating an environment or culture of DEI can bring future profitability which in turn acts as a foundation for potential future stock performance.
We have been through an unprecedented period of liquidity following the quantitative easing that started post the global financial crisis. This has meant that stocks have been able to perform on sentiment even if some of the more traditional accounting metrics are not being met, such as profitability. With an increasing focus on sustainability more generally, fundamental measures could become more important. Business longevity requires a solid foundation - just as a successful triathlon is built on a solid swim leg.
So maybe DEI is key for financial performance?
Well one more caveat. It may need to be material.
A masters thesis from Palmaro and Alami at EDHEC Business School, found that a study of returns from a portfolio of the best companies for diversity from 2001 to 2021 tended to have a lower return-on-equity growth rate than an equally-weighted S&P500 portfolio. In other words, those 'best companies for diversity' had a lower ability to generate profits from the money that shareholders had invested in them.
Palmaro commented that:
"... our research suggests that diversity might not have the impact previously thought. This result should encourage us to take a critical look at how we're valuing companies and whether we're accounting only for the factors that are material to the firm."
Not all diversity matters to financial performance, although it matters for other reasons as we have mentioned. What really matters from a financial perspective is "material diversity".
Edmans's, Flammer's and Glossner's work highlights the difficulties in identifying those factors. Indeed, and this ties in with the data set used in research such as Alami's and Palmaro's, traditional measures of diversity may not accurately demonstrate a culture of DEI.
In any case, just adding diversity to a company doesn't mean you end up with a culture of DEI. That implies that culture of a firm is the sum of its parts.
A firm's culture is the weighted-average of the values that it's people actually follow.
In a future Sunday Brunch we shall look at whether DEI is as important with the investor as it is with the investment. As fund managers look towards potential investments to embrace DEI, have they done the same with their own firms?
In case you missed it ...
Here is a selection of recently published long blogs, Perspectives and Quick Insights that our subscribers get to read in full.
Healthy soil elsewhere drives our economy (Agriculture and natural capital)
Nature insulating us from energy inefficiency (Built environment)
What investors can do to improve our soil (and why) (Agriculture and natural capital)
Choking hazard - the link between air pollution and health (Health and wellness)
But first a couple of things that caught our eye this week...
No new property insurance policies in California?
State Farm has halted new property and casualty insurance applications in California because of what it called “rapidly growing catastrophe exposure”. The company, which has the largest share of US property and personal injury policies in the US, cited rising construction costs and the cost of reinsurance as the main reasons, but also said climate change, global inflation and industry reinsurance costs were beyond its control. We wrote about the impact that climate change would have on insurance in the aftermath of Cyclone Gabrielle in New Zealand back in February. In January we also highlighted an interesting move by the US Treasury to require insurers to provide underwriting data to help them understand risks of major disruptions in insurance coverage driven by climate change. Global natural catastrophe loses in 2022 were almost 40 percent higher than 10-year averages.
Link to blogs 👇🏾
Warnings are over - we really need to start preparing
Climate risk data sought from US Insurers
(Transition / Human Rights, Professional)
Delta Airlines sued over carbon-neutral claims
A Californian resident has filed a class-action lawsuit against Delta Air Lines, claiming the company’s advertising is misleading in its claims of being carbon-neutral. Global airlines have committed to 'net-zero' emissions by 2050 partly through buying offsets. The difficulty is knowing whether there is actually any 'additionality' - a topic we wrote on back in November 2022 when we discussed greenwashing.
Link to blog 👇🏾
Going all out and the risk of inadvertent greenwashing
(Transition / Human Rights, Professional)
What our subscribers are reading this week
Healthy soil elsewhere drives our economy
(Agriculture and natural capital, Premium and Professional)
Soil health is essential to the modern economy. It's not only the foundation for our agricultural production, it also a material contributor to water quality, climate change and human health.
A key aspect of soil health is the recognition that managing nutrient availability alone, such as through the use of agrochemicals (mainly fertilizers), is not sufficient for optimizing plant growth. There is now an increased recognition that some management practices used in intensive agriculture to increase total plant production are actually detrimental to soil health.
Plus, it's not just about feeding the world, as important as that is. Healthy soils are also a major contributor to economic activity and employment. Those interconnections are becoming increasingly strained, which is why financial professionals should care about healthy soils. To misquote the title of a recent film, 'don't look up, look down'.
Link to blog 👇🏾
Healthy soil elsewhere drives our economy
Nature insulating us from energy inefficiency
(Built environment, Premium and Professional)
One way of keeping our homes at an appropriate temperature is through effective insulation. Conventional synthetic insulation materials are often derived from petrochemicals and thus have high embodied carbon as well as end-of-life disposal issues.
Natural materials could be effective insulating materials for the built environment and are sustainable.
The built environment, encompassing residential and commercial buildings, communal areas such as parks, and supporting infrastructure such as energy networks, mobility, and water supply, is an important sustainability theme. It is an integral part of societal existence and a major resource consumption problem (40% of global raw materials) and decarbonisation problem (40% of energy-related GHG emissions) that needs investor, government, business and consumer attention.
Link to blog 👇🏾
Nature insulating us from energy inefficiency
What investors can do to improve our soil (and why)
(Agriculture and natural capital, Professional)
Investors need to care about the state of our soil globally. It's not a problem just taking place 'over there'. It impacts us directly, via the food we grow on the soils in our home region, and indirectly, through the food we import. Impacting the supply chains of all companies in the food industry. But it can feel like an almost intractable problem. The good news is that solutions are known, we just need to find ways of implementing them. Fortunately, finance-based innovation is something we are good at. The impacts of climate change are increasing in frequency and intensity around the world, particularly life-threatening heatwaves, floods, storms, and droughts - leading to further and longer-term impacts such as food insecurity, entrenched poverty, and economic losses. Climate change has already reduced global agricultural productivity growth by 21% since 1961, and by up to 34% in Africa.
Link to blog 👇🏾
What investors can do to improve our soil (and why)
Choking hazard - the link between air pollution and health
(Health and wellness, Professional)
Global excess mortality from all ambient air pollution was between 7.11 and 10.41 million per year. In addition it was estimated to lower life expectancy by between 2.3 and 3.5 years - more than from smoking tobacco. Air quality in general, and pollution in particular, have various significant investment and decision-making implications. Air pollution can be both naturally occurring or produced by human activity. Decreasing pollution with the aim of reducing human illness and suffering should be a goal unto itself. In practice it is also important to consider how such initiatives, that more often than not increase costs and dig into profits, will be beneficial to business and society in the long run, whether it be through decreased healthcare costs, increased health and productivity of the workforce, and reputational gains for such decisions. We look at how it impacts our skin, eyes, respiratory disease, lung cancer, cardiac incidence, dementia, breast cancer, fertility and childbirth.
Link to blog 👇🏾
Choking hazard - the link between air pollution and health
