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At Recap, we believe that the purpose of a company is to provide the most profitable solutions to society’s problems, not just to make a profit. When this is done in a way that creates or exacerbates other problems, companies will, in the long run, fall short.
This result is borne out by the data: companies with strong environmental stewardship, attention to sustainability, and corporate governance show positive returns over the long run. Unfortunately, the pressures of public markets often push companies into short term thinking. The companies — and industries — that are able to endure are those that think long term and adapt to changing circumstances. Instead of just focusing on their shareholders, these firms take a more holistic approach to managing stakeholders of varying types, such as their employees, customers and suppliers and the environment and the communities in which they operate. They also tend to mitigate damage they may leave in their wake, particularly to these other stakeholders, benefiting both the company and everyone in its orbit.
Creative Destruction: The Story of New Bedford
Founded in 1652, the city of New Bedford, Massachusetts, has endured many of the ups and downs in the story of American capitalism. Today it’s a bustling fishing port — considered the most valuable in the country, largely due to its scallop fisheries — and a significant tourism destination for its rich nearly 370 year history. But it’s a far cry from its heyday in the 18th and 19th centuries.
In the late 18th century, Nantucket was the center of the whaling industry in America. However, the American Revolution left it particularly exposed to British attacks. Subject to the British blockade, and suffering due to the economic upheaval caused by the conflict, its economy was decimated by 1800. New Bedford, with its better strategic position on the mainland and deeper harbor, became the natural successor to Nantucket and the whaling industry took hold there.
After the War of 1812’s embargos were lifted, New Bedford’s whaling industry exploded, leading to a half-century of incredible prosperity. New Bedford became the greatest whaling port and the wealthiest city per capita in the world. Herman Melville shipped out aboard a whaling ship from this great port in 1841 and his experiences led to his writing ‘Moby Dick.’ At its peak in 1857, the New Bedford whaling fleet boasted 329 vessels and employed 10,000 men.
However, the discovery of oil in Pennsylvania in 1859 led to the great oil rush and a resultant collapse in the whaling business with its comparatively much more expensive whale oil. This downturn was compounded by the Civil War, which put pressure on the whaling industry by raising insurance premiums and subjecting New England whalers to raids by Confederate ships. The industry entered a period of decline. Where once whaling had been the economic engine behind New Bedford, former whalers were now forced to find work in other industries and other locations.
As the whaling industry was collapsing in the latter half of the nineteenth century, the local textile industry was rapidly expanding to meet consumer demand for cheap, commercially produced fabric. The first mill opened in New Bedford in 1846, and by 1920, there were more than two dozen companies operating 70 mills and employing over 40,000 people in the former whaling town.
But more disruption was on the horizon in two forms. First, the Great Depression wrought havoc on consumer demand for textiles, forcing the backbone of New Bedford’s economy to contract significantly. A reprieve came during World War II as mills received large government orders. However, as soon as the war was over, orders began to decline again as the textile business moved to the South, where labor costs were much lower. Many mills closed, and some firms consolidated to cut costs and gain efficiencies. Wage pressure led to strikes. Former textile workers – like their whaling brethren before them – were forced to find new employment.
What is the lesson we can learn from New Bedford? Capitalism is a great force for technological and economic progress, but with new industries come creative destruction. First, it was whaling displaced by the discovery of oil – cheaper and easier to procure. Then it was textiles, which, for a time, were a boon to New Bedford, before lower labor costs drove owners to more fertile ground in the South, and later Asia. Today, New Bedford is a city of roughly 95,000, and has been replaced in economic importance by other Eastern seaboard cities such as New York and Boston. While the town itself has survived, the workers in those industries experienced significant hardship in the transition. New technologies and innovations may bring prosperity, such as a higher standard of living and economic wellbeing, but the workers left behind are forced to adapt or suffer.
Milton Friedman: Shareholders Only
In his now famous 1970 article in the New York Times magazine, famed economist Milton Friedman stridently argued that “The Social Responsibility of Business is to Increase its Profits.” He wrote:
The difficulty of exercising “social responsibility” illustrates, of course, the great virtue of private competitive enterprise–it forces people to be responsible for their own actions and makes it difficult for them to “exploit” other people for either selfish or unselfish purposes. They can do good–but only at their own expense.
And later went on to equate “social responsibility doctrine” with socialism. He concluded:
That is why, in my book Capitalism and Freedom, I have called it a “fundamentally subversive doctrine” in a free society, and have said that in such a society, “there is one and only one social responsibility of business–to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”
Buffett vs Friedman: Thinking Bigger
One of the last remaining textile manufacturers was New Bedford’s own Berkshire Hathaway. In 1965, shocking news quickly spread across the town that the Stanton family, who had operated the plant for decades, had lost control of their company to a young man in Omaha. A thirty-five-year-old named Warren Buffett knew this company was in a declining industry but thought of the investment as a classic ‘cigar-butt,’ in the words of his mentor and Columbia Professor Benjamin Graham. The idea behind these investments was that investors disregard the remaining value in dying companies — the last ‘puff’ in a cigar-butt — and hence undervalue them such that ‘dollars could be bought for 50c’.
To Buffett, the strategy was clear early on. Textiles were a dying business in the US. Rather than trying to compete in this industry, he would be better off maximizing cash flows in the shorter term, shutting down unprofitable operations, and begin to divert cash flow from Berkshire’s operations to investments in companies providing better returns on his capital. For Berkshire’s shareholders, this was the prudent thing to do, and Buffett’s multi-billion dollar conglomerate still retains the Berkshire Hathaway name. For employees in shuttering operations in New Bedford, this meant losing their livelihoods.
Yet Buffett kept the business going for another 20 years, only closing its final mill in New Bedford in 1985. Why? Warren Buffett, a defender of free-market capitalism, did not fully agree with Prof. Friedman.
In his 1978 annual letter to shareholders, Buffett wrote that the textile business had earned a relatively low return on capital and described that the business was a textbook example of a company with “undifferentiated goods in capital intensive businesses must earn inadequate returns,” and “as long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed.” Mr. Buffett knew that to maximize his shareholder’s profits, he should have completely shut the textile business at Berkshire in the seventies, but he hadn’t. He went on to explain (emphasis added):
We hope we don’t get into too many more businesses with such tough economic characteristics. But, as we have stated before:
(1) our textile businesses are very important employers in their communities,
(2) management has been straightforward in reporting on problems and energetic in attacking them,
(3) labor has been cooperative and understanding in facing our common problems, and
As long as these conditions prevail – and we expect that they will – we intend to continue to support our textile business despite more attractive alternative uses for capital.
Despite the best of intentions, the writing was on the wall for the textile business, and after years of losses, the business was shut down entirely seven years later. In his 1985 letter, Buffett admitted “in the end, nothing worked and I should be faulted for not quitting sooner.” Despite that, he wrote the following:
I won’t close down businesses of sub-normal profitability merely to add a fraction of a point to our corporate rate of return. However, I also feel it inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition, and Karl Marx would disagree with my second; the middle ground is the only position that leaves me comfortable.
Mr. Buffett was writing out of a sense of doing the right thing for all stakeholders involved. The ultimate death knell for Berkshire Hathaway’s textile business was rung by shifting US consumer tastes. In the end, Buffett could not save an investment that had such gloomy prospects, but he approached the issue with more stakeholders in mind: its employees and managers, and the community in which the mills existed, New Bedford.
Enduring Businesses: Broadening the Definition of Stakeholder
Buffett may have been prescient. By acting with a longer-term view as to the economic viability of the community in which his mills were located, as well as his thoughtful view on the problem-solving approach of the management team and the economic prospects of his employees if they were laid off, Buffett was predicting what would later be proven by academics: that stock-price performance may be linked to these notions too.
One of Buffett’s fellow value investors, Christopher M. Begg of East Coast Asset Management, wrote a deeply thoughtful investor letter in November of 2014 in which he compares Coastal Redwood trees in California to successful businesses.
These Coastal Redwood trees, at nearly two thousand years old, are the oldest above-ground living ecosystem on Earth. Begg argues that they are a sound analogy for a business that seeks to endure by growing deep roots and building an enduring culture that prioritizes other stakeholder groups besides shareholders.
A differentiated product, he explains, is not an enduring moat since any differentiated characteristic of value will sooner or later be copied – or in the case of New Bedford, innovated out of existence. A company’s culture, which in turn defines how the business adapts to change and interacts with its ecosystem, is what makes it endure.
The company that acts like a Coastal Redwood has six unique relationships with each of its six constituents:
6. Society (the community and environment they operate in)
Each of the six must be mutually beneficial to be enduring. For example, fostering win-win trust-based relationships with suppliers and encouraging management to own stock and view themselves as stewards for future managers (i.e., applying a long-term owner’s mindset) are ways in which each stakeholder relationship benefits the others. On the other hand, employees are like the leaves of the tree; they do the critical work. Enduring companies recognize and empower employees and foster a relationship of mutual trust.
The company’s relationship with Society or the external ecosystem it operates within is also critical. For a business to survive and thrive, it cannot adopt a parasitic relationship with its hosts, just as a tree cannot. Rather, companies that create mutually beneficial relationships with their communities and limit or eliminate harm to the environment are more likely to endure.
Creating the right culture can set a profitable business on the path to being an enduring one. How a company adapts to change and adversity is critical to its flourishing. To adapt and thrive, the company needs to adopt a long-term mindset and create plans to manage risks that may seem remote. They make contingency plans for if the sea rises due to increased temperatures. They treat their communities with respect, both environmentally and socially, because they recognize the symbiotic relationship inherent in both. Much of the wisdom from Begg’s letter resonates in the principles of Environment, Social, and Governance (ESG). It is our view that businesses that strive to lead on ESG are on the right track, and recent research bears this out.
The Academic Research View
In recent years, dozens of papers published on ESG have reached an intriguing conclusion: companies that score highly on ESG metrics outperform the market over the long run. They tend to carry higher valuations, but also tend to outperform on a total return basis, reflecting a relationship between companies we call ‘High Quality,’ which tend to carry premiums in the valuations as rewards for having been profitable and allocating capital effectively. Another explanation is that these firms manage long-term risks better and hence are rewarded with a premium.
This kind of research is possible because ESG investing has taken many leaps forward over the past decade – particularly, much-improved data collection and increasing consensus about which metrics matter and how to standardize them.
The Sustainability Accounting Standards Board (SASB) has helped establish a set of standard categories for ESG data and created a ‘Materiality Map’ to help investors cut through the noise to what matters for a company. Different industries have different ESG metrics that drive financial risk and returns. For example, greenhouse gas (GHG) emissions may not be a material value driver of value for a bank, but it surely is for an airline.
Intuitively this bolsters the argument that a company that seeks enduring long-term success needs to consider its responsibilities to all its stakeholders carefully. It may not be surprising then that 181 CEOs signed on to the CEO Roundtable’s new definition of the purpose of a corporation: to promote “an economy that serves all Americans.” They know, as we have argued, and the market has demonstrated, that corporate sustainability creates an ‘ESG premium’ and that high ESG scores will be reflected positively in their company valuations.
For those interested in the research around the ‘ESG premium,’ we suggest starting with this paper.
The Purpose of a Business
At Recap, we stand for free markets and vigorous competition. This will naturally bring about winners and losers, but we believe that for companies looking to endure in the long term, they should embrace their roles within their ecosystem. These are the ESG leaders we invest in. They stand the best shot of becoming Coastal Redwoods who have recognized and developed symbiotic relationships with their stakeholders to ensure that they survive and thrive long into the future.