The trend towards passive management – where investment managers track market indices rather than pick individual stocks – has caused some to question the merits of active management. A comparison of these strategies is usually confined to portfolio construction and cost; but there is another aspect of active management that is often overlooked: shareholder activism, which includes engaging with company management and voting during shareholder meetings. Grant Pitt and Pieter Koornhof explain.
Active versus passive: beyond portfolio construction
Passive management is an investing strategy that tracks an index or portfolio. Active management is the opposite: active managers dedicate research efforts to analysing the intrinsic value of listed securities, buying those they believe are relatively cheap and avoiding those they believe are expensive, actively constructing their portfolios. But for us at Allan Gray, active management does not end there. We take our role as stewards of our clients’ hard-earned savings seriously and think that proactive engagement with the board and executives of companies whose securities we have bought for our clients can result in better investment performance. These engagements can potentially shape a company into a better and more sustainable long-term financial prospect, which is likely to increase its valuation. Passive managers, on the other hand, very rarely engage with the companies in which they invest.
Engagements with companies
To give you a sense of our involvement as active managers of our clients’ capital: during 2015, our analysts and portfolio managers formally engaged with company representatives on 464 occasions. These engagements typically took the form of meetings with both executives and non-executives, site visits to companies’ operations, formal written correspondence and other forms of engagement such as conferences, road shows and analyst days.
During these engagements various issues were discussed, including environmental, social and governance (ESG) and sustainability issues, which we believe, if neglected, may impact a company’s long-term economic success. This is because, over time, irresponsible and unsustainable conduct will weigh down on a company’s earnings and therefore its valuation.
Although we always strive to engage with companies in a constructive manner, we are not afraid to challenge management if we think the circumstances warrant a more forceful approach.
To provide insight into how our engagements work in practice and how they are incorporated into our active investment process, below is an example of a stewardship activity that we have undertaken. You can also read our approach to responsible investing and our policy on ownership responsibilities.
Improving executive remuneration at Sasol
We acquired a significant position in Sasol for our clients over the course of 2010 and 2011. While we considered Sasol to be an attractive investment opportunity at the time (and still do today), we thought that Sasol’s executive remuneration scheme was poor and accordingly recommended that our clients vote their shares against the scheme at the 2011 annual general meeting. We had a number of concerns with the scheme at the time: the disclosure was minimal, many of the performance targets were low, the majority of the long-term incentives (LTIs) were not subject to performance conditions and simply vested over time, executives did not own shares in the company and most of the LTIs were delivered through share appreciation rights. These instruments do not provide suitable alignment with shareholders as they result in executives not sharing in downside risks if performance is disappointing and, as they are delivered in cash, it is the default outcome that executives do not own shares in the company. This lack of alignment with shareholders was especially concerning in light of the large capital projects that the company was undertaking.
We subsequently started working with Sasol’s Remuneration Committee (Remco) to improve the scheme. This included detailed analysis and benchmarking of the remuneration scheme, meeting with the Remco in person on a number of occasions and further formal correspondence through letters to Sasol’s board. While the scheme was still short of best practice, we recommended to our clients that they vote their shares in favour of Sasol’s remuneration scheme in 2012, 2013 and 2014. We did so to recognise the progress that was being made and to give Remco a clear mandate to make further improvements to the scheme. Though it took some time for our efforts to bear fruit, the scheme has transformed dramatically over the last four years and is now close to being best in class: disclosure has been enhanced; performance targets required for incentives to vest have been made more challenging; all the LTIs are subject to stringent performance conditions and executives are formally required to build substantial shareholdings in the company. These changes go a long way towards ensuring that executives act in the long-term best interests
Despite the progress, we believe there is still some room left for improvement and we continue to engage with Sasol’s Remco on a regular basis to ensure that the scheme keeps evolving to the benefit of shareholders. In particular, even higher shareholding requirements for executives and the use of equity-settled incentives would further improve alignment with shareholders. We also consider changes to the macro environment, such as the collapse of oil prices over the last 18 months, when thinking about appropriateness of the performance factors and targets that are used to incentivise executives.
Actively engaging with management and also assisting our clients to exercise their right to vote are important components of the overall service we provide to our clients.
We provide voting recommendations for general meetings of companies which have a material weight in your portfolio and for smaller companies in which our clients collectively hold a significant percent of the company. We will always make voting recommendations which we believe at the time to be in the best interests of our clients. Over the 12 months to 31 December 2015, we made voting recommendations on 1 476 resolutions tabled at shareholder meetings of South African listed companies. We disclose these voting recommendations, together with the outcome of the shareholders’ vote on each relevant resolution, quarterly on our responsible investing page.
Responsible investing needs active management
Responsible investing is receiving increasing attention: globally, through the United Nations-supported Principles for Responsible Investment (PRI) Initiative, and in South Africa through the Code for Responsible Investing in South Africa (CRISA). This is positive for investment managers like us and our clients: there is no doubt that long-term sustainable returns are dependent on stable, well-functioning and well-governed social, environmental and economic systems.
Effective responsible investing depends on active investment research – to identify issues to engage management upon and to do so intelligently – and on active investment management, which allows a manager not to own companies which don’t deal with their ESG challenges or which don’t respond on these issues. Since they rarely address these issues and are poorly resourced to do so, passive investment managers weaken shareholders’ ability to drive ESG issues with company managers, to their clients’ long-term detriment.