Former Trillium CIO Talks Good Investor Relations

This month, Compliance Week Columnist Lou Thompson is publishing excerpts of a Q&A interview he conducted with Sam Jones, the recently retired chief investment officer at Trillium Asset Management. While at Trillium, Jones was a pioneering advocate for socially responsible investing and emerged as a leading proponent of good governance practices now in the mainstream.

Prior to his tenure at Trillium, Jones also held positions at investment firms such as Keystone Investment Management, Scudder Stevens & Clark, Crocker Investment Management and Drexel Harriman Ripley. Jones now serves on the CFA Institute board of governors and once chaired the audit committee; in total, he has been a player on the investor relations and corporate governance scenes for more than 41 years.

We’ve seen dramatic shrinkage in sell-side research following the separation of research from investment banking. What are the ramifications of that?

Sarbanes-Oxley, in conjunction with the $1.4 billion settlement with several major brokerage firms, succeeded in redefining how analysts were compensated on the sell-side. Very few of the established leaders on Wall Street were able to fashion sustainable profit models based on the lofty bonuses that had attracted and retained top research talent for years. As a consequence, Wall Street suffered a cathartic brain drain as top sell-side analysts left either because of cutbacks or more lucrative opportunities. Meanwhile, the buy side, faced with dwindling sources of fundamental research, has had to become more resourceful.

Second, several large institutional investors have opted for paying for Wall Street research with hard dollars. That is, they directly expense the cost of buying outside research, on top of funding their own internal research.

Small and mid-sized asset managers have benefited for years from paying for Wall Street research with commissions, or “soft dollars,” generated by trades in their client accounts. Soft dollar research is allowed under the safe harbor protection of Section 28(e) of the Securities Act.

If smaller advisers are denied that safe harbor—as has been discussed recently in Washington—they would be hard-pressed to keep up with the very large firms insofar as affording research is concerned. For those who could not easily absorb the added bite of hard dollar research expense on their profit margins, their survival is potentially at risk.

So what would they do?

Raising management fees to compensate isn’t an option in today’s hotly competitive environment. Many smaller firms have already morphed into asset allocators, relying more on adding value through diversification strategies. They are investing mainly in mutual funds, exchange traded funds, and structured products instead of doing traditional stock-picking that demands fundamental research depth.

What do you think of companies that still provide quarterly earnings guidance?

The CFA Institute has been in favor of having companies focus more on long-term value drivers and strategies, stressing leadership, communication, and transparency. The point is to break the cycle of playing the quarterly numbers game, suffering the perils of so-called “whisper numbers,” and so forth. Too many analysts became lazy, relying heavily on management guidance rather than conducting in-depth research.

Etched in my memory are the haunting words of Patti Domm of CNBC who said several years ago that while reporters had become good analysts, analysts had become good reporters. Ever since then, I’ve become accustomed to reading e-mails summarizing analysts’ digests of what managements said, and how the latest guidance impacted the analysts’ earnings models.

But now the unprecedented lack of visibility of the downward global spiral has prompted more and more companies to forgo giving quarterly guidance. Time will tell if those decisions are merely temporary.

We frequently read about the “value traps” in the depressed stock market. What is a value trap, and what are these attributed to?

Value traps are commonly attributed to stocks that appear to be selling at lower than historically normal price-to-earnings (P/E) ratios—that is, really mouth-watering “cheap” stocks. The problem is that the seemingly low P/Es may be victims of false earnings, where the analysts’ projections may have been way too optimistic or based on “normalized” instead of more realistic earnings.

For example, this past year the financial sector has been a prime example of value traps. The bottom line: trust cash earnings more than reported “E” until genuinely normal conditions are restored.

Why should companies pay closer attention to instituting socially responsible practices and communicating those to the investment community?

Publicly traded companies worldwide face pressures not only from investors, but also from, for example, insurance providers with respect to such burgeoning issues as climate risk. Companies are confronted with rising insurance premiums to cover perceived risks from environmental liabilities, at the same time that a coalition of institutional investors with assets of some $7 trillion have upped the ante calling for more full disclosure regarding issuers’ strategies and positions for handling regulatory, physical, reputational, and litigation risks. One of the biggest frustrations expressed by issuers is the lack of standards for reporting measurable data. The public talks about carbon footprints and water footprints, but what are the commonly agreed-upon measures of such information?

Fortunately, progress is being made globally by such bodies as the U.N. Principles for Responsible Investment and the Global Reporting Initiative. They are attempting to forge guidelines and standards that hopefully will succeed in garnering widespread acceptance by both issuers and investors.

For example, last December in Paris, the UN PRI announced … plans to launch a global ESG [environmental, social, governance] research database. According to its press release: “The database is designed to identify and provide incentives for investment research that takes a long-term view and explicitly integrates material ESG issues into financial analysis.” Meanwhile, Trillium Asset Management—where I was chief investment officer for 14 years—is currently testing a variety of quantifiable ESG inputs to see which ones best add value to Trillium’s equity selection multi-factor models.

Finally, issuers need to wake up to the fact that socially responsible investing is mainstream and that they make a big mistake if they don’t take the efforts necessary to address front-of-mind CSR and ESG matters. The weight of the evidence reflects that competitive returns are being generated by SRI and environmentally screened mutual funds … So, yes, companies and their boards of directors should consider what they need to measure from the standpoint of risk assessment for their own protection, let alone to disclose to investors.

Looking back over the past 41 years you’ve been in the investment business, is there any one trend that rises above all when it comes to changing the investment world?

Technology, both with respect to communication technology and financial engineering. Information travels at the speed of the Internet: Witness all the handheld gadgets, social networking sites, and blogosphere. My training wheels were a K&E slide rule on one side and semi-logarithmic graph paper on the other. I remember the first legitimate commercial spreadsheet, VisiCalc, and vividly recall computer legend Ben Rosen, long before he founded and became chairman of Compaq Computer Corp., demonstrating the software in the 1970s. As a member of CFA Institute’s XBRL Working Group, it’s my hope that soon I’ll be able to instantly download into a smart phone company financial data from a SEC EDGAR-like database under development the moment the data is filed.

Regarding financial engineering: Although many of the most recent exotica are being blamed for the havoc wrought in the credit and mortgage markets, one can’t argue about the speeds at which the rocket science of quantitative tool development and new investment vehicle creation have moved. The efficient-market hypothesis is medieval history. We’ve blown through modern portfolio theory and capital asset pricing models in a blur.

Whether rocket science trumps the speed of information flows is arguably irrelevant. What’s critical is the question of whether risk measurement and control can keep step with the financial engineers. That is, we want to encourage risk takers to find new rewards, so long as we can put in place the mechanism for measuring as accurately as reasonably possible the extent of the attendant risks.

Thanks, Sam.