Blog

The Case for Scoring Leadership Maturity

The corporate narrative, from its advertising to its annual report, is like a good story. It sells the idea of a noble enterprise. In extreme cases, a company’s mission can become something like sacred, an icon around which people bind their allegiance. As a result, signs that the mission is succeeding are elevated to the status of hard evidence. Counter-narratives, no matter the source, are suspect, and so is anyone who questions accepted truths. Good stories, then, can blind or deceive people, and lead them to behave unethically—and perhaps even to outright steal, defraud, and corrupt. This can break the crucial conversation between society, the firm, and the investment community. In the absence of accurate, material, and accountable reporting—which we go on to suggest has several benefits—corporate management can deceive its stakeholders to a point where a ruinous collapse becomes inevitable.

 

The way this sort of deception operates in business and business ethics is well known. For example, a 2008 study found that, of the ten most common stocks selected by socially responsible mutual funds, nine companies were simultaneously praised in areas they were condemned. The Rainforest Action Network named Bank of America a winner among its peers in reducing greenhouse gases at its facilities, while at the same time, Riskwaters Group condemned the bank for lending money to businesses involved in crude oil exploration.

 

The investment community itself is capable of self-deception. A 2016 study analyzed over 2,500 shareholder proposals regarding environmental, societal, and governance issues. Activist investors, it found, often choose to pursue narratives (often topical issues of the day, such as climate change, human rights, or diversity) without considering how these issues might affect the financial performance of a company. More than half of proposals (58 percent) focused on irrelevant factors, suggesting, as the authors put it, “notable inefficiencies in the engagement efforts conducted by many investors.” Proposals on less important issues were, intuitively, associated with subsequent declines in firm valuation. Take a bank that is considering investing solar panels versus a more detailed understanding of the affordability of its loans across its customer base. The former might be more attractive, but not as material to value creation as the latter.

 

Why do companies tend to focus on immaterial issues? The 2016 study’s observations agree with our own: Management incentives are often misaligned with shareholder interests, there is often a low awareness of how specific issues may drive or destroy value in the long term, and/or management might be guilty of diverting attention away from poor performance on material issues.

 

Take the banking industry, for example. It was already lumping together risky mortgages into larger instruments, so-called Collateralized Debt Obligations (or CDOs), back in 2002. The deception that clouded the conversation between US banks and their stakeholders allowed this unsustainable practice to grow to such proportions that, when the bubble burst in 2008, it nearly broke the entire financial system. In Lehman Brothers’ 2007 Annual Report, five times as many column-inches were written on the company’s contribution to the climate change debate as on the restructuring of its global mortgage origination business. The report offered no reporting on the underlying risks relating to lending into the subprime housing market. Deception becomes self-deception, ultimately leading to unethical business practices in order to support the demand for unsustainable profit.

 

How can society prevent that? A protocol for formal reporting, which incentivizes management to assess and report on societal issues through an investor lens, could help. Two steps are required: One, to identify issues and understand how these might create or destroy value through their impact on the firm’s relationships and/or resources; and two, for management to account to investors for how the firm makes progress on these issues, creating long-term value.

 

Happily, this protocol already exists. In 2013, the International Integrated Reporting Council—a global coalition of regulators, investors, companies, and others—launched its International Integrated Reporting Framework, designed to replace the traditional Annual Report. The council states that its vision is to “align capital allocation and corporate behavior to wider goals of financial stability and sustainable development through the cycle of integrated reporting and thinking.” The framework involves an assessment of material issues (those matters that could substantially influence an organization’s ability to create value for capital providers) and reporting on how the firm responds to the challenges these issues present. Ideally, this includes indicators of progress against targets for improvement, how the organization holds its leadership accountable, and how its strategy is linked to these material issues.

 

Consider the case of Clayton Homes, a Berkshire-Hathaway subsidiary, during the 2008 financial crisis. The company would have been particularly vulnerable to loan defaults at the time, as its business involved selling fabricated homes in the subprime housing market. However, Clayton Homes had long adopted conservative financing practices. In the run-up to the financial crisis, it stuck to its clearly communicated policy, the outcomes of which were reported to shareholders: It sold only to customers buying a Clayton home as their primary residence and ensured buyers met the company’s affordability criteria (see Warren Buffet’s 2008 letter to shareholders). As a result, Clayton Homes suffered few defaults during the crisis, and was even able to substantially increase its share of the market as others’ shares collapsed.

 

How does society put pressure on corporate leadership to adopt the council’s reporting protocols, and to hold more responsible discussions with shareholders? What’s missing, in our view, is a way to assess the quality of a firm’s reporting against the council’s new standard—a qualified system for rating the leadership’s response to its material issues. We would call this an assessment of leadership quality, or maturity, and posit that this would provide the investor with a level of confidence in management’s ability to create value from its business model, maintaining and even building its relationships and resources (i.e. the drivers of value) over the long term.

 

Traditionally, the external audit process served as the custodian of this function, assessing reports for key audit matters. However, these are almost exclusively financial—for example, the valuation of certain significant assets or liabilities. This is limiting, not only because there’s no interrogation of non-financial issues of societal concern, but also because audit outcomes are binary, “unqualified” or “qualified.” Every effort is made to ensure an unqualified audit. A qualified audit effectively marks the firm’s report as failing the standard. Much backroom negotiation (often including some creative accounting) results. This goes on until the audit firm is able to pronounce that nothing came to its attention to preclude it from passing the audit (in the double-negative speak of the profession).

 

Leadership maturity cannot be assessed as a binary. Any leadership team is likely to underestimate the impact of some issues and overestimate the value of others; reporting is unlikely to be uniformly balanced, with 100 percent reliable, comparable, and material indicators of performance; and a company’s strategy may be only partly linked to resolving the challenges presented by its value-driving issues.

 

For example, an unsustainable strategy, for banks pre-2008, was collateralizing individual mortgages as a means to reduce risk. The underlying societal issue, the issue that could drive or destroy value, was the affordability of home loans, which requires nuanced thinking to monitor effectively. The proportion of a customer’s salary servicing mortgage debt should have driven strategy (as in the case of Clayton Homes). So, judgement matters, something that quants and auditors typically find antithetical to their methods.

 

A rating of leadership maturity, we hypothesize, can emerge from applying an assessment model to annual reporting. We assess the issues that drive value for the firm—its material issues—and we assess the quality of the management’s response to those issues in a number of ways. One, how well leadership understands the potential impact of the issue on its long-term performance; two, how effectively it measures the firm’s performance against benchmarks (e.g. peers) and targets for improvement; three, leadership accountability (through executive remuneration, for example); and four, the firm’s strategy—how clearly linked it is to addressing the underlying issue.

 

Firms that deny the relevance of a material issue, or seek to deceive, are scored negatively, while those showing commitment, engagement, and a strategic response are marked positively. A final score for leadership maturity is simply the average of all the issue scores for a company, where each issue is weighted for its materiality.

 

Such a score may incentivize leaders to improve their understanding of the issues that could sink or add value to their businesses. It could concentrate their energies more effectively on seeking solutions to societal and environmental challenges, to their firm’s competitive advantage. Bubbles in the market that ultimately lead to damaging losses for both business and society may be less likely to develop, since material issues will more often be noted as soon as they surface. What’s more, the conversation around pernicious societal challenges, from the field of human rights to climate change, may improve dramatically, moving the market to respond with solutions that benefit us all.

 

Rob Worthington-Smith has over 25 years’ experience as a business analyst and seven years as a writer of integrated annual reports for JSE-listed companies across a variety of industries, including banking, insurance, resources, manufacturing, mining, electronics, and business process outsourcing. In 2019, Rob was awarded top ESG analyst in the Financial Mail’s survey of the South African asset management industry.

 

Matt Worthington-Smith is currently engaged in the MPhil programme in Inclusive Innovation at the University of Cape Town’s Bertha School of Business. His dissertation seeks to understand the difference in approach between how investors on the one hand, and ESG analysts on the other hand, include ESG issues into investment decisions. Matt is responsible for building and maintaining the databases and algorithms that serve the FarSight model for rating leadership maturity.

 

Rob and Matt developed the FarSight Model for rating leadership maturity based on the quality of leadership response to material environmental, societal, and governance issues. Their research on the top 100 listed companies in South Africa is used by asset managers to understand potential exposure to risk and confidence in leadership’s ability to deliver value over the long term.