A Horse Named Materiality

SASB founder Jean Rogers reflects on the ESG revolution and why we need to move away from “vanity metrics” to more meaningful indicators of change

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A funny thing happened on the way to the forum in Davos this year. A letter penned by a hedge fund manager, Seth Klarman, generated buzz amongst attendees. Mr. Klarman runs the Baupost Group, an asset management firm famous for both its value investing style as well as the many happy returns that have accrued to clients. Mr. Klarman is apparently concerned about systemic issues such as inequality that could contribute to the instability of capital markets and even tarnish the reputation of those on Wall Street. He’s concerned enough, it seems, to write about it in his year-end letter to clients. Says he, “Social cohesion is essential for those who have capital to invest.” Why, he sounds like a downright socially responsible investor! In a new twist on the Brundtland commission’s classic definition of sustainable development, which emphasizes meeting the needs of the current generation without compromising the ability of future generations to do so, Mr. Klarman wants to “leave and improve capitalism for the next generation to benefit just as much as we did”.
So, what should we in the sustainable investing movement (in all its fractious glory) make of Mr. Klarman’s newfound enlightenment? Should we giddily rush to gouge another $28bn notch into the AUM-laden belt of PRI signatories? Or should we pillory him on the altar of old-school capitalism at which he worships, because deep down he’s not a true believer?
While this ambivalence may feel chaotic and unproductive, it follows the exact pattern laid out with such prescience in Thomas Kuhn’s classic work “The Structure of Scientific Revolutions.” What we are living, in Kuhn’s words, is a paradigm shift—a rapid evolution of capitalism as we know it, from winner-take-all to a kinder, gentler version that views finance as a force for good. Revolutions are messy, and this one is no different—replete with a simultaneous thirst for converts to affirm the validity of these new concepts and the abhorrence of newcomers by the early adopters who believe they are the rightful stewards of the movement.
The transition to sustainable capitalism is a work in progress. To harness its full potential requires both appreciation of what has come before—to make the movement possible—as well as embracing new converts, even if they have unorthodox views by the movement’s standards and see the challenges in a new light. We should never lose sight of the end game: improving the social and environmental performance of companies by leveraging the tool of finance. Sustainable capitalism is not the goal. A sustainable world is.
So, what has come before that might shed light on Mr. Klarman’s concerns? Regarding systems theory and capitalism, some of the finest work in this space is being done by Mr. Steve Lydenberg of The Investor Integration Project (TIIP). PRI just launched a practical guide for investors on inequality and systems instability based on TIIPs work. Of course, inequality is but one of many systemic risks—including climate change—to an investment portfolio. Research by the Sustainability Accounting Standards Board (SASB) has shown that climate risk affects 72 of 79 industries, and therefore you cannot diversify away from it.
As Mr. Klarman said in his letter, “there is no way to hedge these risks other than to work together to reverse course …” If Mr. Klarman recognized the increasing risk to his portfolio from climate change, and the ongoing threat of weather events, wildfires, and business disruption, he might approach investments like PG&E a bit differently. You see, the planet doesn’t care about insurance or who gets paid out first after bankruptcy. (1)
Even though Mr. Klarman has a lot to learn about what has come before, what the world needs now is for all investors to focus on performance. This is why we should embrace Mr. Klarman with open arms.

_(1) James Hawley and Jon Lukomnik have just published an excellent paper describing the rise of the systems approach and the need to go beyond modern portfolio theory. When you can’t diversify, you have to focus on performance. In the context of “universal ownership,” they call this “beta activism.”_He can make a big difference by driving not only financial performance, but sustainability performance. In fact, value investing and sustainability performance go hand in hand when considered through the lens of materiality.

Revolutions are messy, and this one is no different—replete with a simultaneous thirst for converts to affirm the validity of these new concepts and the abhorrence of newcomers by the early adopters who believe they are the rightful stewards of the movement.

Alpha-seeking value investors look for things the market doesn’t see, buy companies that are undervalued, work with them to improve performance on material factors, and reap the rewards when the market catches up. Turns out, value investing may be the best strategy there is for improving sustainability performance in any asset class. Remember that 4.5% alpha that Professor Serafeim found when companies outperform on material sustainability factors? You don’t get that alpha by just knowing what issues are material. You don’t get it from disclosure (2). You don’t get it by buying best-in-class. (The leaders are already performing at the top of their game.)
The only reliable way to capture alpha over the long term is from driving performance on material issues. Whether you are invested in real estate, private equity, public equity, bonds, or all of the above (like Mr. Klarman), the value approach helps to identify opportunities to drive financial value through improved sustainability performance. The key is to focus those efforts on the material sustainability factors that can catalyze the realization of a company’s intrinsic value. Mr. Klarman can do the movement a great service by driving performance gains to prove that financial returns and sustainable outcomes are mutually supportive.
Materiality is a concept that’s as near and dear to Mr. Klarman’s heart as it is to mine. I have a picture of a special horse named Materiality on my wall at home. He’s a beautiful, strapping Bay colt with big, soulful eyes and a striking white blaze down his nose. In 2015, at 3 years old, he won several key races and qualified for the Kentucky Derby. On the day of the big race, my daughter and I watched intently, rooting for him. I thought about betting everything SASB had on him (which wasn’t much at that time—we were constantly on the verge of bankruptcy). Materiality ran a beautiful race, even challenging the leader at one point before finishing in a respectable 6th place. The horse named Materiality was once owned, and given his name, by none other than Mr. Klarman. Sadly, Materiality is no longer with us, but his spirit lives on. And as a core principle of sustainable investing, materiality is off to the races.
Mr. Klarman, you may be anxious at the state of the world and the effect it can have on capital markets, but think about the state of the markets—where $1 of every $4 is now sustainably invested—and the effect that can have on the world. Don’t just write a letter to your clients—be part of the sustainable capital revolution. Move the conversation forward from vanity metrics like AUM to meaningful performance gains. For the sake of the next generation, bet on the horse named “materiality” once again. By fixing capitalism for the next generation, we might just fix the world, too.

Jean Rogers, PhD, is the founder and former CEO of the Sustainability Accounting Standards Board, recognised by Barron’s in 2018 as one of the top 20 most influential people in the field of sustainable investing.

(2) Steve Lydenberg, David Wood and I wrote a paper in 2010 called “From Transparency to Performance”, which laid out how to identify material sustainability issues by industry. It made the case for moving beyond disclosure, and it is the blueprint for SASB’s approach.