The Hermes Principles What shareholders expect of public companies – and what companies should expect of their investors Contents 3 Introduction 4 Investment principles 5 Capital market behaviour 6 The Hermes Principles 7 Communication 8 Financial 15 Strategic 17 Social, ethical and environmental 19 Conclusion The aims of this document Hermes believes that companies perform better where there is understanding between them and their owners. A company is a joint enterprise between those that run it – its directors and managers – and those that own it – its shareholders. Investments in public companies are more likely to succeed if investors communicate reasonable expectations properly and corporations better understand what is being asked of them. Hermes would like to thank the senior business figures who contributed their comments in the writing of this document. © Copyright Hermes Pensions Management Limited, 2002 The Hermes Principles ISBN 0-9543843-0-X 3 Introduction Hermes Governance Code www.hermes.co.uk/corporate- governance/PDFs/statement.pdf This document sets out principles to address a simple These principles are complementary to Hermes’ At Hermes we aim question: ‘What should owners expect from UK public position on corporate governance. Governance sets to give enduring companies and what should these companies expect out the structures and processes by which a company support to companies from their owners?’ should be controlled through its board. It should which demonstrate encourage positive entrepreneurial behaviour, while commitment to Its aim is to create a common understanding, having appropriate checks and balances through its long-term shareholder between managers and owners, of the proper goals independent directors and the right balance of power value of a public company. to ensure decisions are wisely made. We monitor the governance of the companies in which we invest on It sets out a number of expectations which Hermes behalf of our clients closely, giving support to those believes should exist between owners and managers. which demonstrate an appropriate structure, and By being explicit about appropriate expectations, we intervening to change those which do not. aim to get a better framework for communication and dialogue between boards and shareholders, and so So far Hermes (and indeed all other fund managers) help boards manage their companies better. have been less explicit in addressing the question of the management implications of accepting the goal of The ultimate goal of the company is to create wealth value creation. This document aims to fill that gap. for its shareholders. This in turn suggests a number We would be pleased to discuss these principles of actions which it is reasonable for shareholders to with the managers of public companies, other expect of companies. shareholders and any other interested parties to create the greatest possible clarity about our The expectations in this document are derived from expectations. Hermes’ extensive experience as an active and engaged shareholder on behalf of its pension fund We believe these principles have significant clients (throughout this document reference to implications. We would like to replace the damaging Hermes as shareholder is in recognition of Hermes finger-pointing which has characterised the City- as the agent for the owners). Hermes invests in Industry debate in the past, with a positive dialogue some of the best companies, that already deliver between managers and owners about the proper shareholder value according to these principles. We purpose of the corporation. also intervene in companies which have not delivered shareholder value. Responsible behaviour by boards requires responsible investors. A company that is This experience, together with that of similar funds demonstrating commitment to delivering long-term around the world with whom Hermes has close shareholder value should expect ongoing support relationships, has provided a number of lessons from its shareholders. At Hermes, we aim to give about why companies often fail in their primary goal enduring support to companies which demonstrate of delivering long-term value. Our joint experience, of such a commitment. ■ achieving outperformance on those investments where intervention has altered corporate behaviour, suggests there are good central management disciplines which will greatly increase the likelihood of value delivery. It is important that, as investors, we are explicit about the importance we place on these disciplines. We are not seeking to place new burdens on businesses. It is not in our interest as investors to do that. What we might expect as one outcome of this document is some reappraisal of the way that businesses communicate with shareholders. 4 Investment principles The shareholders’ Those who control the largest blocks of shares in the able to demonstrate that their investment decisions interest is the UK, are the investment ‘institutions’. The ultimate are soundly based. A company should be able to objective of beneficiaries of most institutional investment activity demonstrate its competitive advantage, both at the company are those who hold pensions and life insurance corporate and at business unit level. policies. In Hermes’ case, several million people depend on our investment to secure their income in And in so doing it should demonstrate old age. Hermes’ clients have liabilities which extend ethical behaviour. for a long period of time. A typical ‘average’ liability would be well over a quarter of a century. It is these As a long-term diversified investor, we oppose liabilities that we seek to cover by investing in and companies behaving in a way which knowingly becoming the part-owners of public companies. passes costs on to other companies or to the tax payer, and as such is socially or environmentally The interests of shareholders are not delivered by unacceptable, or unethical. It makes no sense if formal contract, as the interests of bond holders, business success is achieved by creating other costs consumers, or even employees are. The shareholders’ (‘externalising costs’) which the beneficial owners of interest is the objective of the company. The definition companies will ultimately pay for. and implications of this interest is the aim of this document. We hold it as axiomatic that the primary In summary, a company’s primary consideration goal of a UK listed company is to be run in the long- should be the generation of long-term shareholder term interests of its shareholders – to generate value value, and this should be based on appropriate for them. financial disciplines, competitive advantage, and within a framework which is economically, ethically Central to this goal is the need to and socially responsible and sustainable. create a financial surplus. Hermes believes these goals should be shared by For long-term value creation, it is essential that other long-term investors such as pension funds and companies create a financial surplus in excess of life insurance companies. In our experience many their cost of capital. It is that surplus which pays for managers tell us that their discussions with the pensions and insurance policies. Growth, earnings investment community rarely focus on these issues. per share, return on capital employed and market They ask how a company can be expected to show share measure the ways that surplus is created, but absolute commitment to long-term shareholder value are not surrogate measures for the financial surplus when the majority of its investors fail to demonstrate itself. It is possible to demonstrate earnings-per-share adequately that this is what they require, or express growth while destroying shareholder value. whether they consider the company – as seen from their perspective – is achieving it. Some of these Financial surplus is achieved by having a issues can be better understood by thinking about competitive advantage. the behaviour of the capital markets. ■ Given the lengthy timeframe for realising the returns on projects and the uncertainty under which most business decisions are made, companies need to be ‘Several million people depend on Hermes’ investments to secure their income in old age.’ The Hermes Principles 5 Capital market behaviour Much discussion between companies and A large infrastructure of information sources and The best companies shareholders is about helping investors to decide opinion supports this trading activity. The commission ensure they have a if, over the short run, a company’s shares are likely brokers receive on trading shares is the prime source proper dialogue with to rise or fall. This will usually be based on some of their income. Most brokers’ reports on companies, their investors directly, concept of over or undervaluation, often over a short will be headed ‘buy’, ‘sell’ or some other trading not just through time period. Therefore companies may feel investors recommendation. intermediaries have an obsessional concern with short-term performance. Often they are correct. Fund managers As we have said, there is nothing wrong with this wish to understand short-term performance so that trading activity in itself. What can cause problems they can exploit relatively short-term movements in is if the attention given to short-term performance the share price and hence outperform their peers in a distracts company managers from the goal of creating relative sense. This attention to relative performance long-term shareholder value. If there are some is one of the key factors in assessment of fund participants in the market who seek to bet on managers themselves, yet pension fund or insurance performance over a shorter time period, so be it, but liabilities are met out of absolute returns over the long this should not distract company managers from their term, not relative ones in the short term. long-term goals. The principal way in which fund managers seek to Warren Buffet, the legendary American investor, outperform each other is through buying and selling describes the process of share trading as ‘gin rummy company shares. If a fund manager judges that the capitalism’. Money managers ‘discard their worst card company’s shares seem overpriced by the market at each turn’. relative to its future prospects, they will sell or maintain the option to sell the shares, and vice-versa Consider an analogy. The marathon is a 26-mile race. if it is underpriced. Trading in company shares During a marathon, people may take bets on who will does have a value. It keeps the market ‘liquid’, run the next mile the fastest. The person who runs allowing funds to assess the value of their assets the next mile fastest may be well positioned to win properly, and can be a signal to management of the race. But if the runners become so obsessed by performance issues. the betting on performance in the short term that they exhaust themselves, they are unlikely to succeed. Because this trading activity implicitly dominates both performance measurement and information supply in It is important that company managers understand the investment industry, it can also dominate the that much of the questioning they receive from discussions between shareholders and the brokers and fund managers will be to help them companies in which they invest, particularly when make a decision about the short-term direction of the brokers themselves also seek to be intermediaries company’s shares and hence whether or not to buy between investors and companies. The best or sell shares. This is entirely legitimate. But it should companies ensure that they have a proper dialogue not determine the basis on which a company is run. with their investors directly, not just through Nor is it an alternative to proper stewardship by intermediaries. However, too many companies shareholders as owners. ■ focus investor relations activities on brokers and analysts, rather than on those actually investing. ‘Some participants in the market seek to bet on performance over a short time period. This should not distract company managers from their long-term goals.’ 6 The Hermes Principles Hermes’ overriding requirement is that companies Principle 5 ‘Companies should have performance be run in the long term interest of shareholders. evaluation and incentive systems designed cost- Companies adhering to this principle will not only effectively to incentivise managers to deliver benefit their shareholders, but also we would argue, long-term shareholder value.’ the wider economy in which the company and its shareholders participate. We believe a company Principle 6 ‘Companies should have an efficient run in the long term interest of shareholders will capital structure which will minimise the long-term need to manage effectively relationships with its cost of capital.’ employees, suppliers and customers, to behave ethically and have regard for the environment and Strategic society as a whole. Principle 7 ‘Companies should have and continue to develop coherent strategies for each business unit. Communication These should ideally be expressed in terms of market Principle 1 ‘Companies should seek an honest, open prospects and of the competitive advantage the and ongoing dialogue with shareholders. They should business has in exploiting these prospects. The clearly communicate the plans they are pursuing and company should understand the factors which drive the likely financial and wider consequences of those market growth, and the particular strengths which plans. Ideally goals, plans and progress should be underpin its competitive position.’ discussed in the annual report and accounts.’ Principle 8 ‘Companies should be able to explain why Financial they are the “best parent” of the businesses they run. Principle 2 ‘Companies should have appropriate Where they are not best parent they should be measures and systems in place to ensure that they developing plans to resolve the issue.’ know which activities and competencies contribute most to maximising shareholder value.’ Social, ethical and environmental Principle 9 ‘Companies should manage effectively Principle 3 ‘Companies should ensure all investment relationships with their employees, suppliers and plans have been honestly and critically tested in terms customers and with others who have a legitimate of their ability to deliver long-term shareholder value.’ interest in the company’s activities. Companies should behave ethically and have regard for the Principle 4 ‘Companies should allocate capital for environment and society as a whole.’ investment by seeking fully and creatively to exploit opportunties for growth within their core businesses Principle 10 ‘Companies should support voluntary and rather than seeking unrelated diversification. This is statutory measures which minimise the externalisation particularly true when considering acquisitive growth.’ of costs to the detriment of society at large.’ ■ The Hermes Principles 7 The Hermes Principles Communication Principle 1 ‘Companies should seek an honest, open delivered. Many companies do this very well, but a lot and ongoing dialogue with shareholders. They should of annual reports go into great depth describing the clearly communicate the plans they are pursuing and range of a company’s activities and aspirations for the likely financial and wider consequences of those growth, while failing to explain how or whether plans. Ideally goals, plans and progress should be shareholder value is being created by these activities. discussed in the annual report and accounts.’ There is one important rider to this discussion. The A company cannot control its share price, which will price of a company’s share reflects the market’s view be affected by many external factors. However, it can of the company’s prospects, and therefore its cost of seek to be clear about its goals, and the financial, capital. If a company’s share price is low, it probably strategic and ethical disciplines by which it is reflects fundamental doubts about its prospects. managed. This will create the best chance of a Where this is the case, and management are company being evaluated properly, and gaining the confident that the business is worth more, it is quite full benefit of access to a lower cost of capital through appropriate that they should respond by reappraising public capital markets, and of delivering value to its the capital structure and, if appropriate, buying back owners. This is a continuing process of providing their own shares. A company which is maximising information and correcting misinformation to ensure shareholder value should always consider a the fullest possible understanding of the company by repurchase of shares where this provides superior the market. If a company does not communicate returns to investing in the business. ■ properly, it may not get proper credit from its shareholders, even if it is succeeding. It is important that companies are honest about their prospects, and do not seek to excuse current failure by promising success in the future. For those companies with a long investment time frame, such as those involved in drug development or aerospace, there may be considerable delay between an investment and its subsequent return. However, there may be cases where companies simply promise better return in the future without any credible operational or strategic plan to achieve that improvement. It is therefore important that companies are able to articulate a credible plan as to how and when performance and shareholder value will be Principle 1 ‘Companies should seek an honest, open and ongoing dialogue with shareholders. They should clearly communicate the plans they are pursuing and the likely financial and wider consequences of those plans. Ideally goals, plans and progress should be discussed in the annual report and accounts.’ 8 The Hermes Principles Financial Measuring returns Figure 1 WACC – principles Principle 2 ‘Companies should have appropriate A company will usually be funded by a mixture of measures and systems in place to ensure that they equity and debt. WACC – the weighted cost of know which activities and competencies contribute capital – is the cost of funding taking into account most to maximising shareholder value.’ the cost of debt and equity capital. Many who work outside the financial system might WACC can be a difficult number to calculate assume that it is easy for managers to determine precisely. It is important that investors know that whether they are delivering, and for shareholders to companies understand their cost of capital, but determine whether they are getting the best financial very few companies state clearly in their annual returns. In reality things are much more complex. It is report and accounts their WACC assumptions. therefore important that shareholders are clear about Given that WACC underpins the financial goals of what measures of return companies should use. a company seen from an investor perspective this is somewhat surprising. One of the few The primary goal of a company should be to companies that does make a clear statement on maximise shareholder value. In financial terms this is its WACC is Geest plc. It is also a good example best measured by the present value of the cash flows of frank reporting to shareholders. from investment, discounted at an appropriate cost of capital. The best companies are demonstrably aware ‘Geest seeks to enhance shareholder value. of the importance of the Weighted Average Cost of The average post-tax return on invested capital Capital (WACC) to all decision making (figure 1, including goodwill in 2000 was 16% (1999: 17%) right). For most companies, the post-tax weighted versus a weighted cost of capital (WACC) of less average cost of capital (WACC) might be around 7- than 10%. Geest has had an inefficient balance 8% per annum over the long term (figure 2, opposite). sheet entirely funded by shareholders, and as a WACC is an important number. If a company sets it result we have operated with a sub-optimal too high, it will discount too heavily the value it WACC. As borrowings increase to fund our creates, particularly over the long term. If it sets it too growth, our WACC will decrease.’ low, it will invest in a way which destroys value. Geest plc annual report 2001 Financial reporting disciplines often do not accurately measure or report the cash returns from any cannot measure the true value of the company. investment and hence whether WACC is being achieved. Modern financial accounting is based on Basic financial accounting measures are widely used measuring the assets of a company (as expressed in as targets for managers and companies, primarily the balance sheet), and transactional movements because the ubiquity of accruals-based, historic cost, between today’s balance sheet, and the one drawn financial accounting systems makes them easy to up the previous year (the profit and loss account). use. If, from time to time, companies wish to focus on It is a hugely important discipline, but one which such measures, this may be quite appropriate for Principle 2 ‘Companies should have appropriate measures and systems in place to ensure that they know which activities and competencies contribute most to maximising shareholder value.’ The Hermes Principles 9 The Hermes Principles – Financial continued managerial and motivational reasons. Companies Figure 2 WACC – amount should bear in mind that the ultimate goal is long-term As this document is written in late 2002, an shareholder value, and that this is best measured in average FTSE 100 company cost of debt might terms of cash flow returns. We welcome initiatives by be around 6% (4% post-tax). A large FTSE companies and their advisers to establish systems company may have a cost of equity of between based on this measure. 7% and 9%. Therefore WACC for an average large FTSE company may be of the order of 7%- Most companies have planning systems which 8%, and higher where risk perceived by investors include a full discounted cash flow model of the increases the cost of both equity and debt capital. options available to them and make objective decisions on this basis. Indeed it is rare for boards of As pension fund investors, our required return on directors to approve any investment which does not equities is projected at 8%. The FSA assumed demonstrate a positive present value. The question investment returns for assessing maturity therefore arises; ‘if companies plan to deliver targets of life policies are 6%-8%. The purpose shareholder value, why do some fail to do so?’ of highlighting these numbers is not to set expectations for returns on investment, but There are many reasons why the value gap exists. to set them into context in a realistic way. For example, although impact on shareholder value Reasonable expectations are more likely to is usually measured before any investment is made, result in rational plans that will deliver reasonable it is less often measured afterwards in a fully outcomes. objective way. Boards should be encouraged to review investment assumptions and projections after Good companies make realistic assumptions. the event to track against reality, rather than just However some are tempted to make unrealistic comparing the outcome through budgetary assumptions about profitability and then discount processes. If they don’t, managers and investors at a high rate to counter the risk of their optimism. will have little guide as to which of their decisions This has implications for the types of projects that have been successful. will be invested in. With higher discount rates time distant returns count less in relative terms. An Secondly, plans, though based correctly on present overly high discount rate discriminates against value, can fail to incorporate the full consequential longer term projects and builds in unhelpful costs associated with a project on the whole short-termism. business. Thirdly, internal company goals can detract from the absolute cash outperformance; or seek to grow scale creation of shareholder value. For example, without delivering value to shareholders. companies may encourage the maximisation of returns on capital, rather than the maximisation of 10 The Hermes Principles – Financial continued Returns and growth Figure 3 Growth in the economy and Principle 3 ‘Companies should ensure that all growth prospects of individual investment plans have been honestly and critically companies tested in terms of their ability to deliver long-term The UK Treasury trend growth projections are shareholder value.’ 2%-3%. Clearly some companies will be capable of achieving growth substantially higher than this. The purpose of the capital markets, through which However, as a diversified investor, it has long most institutions make their investments, is to allocate been apparent that the sheer numbers of resources to those companies and projects where companies aspiring to growth substantially in there is a high return and away from those which excess of this does not stand up in overall have lower returns. When capital markets work economic terms. We would encourage every effectively, they will, through this process, encourage company to exploit profitable opportunities to high productivity of capital and a high level of growth. However plans should be based on the economic growth. High capital productivity and high reality of likely future customer requirements and growth will generate long-term shareholder value and on competitive pressures, which mean that real strength in the overall economy (figure 3, right). price reductions and service improvements may be needed simply to stand still. As a shareholder Hermes wishes to promote investment and growth that is sustainable. Similarly, trend economic growth is just that, an average. Investment plans should make We would not want companies to pursue growth for reasonable assessments of changes in economic growth’s sake. If they do they may prevent investment circumstances in the normal course of an by other companies which may have a better chance economic cycle. of creating sustainable long-term value. Creating that value usually demands that a company has fully thought through its strategy, a subject which is discussed later. Principle 3 ‘Companies should ensure all investment plans have been honestly and critically tested in terms of their ability to deliver long-term shareholder value.’ The Hermes Principles 11 The Hermes Principles – Financial continued Growth and risk Figure 4 Acquisitions Principle 4 ‘Companies should allocate capital for For a company making an acquisition of another, investment by seeking fully and creatively to exploit shareholder value will only be created if the opportunties for growth within their core businesses acquiring company is able to add value to the rather than seeking unrelated diversification. This is acquiree which is greater than any premium they particularly true when considering acquisitive growth.’ have to pay. Acquisitions can be a way of building businesses that would take years to build from Where companies do have the opportunity to grow scratch. Acquisitions can be beneficial where profitably, they should do so with full momentum, companies concentrate on buying activities with communicate their plans clearly, and expect which they are familiar and which fall within their shareholders to support them. One aspect of own competence and capability. They can, for sophisticated capital markets is that they allow example, extend the core business' product range shareholders to diversify their risk very broadly. At or geographical reach. However evidence from Hermes, we invest our clients’ funds in the shares firms such as KPMG and PA Consulting has of over 3,000 companies worldwide, plus corporate shown that as many as 80% of acquisitions fail to and government bonds, cash and property. deliver shareholder value. Against this evidence we would urge management to be particularly As shareholders we expect listed companies to exploit careful before embarking upon acquisitive growth. their competitive advantages and to grow, provided this There as many pitfalls, not least the acquisition generates a capital surplus. This may involve taking process itself. Companies should stay within the considerable risks, and appropriate risk assessment envelope of their proven skills and competences should be done. However, even then we fully and should not seek acquisitions of businesses recognise that some plans may fail. That is why our outside that boundary. Cultural compatibility investments are spread so widely. As a result we can between acquirer and acquiree is also essential. support companies which take well judged risks in Executive incentive schemes should be designed order to grow. so that acquisition for its own sake, as opposed to enhancing value, is discouraged. Companies often seem unwilling to take advantage of this, and instead seek to balance risk within their portfolio of businesses. At one time strategic Essentially the advice would be that a company consultants would wrongly recommend that all should try to create its own internal capital market. companies should have a balance of businesses, Such approaches make little sense to diversified some of which were generating cash, others of which investors (see figure 4, above). were spending it. They falsely suggested that if a company had businesses which absorbed cash, Conglomeration is not an adequate financial strategy it should buy ‘cash cow’ businesses to fund them. on its own. We recognise we are putting considerable Those with ‘cash cow’ businesses should acquire demands on managers. They may feel that they take businesses which needed investment capital. less risk by backing several business ideas, rather Principle 4 ‘Companies should allocate capital for investment by seeking fully and creatively to exploit opportunties for growth within their core businesses rather than seeking unrelated diversification. This is particularly true when considering acquisitive growth.’ 12 The Hermes Principles – Financial continued than putting all their resources and focus into the Incentivising long-term performance management of a few of their best opportunities. In Principle 5 ‘Companies should have performance that way they may feel they can spread the financial evaluation and incentive systems designed cost- risk. More often, however, such approaches fail. effectively to incentivise managers to deliver long- Successful companies are usually the leaders in their term shareholder value.’ field. By minimising financial risk, businesses often increase the likelihood that they will fail to gain a Over the last few years there has been much debate leadership position, and hence they increase their on the subject of executive remuneration. Headlines strategic risk. This is not in the long-term interests of have tended to focus on the specific amount of shareholders, who have other ways of diversifying remuneration rather than the principles behind it. For financial risk. long-term shareholders, the primary issue is simply to ensure that remuneration is adequate to hire and We recognise this is a tough discipline to place on retain appropriate staff, and to incentivise directors managers and may require a change in attitude of and managers to deliver long-term shareholder value. investors as well as boards. Many remuneration and incentive packages fail to meet these criteria. The fact that they don’t is apparent from the continued use of measures which don’t reflect long-term value. Many top management incentive schemes are highly geared through options; some pay out for performance which is indifferent when measured on a relative scale, hence they can reward failure as well as success. As shareholders we are concerned about the generation of value in the long term. Companies should only expand where they can achieve an adequate return. However it does mean that, in taking decisions, directors and managers should be concerned about effects on the long-term value, not just on apparent performance in the short run. If shareholders have been fully informed about long- term company prospects, efficient capital markets will ensure that companies which do take a long-term view will be appropriately rewarded. Boards need to be sure they are not detracting from Principle 5 ‘Companies should have performance evaluation and incentive systems designed cost-effectively to incentivise managers to deliver long-term shareholder value.’ The Hermes Principles 13 The Hermes Principles – Financial continued long-term performance by the signals they may Lowering the cost of capital receive from an investment community concerned Principle 6 ‘Companies should have an efficient with the trading of shares. This was discussed earlier. capital structure which will minimise the long-term It is important that corporate managers are not misled cost of capital.’ by questions which are directed at helping fund managers trade shares, into believing that the It is the role of capital markets to make funds objective of a company is to deliver short-term available in those areas where return will be highest. results, whatever the cost. This is not just a problem It is the role of companies to secure funds on behalf caused by the behaviour of brokers, or boards overly of their shareholders, where costs will be lowest. This sensitive to their views, but also the relative passivity means that companies should seek an appropriate and silence of investors in undertaking their balance of debt and equity. If they do so, they will stewardship duties. lower their overall cost of capital, thus generating shareholder value. The appropriate debt/equity ratio is a question for the board, and will be dependent on the particular circumstances of the company concerned. However, we would note that there are companies which have, for considerable periods of time, had substantial cash balances or undergeared balance sheets. This may be inappropriate in an organisation which is seeking to maximise shareholder value. Equally there are companies which have found themselves ‘overgeared’, but believe that their relationship with their shareholders is such that they feel unable to come to the equity market for the necessary funds. Sometimes their shareholders’ attitude reflects a healthy scepticism about the company and its prospects. However, excessively negative attitudes can also lead to a significant loss of long-term value for shareholders, as companies whose underlying businesses may be strong are forced to take inappropriate measures to protect short-term cash flow. It is therefore essential that there is honest and open dialogue between directors Principle 6 ‘Companies should have an efficient capital structure which will minimise the long-term cost of capital.’ 14 The Hermes Principles – Financial continued and shareholders, so that a company can have access to the necessary funds to maintain an effective capital structure. Investment institutions should support companies seeking to achieve such a goal. ■ The Hermes Principles 15 The Hermes Principles Strategic Strategic expectations case’ assumption must be that if a business has no Business unit strategy competitive advantage, it is difficult to see why, Principle 7 ‘Companies should have and continue to over a number of years, it will be able to sustain a develop coherent strategies for each business unit. superior return, and hence generate long-term These should ideally be expressed in terms of market shareholder value. prospects and of the competitive advantage the business has in exploiting these prospects. The In assessing competitive advantage, a company company should understand the factors which drive should be able to explain what particular strengths or market growth, and the particular strengths which resources it has access to, which allow it to maintain underpin its competitive position.’ the advantage. A company may have a cost advantage which derives from scale, factor costs, Long-term shareholder value requires the generation brands, technology or a combination of many of of return well into the future. Today’s financial these and other features. (These are often referred to accounting returns are often an inadequate predictor as ‘core competencies’). The greater the competitive of future prospects for shareholder value. This is advantage which a company enjoys, the higher particularly true for businesses which are highly should be its profitability relative to other industry cyclical or where new investment takes many years participants. to pay back. For this reason, if shareholders are to assess the degree to which a company will generate In asking that companies express themselves in this long-term value, they will need to understand the way, we are not seeking to limit the methods by which strategy of its businesses. It is business strategies, strategies are created. We are well aware that in good quite as much as balance sheet assets, that businesses, strategy development is a creative and shareholders invest in. intuitive activity, subject to organisational, cultural and personal influences, as well as to analytical inputs. We As with measuring financial returns, it is important would never wish to stifle this creative process. that, as shareholders, we define what we consider to be an adequate strategy. We believe an appropriate However, if shareholders are to be able to requirement is that boards should be able not only to understand, and from time to time to challenge, the discuss the goal of strategy, but also the method by way in which the companies they own are managed, which that goal is to be achieved. then there is the need for some minimum expression of the strategy and the competitive advantage which Critical to describing the method is a clear underpins it. understanding of (i) the demands and the dynamics of the market, and (ii) the business’s competitive It is therefore an essential requirement that advantage in terms of, for example, consumer value, management is able to describe a coherent strategy cost or access, which allow it to maintain a superior for each of the businesses they are in. ■ return to other competitors within the market. A ‘base Principle 7 ‘Companies should have and continue to develop coherent strategies for each business unit. These should ideally be expressed in terms of market prospects and of the competitive advantage the business has in exploiting these prospects. The company should understand the factors which drive market growth, and the particular strengths which underpin its competitive position.’ 16 The Hermes Principles – Strategic continued Corporate strategy Principle 8 ‘Companies should be able to explain why they are the “best parent” of the businesses they run. Where they are not best parent they should be developing plans to resolve the issue.’ What is true at business unit level is equally true at corporate level. Many larger quoted companies participate in a number of different businesses, whether these are defined by market, product or activity. In each case it is essential, if the corporate goal is to generate long-term shareholder value, that the board can explain why it is the ‘best parent’ of any subsidiary company it owns. If a business would generate greater value if it were independent, or managed by another corporate body, then the board should consider plans to divest it. ■ Principle 8 ‘Companies should be able to explain why they are the “best parent” of the businesses they run. Where they are not best parent they should be developing plans to resolve the issue.’ The Hermes Principles 17 The Hermes Principles Social, ethical and environmental Behaving ethically position of those whom their action affects, and that Principle 9 ‘Companies should manage effectively they deal fairly with them. relationships with their employees, suppliers and customers and with others who have a legitimate Many ‘special interests’ may challenge corporate interest in the company’s activities. Companies activity from a sectional point of view. We would want should behave ethically and have regard for the a company to engage in a process of understanding environment and society as a whole.’ the appropriate pressure which society is legitimately putting on it, and its industry, and respond Well managed companies cannot ignore the impact of accordingly. Once a company has understood the their activities on the wider society. Company activity argument it may, of course, be appropriate for it to should be subservient to the law. Basic economic resist such pressures. efficiency would argue it is appropriate that companies are open about the impact of their activities. Doing well economically and behaving responsibly are not mutually exclusive. This does not mean that businesses have limitless social obligations. It is the responsibility of businesses to generate a capital surplus. But it is not appropriate to generate such a surplus without regard to wider obligations. Of course, to require companies to behave ethically raises many questions, both theoretical and practical. We live in a society where it is appropriate for legislators to pass laws which govern company activities. These do not necessarily set a minimum requirement. It is not our role to act as moral philosophers, still less do we wish to micromanage companies’ responses to ethical issues, any more than we would wish to micromanage their commercial operations. However, we believe that ethical behaviour by companies is likely to involve some notion of fairness and reciprocity; that managers seek to understand the Principle 9 ‘Companies should manage effectively relationships with their employees, suppliers and customers and with others who have a legitimate interest in the company’s activities. Companies should behave ethically and have regard for the environment and society as a whole.’ 18 The Hermes Principles – Social, ethical and environmental continued Externalisation of costs Principle 10 ‘Companies should support voluntary and statutory measures which minimise the externalisation of costs to the detriment of society at large.’ Business, of course, has to work in a competitive environment. This can create the conditions where there is a high incentive for businesses to ‘externalise’ costs – ie to make a profit for the company while high costs are incurred by society at large. Since Hermes opposes such activity we ask companies to welcome those frameworks, voluntary where possible, statutory where necessary, which encourage businesses not to externalise costs. This is not to encourage regulation per se. Of course it is important that where regulation exists it recognises the need to allow the greatest possible flexibility which will encourage positive entrepreneurship. However, most investors are widely diversified; it makes little sense for them to support activity by one company which is damaging to overall economic activity. The ultimate beneficiaries of most investment activity include the greater part of the adult population who depend on private pensions and life insurance. It makes little sense for pension funds to support commercial activity which creates an equal or greater cost to society by robbing Peter to pay Paul. Where companies are aware that such conditions exist, it is appropriate for them to support measures to align shareholder interests with those of society at large. ■ Principle 10 ‘Companies should support voluntary and statutory measures which minimise the externalisation of costs to the detriment of society at large.’ The Hermes Principles 19 Conclusion In this document Hermes has explained what we At all times Hermes stands ready to discuss expect from the companies we invest in. This has these expectations with companies. If there are implications for financial returns, for strategy and circumstances where they are too rigid we will of for the wider responsibilities of businesses. We trust course be flexible in responding to particular that, in our joint enterprise with companies, these circumstances. But, barring those specific occasions, principles help set a framework for what companies we do expect companies to seek to exercise the should expect from responsible investors. We believe disciplines we have outlined. For most those that companies with concerned and involved disciplines will already be in place. Others will seek to shareholders behaving as owners are more likely to introduce them. Those companies which do not meet achieve superior long-term returns than those without. our expectations should anticipate that, as engaged We hope that this creates both a constructive owners on behalf of our clients, we will wish to pursue platform for communication and dialogue, and a basis why they have failed to do so. on which it is appropriate for shareholders to discuss and question management behaviour. A corporation is a joint enterprise between its providers of capital and those boards who manage We believe most businesses in this country do seek the business. It cannot be right that investors in to achieve these goals, and do so through a system companies have neglected to behave like owners of corporate governance which meets our and instead appear more like spectators observing governance standards. Management of companies events without any sense of being able to help which are run in the long-term interests of determine outcomes. shareholders can be confident of Hermes’ support, including the expectation that we will support them in We look forward to an active and constructive a hostile takeover situation and in raising capital. dialogue with the companies in which we invest. ■ In drawing up these expectations for companies, we are not seeking to limit management scope or creativity. Still less are we seeking to micromanage companies. The disciplines we have outlined are the natural disciplines we would expect of companies which seek to maximise long-term value for their shareholders. The Hermes Principles Published by Hermes Pensions Management Limited Lloyds Chambers 1 Portsoken Street London E1 8HZ www.hermes.co.uk Hermes Pensions Management Limited is regulated by the FSA The authors; Tony Watson, Chief Executive, Hermes Pensions Management David Pitt-Watson, Managing Director of the Hermes UK Focus Fund ISBN 0-9543843-0-X