Integrated reporting promises to measure the intrinsic value of companies and thereby become a vital tool for the stakeholder group that holds the financial purse-strings-the company’s shareholders. How well are today’s integrated reports measuring up to expectations?
Anyone who has read annual reports for the last decade or two will have noticed a substantial change in the messaging, the approach and the content of such reporting.
Dumbing down by dressing up
When sustainability emerged on the corporate agenda, annual reports went through an identity crisis. Many corporate PR people saw this as an opportunity to showcase all the good things the company does for the environment and needy communities.
Considering the irrelevance of most of this information to the business, shareholders very quickly learned to ignore all the glossy pages making up the front of the report and concentrate rather on the financials, where the management accounts and ‘notes to the financials’ provided far more useful information about the performance of the company.
A few companies began to take non-financial reporting more seriously. These early adopters were driven by two extremes. On the one hand, reputational benefits that suited the brand were seen as drawcards – a strategy that Woolworths applied when it launched its ‘Good business journey’. On the other, deterrents such as the severe legislative penalties facing non-compliant companies in the mining and resources sectors took effect. Stakeholders started to scrutinise issues such as safety and local economic development, and poor performance in these areas, even 10 years ago, undoubtedly had an effect on operational risk and consequently investor valuations.
Soft issues increasingly affect your destiny
Aside from these isolated cases, nonfinancial reporting has barely influenced the investor and his army of ‘quants’. But stand back far enough, say from the perspective of a Soros, a Lynch, a Buffett or plain old hindsight, and it is clear that many of the major market collapses, as well as individual corporate failures, have actually been a result of non-financial miscalculations. The near collapse of the financial system in 2007/8 is an obvious example: banks behaved irresponsibly in their lending practices. Central banks encouraged creative lending solutions, property buyers and speculators succumbed to the temptation of cheap debt, shielded from reality by the momentum in the property market bubble.
But that’s a well-worn example. More topical is the season that began with the Arab Spring and seems to be spreading through emerging market regions – exposing issues founded on the fundamental inequality of these societies. Companies operating in emerging market regions face major risks. There are risks to the company’s reputation (sourcing from manufacturers violating human rights), to the company’s operations (strikes and violent protests by labour and communities dissatisfied with their treatment), and to the company’s licence to operate (non-compliance with social and environmental legislation).
Investors rate their sector knowledge
Investment analysts are well aware of these risks and invest substantial effort and resources in trying to understand the sectors they invest in, as well as the comparative vulnerability or advantage of individual companies operating in each sector. Knowledge of the industry is a basic requirement underpinning such research. Indeed, the best investment houses have analysts that spend most of their working days following a particular sector. These specialists are in tune with the story behind the numbers in the financial annual report. While their interests may be more focused on non-financial risks that could affect the short- to medium term performance of a particular company, rather than on longterm societal and environmental concerns, nonetheless, intangible value increasingly makes up a significant proportion of a company’s analysis.
The report should assist the analyst
David Couldridge, senior investment analyst at Element Investment Managers, gives his view of the responsible investor’s mandate: “Full integration requires the inclusion of the estimated future financial impact of material sustainability factors in the valuation of prospective investments (intrinsic value) and the use of all ownership tools (engagement and proxy voting) to reduce risk and add value.”
The holy grail for the integrated report, therefore, is to be able to communicate the company’s response to its most material issues, and thereby an understanding of the intrinsic value of the company. Achieving this would unlock the potential that non-financial reporting has for providing better leading indicators of performance than does financial reporting.
Given the gradual maturing of the investment industry, how do today’s annual reports stack up? Has the trend towards integrated reporting begun to provide investors with the kind of information that can help inform them of the company’s intrinsic value?
What Trialogue’s study looked at:
Drawing on guidance given by various standards, such as Accountability’s AA 1000 standard and the International <IR> Framework, Trialogue’s Responsible Investing model rates companies for:
- The level of maturity of management’s response to the
most important issues facing the company
- The company’s performance in responding to its most important issues
- The company’s strategy for mitigating the risks associated with these issues and gaining
comparative advantage from the opportunities presented by these issues
Our survey of management maturity
In a study of six companies in the retail sector, conducted by Trialogue earlier in the year, both Woolworths and Massmart stood out well above their peers in terms of the maturity of their response to their material issues. The issues described in both companies’ reports accurately reflected the issues facing the sector, and they made transparent disclosures in their reports regarding how they were performing and what their strategies were for dealing with the issues and exploiting the opportunities thus presented. By comparison, other retailers, including Pick n Pay, Shoprite and Mr Price, were rated poorly on the evidence presented in their reports.
While the model does not distinguish between maturity of reporting and maturity of management response, companies should realise that the integrated report has now emerged as the primary communication tool for conveying the company’s value proposition to an increasingly educated readership. And poor reporting will damage company reputation more than ever before.
Trialogue’s study was fundamentally a qualitative analysis. Another angle for assessing the maturity of non-financial reporting is to analyse the disclosure of non-financial indicators. Financial reporting and the accompanying management ratios accurately reveal the strengths and weaknesses in a company’s performance. Indicators such as debtors’ days and stock turn are well understood by retail analysts, for example, and the benchmarks for even subsectors within the industry will be at the fingertips of most company directors.
Non-financial information is generally rather fuzzy and hard to define, even within a sector. How does one measure customer satisfaction, or employee satisfaction, for example? Even clearly defined indicators, such as ‘injuries on duty’, are often woefully misunderstood by corporate reporters. The very advantage of non-financial measures, that they are often leading indicators of future performance, also works to their disadvantage in terms of disclosure. Companies are, not surprisingly, sensitive about sending out uncomfortable signals of future performance into the marketplace.
The holy grail for the integrated report is to be able to communicate the company’s response to its most material issues, and thereby an understanding of the intrinsic value of the company.
The IRAS sustainability indicator survey
How well do this year’s annual reports perform in terms of reporting on nonfinancial performance? According to Michael Rea, MD of IRAS, a company specialising in assuring the non-financial information in company reports; not nearly well enough to serve the interests of stakeholders, let alone the investor.
This year, IRAS undertook a survey of the annual reports (and related company website information) of 331 companies on the JSE, and from the nonfinancial indicators disclosed, compiled a Sustainability Data Transparency Index (SDTI). This Index consists of 56 data points (data which companies ought to be reasonably expected to provide), as well as a series of more than 30 ratios calculated by IRAS to describe companies’ sustainability performance.
Rea’s IRAS survey reveals just how immature non-financial reporting is, 13 years into the new millennium. Only 17% of the 331 companies surveyed provided HDSA procurement data, only 30% provided electricity consumption data, and only 17% provided lost time injury data. Making sense of non-financial information is also difficult. How does one compare the usage of resources, for example, across companies of different sizes, even within the same sector? Rea generally recommends using the number of person hours worked as a denominator to calculate intensity ratios. But even here, difficulties are raised by the inadequacy of reporting standards. In the survey, 80% of the companies surveyed disclosed the number of people employed within the company, but two-thirds didn’t mention the number of contractors, making the calculation of the denominator virtually impossible to establish accurately. Even defining a contractor for the purposes of calculating ‘person hours worked’ presents challenges that traditional standards, such as GAAP, would gulp at. Using the figure to calculate a measure of a company’s vulnerability to serious injuries and fatalities, while potentially highly useful, is as yet far too unreliable to be taken at face value.
Spurring on further disclosure
This was the inaugural SDTI survey. Scores ranged from 12% to 75%, with an overall average score of 34%, and a median score of 31%. On average, JSE companies disclose only a third of the basic non-financial indicators necessary to measure non-financial performance. While this may seem shockingly low, it will serve as a baseline to look back at in years to come. If Rea’s survey has as much influence on the reporting industry as his previous GRI indicator survey did over the previous three years, we can look forward to a significant improvement in sustainability data transparency over the next few reporting periods.
Copies of the IRAS report can be obtained from the company’s website at www.iras.co.za
For full access to the SDTI database, enquire at email@example.com
Social media will ‘out’ your story
In the meantime, the writing is on the wall for corporate South Africa. More and more, influential stakeholders are reading company reports. Gone are the days when the PR agency could simply spin the good news story. Information is emerging, both from within, as well as from the spreading social media network, and it is laying bare the story of how well companies are dealing with the real issues that drive the value creation story. Four years ago, a dip in customer satisfaction with Toyota’s passenger vehicles severely reduced the company’s market share, wiping billions of dollars off its market value. The company was forced to completely transform its quality management systems, as well as its competitive customer experience’ score (from a survey run by Ipsos), before it could begin clawing back its customer goodwill and the reputation it had enjoyed for so long.
Indicators must promote real improvement
South Africa’s mining sector is in crisis. Mining companies cannot be accused of under spending on local economic development. Thousands of houses have been provided, roads surfaced, libraries and schools built, not to mention education and welfare programmes provided for mineworker families and their communities. But the Mining Charter only scores community consultation with a ‘yes/no’ tick-box. How can such a blunt reporting instrument contribute to the quality of management’s response to this vital issue?
Stakeholders, ranging from foreign investors to the South African public, now want to know how effectively all affected parties, labour, government and mine management are showing maturity of leadership in their engagement. And looking at the spend column, the other indicator on the Mining Charter scorecard, how effectively is the LED budget being spent on programmes with sustainable impact? These are issues that, being increasingly understood by all stakeholders, will demand far better measurement and reporting in the years to come. Of course, along with better measurement will come better management, ultimately leading, one hopes, to a more harmonious partnership between government, labour and industry.
Early adopters will endure
Annual reporting, spurred on by King III, entered a new era at the outset of this decade. As the IRAS report reveals, there are precious few early adopters that can truly count themselves as mature reporters. But those in the vanguard are without doubt showing their stakeholders that they have a leadership body that is prepared to face up to their challenges with maturity. By measuring company performance and sharing their strategic response, they are showing their stakeholders how capable they are of building their business relationships and resources, and trouncing their less responsive competitors.
Next time you read an annual report, take note of that glossy front section. There is revealed the quality of the management team in which you may have entrusted your hard-earned investment.
Originally published in the Sustainability Review (Issue 13: August 2013)
Published on the Trialogue Website: August 21st, 2013