Understanding Management and Key Issues (4Q 2021)

A deep understanding of key issues facing a company provides us the credibility to engage with management and setter them toward ESG improvement and creation of shareholder value.

As long-term investors, fundamental bottom-up due diligence is the backbone of our approach to active ownership, and active ownership is a foundational principle of our approach to making ESG-integrated investment decisions. A deep understanding of all the key issues facing a company, ESG or otherwise, provides us the credibility to engage, challenge, and ultimately create an ongoing dialogue with management teams.

The nature and content of our discussions with company management varies, of course, with each unique situation. Nevertheless, our discussions with management typically have one or multiple of the following purposes in mind:

1. Test assumptions — once we have become knowledgeable of the company and industry, we test the assumptions of our investment thesis with company management. These conversations are intended to challenge and/or deepen our understanding of issues that we have identified as material, or potentially material, to the investment.

2. Maintain an informed dialogue — we seek meaningful discussions with management and heads of major business segments to stay apprised of strategic and operational decisions. We continuously evaluate whether any incremental information/company developments are consistent with long-term shareholder value creation, and the drivers of our investment thesis.

3. Advocacy — we advocate for decisions that we believe will enhance long-term shareholder value, with a responsibility to all constituencies. With increasing regularity, and as we demonstrate the thoroughness of our research, companies also proactively seek our input on a range of issues.

In some cases, our engagements with management teams play a heightened role, particularly when the ESG controversy itself has created the value opportunity. Integrating our assessment of the ESG controversy into our valuation work, and engaging with management to influence both the financial and ESG outcomes, can result in significant future upside.

As active owners, we also believe we have the potential to influence the decisions and trajectory of companies in which we invest. That is not to say engagement makes every company investable. Rather, our deep research and industry knowledge allow us to determine which companies have the potential for improvement, ESG or otherwise. When we decide to invest, we implicitly commit to engaging management teams, helping steer companies toward long-term shareholder value.

Example 1: Ford, American car manufacturer, B rated by MSCI

Ford Motor Company is the eighth largest automaker in the world with a history dating back to 1903. Headquartered in Dearborn, Michigan, the company primarily sells vehicles under the Ford and Lincoln brands and is best known for its F-Series pickup, which has been America’s best-selling vehicle for 40 straight years.

Our investment thesis for Ford was tied to the company’s restructuring plan and adoption of electric vehicles (EVs). At the point of investment, Ford had significant operational issues hindering profitability and was viewed as at-risk from a transition to EVs. We saw an opportunity for earnings improvement from a combination of redesign and cost controls, and a belief that the Ford brand would still be relevant as consumer preferences moved toward EVs.

Our conversations with management over our investment period led us to believe they were making all the right moves to position the business for higher margins, including discontinuing sedans in North America, focusing Europe on commercial vehicles, exiting unprofitable international geographies, getting warranty costs under control, and driving material cost improvements through de-contenting vehicles. Taken together, Ford’s restructuring initiatives would help the company achieve its margin goals by 2023 – a forecast that has recently become market consensus.

With the quickening pace of EV adoption, Ford had to further restructure the company and speed up its plans for EV development. While costs to transition the company are massive — Ford is forecasting $30B through 2025 – the real risk to Ford was not moving fast enough in its electrification transition. Retaining market share would become increasingly difficult the longer it delayed its EV transition.

Our engagements with senior management pushed for more clarity on Ford’s financial commitment and timeline for investing in EVs. We were supportive of CEO Jim Farley’s strategy to position Ford as a leader in electrification. To that end, Ford is targeting 40% of fleet volume sales to be electric by 2030 and has priced its recently announced F-150 Lightning electric truck on par with a comparable ICE version. The strength of Ford’s iconic models is likely to help it weather the transition successfully.

Ford’s current B rating from MSCI somewhat misrepresents its role in the electrification transition and takes a rather backward-looking view of Ford’s overall performance. While we do not discount the very real issues the company has to contend with, we remain confident in Ford’s ability to execute on its ongoing global redesign and plan for electrification.

Example 2: Hon Hai Precision Industry Co., Taiwanese multinational electronics contract manufacturer, BB rated by MSCI

Hon Hai is the world’s largest electronic manufacturing services (EMS) / original design manufacturer (ODM) company, providing a range of services from assembly to component and whole device manufacturing. Hon Hai leverages its scale, operational expertise, and proprietary technologies to maintain its leading position on existing and new technology platforms.

When we invested in Hon Hai, the company was just coming out of a series of social scandals related to worker suicides, significantly damaging its reputation. The seasonality and tight margins of the business appeared to drive a culture of long hours, tough working conditions, and relatively low pay. In response to investor and customer pressure, Hon Hai took action to improve labor practices. Nevertheless, we considered social issues a tail risk that we needed to continue to monitor.

More recently, Hon Hai was accused of using controversial Uighur labor. We took these allegations seriously and engaged with Hon Hai. In so doing, we could not find any evidence of complicity in the mistreatment of Uighur and other minorities inside and outside Xinjiang. Hon Hai, along with a wide range of manufacturers in China, was required to participate in the government’s ‘poverty alleviation’ program, and employed Uighur workers in its factories in the past. However, as the program generated significant controversy, Hon Hai told us they discontinued participation.

From a business perspective, ensuring a supply chain that meets international standard is critical to the long-term success of Hon Hai. For example, Hon Hai has been subject to inspection of its facilities and practices by customers, including Apple, for which it is a major supplier. Management has been focused on ensuring compliance with best practice operating standards, including a commitment to human rights and equal treatment of workers. We have advocated for increased transparency of reporting on these issues, and have been pleased to see incremental disclosure. We maintain an ongoing dialogue with the company on social issues.

Our view of the corporate governance foundation at Hon Hai has become more favorable since the largest and controlling shareholder stepped down as CEO and chairman. Under his leadership, we were concerned that capital allocation was not always in the best interests of long-term shareholders. We engaged extensively on this issue and are pleased with its increasingly prudent approach to capital allocation.

For all these reasons, we think that the future of ESG at Hon Hai is stronger than past incidents, as an ESG rating from MSCI oscillating between B and BB might also suggest. There is, of course, always room for improvement in the management of social issues for a company that relies on the mobilization of a large low-cost labor force. We will continue to engage to encourage the adoption of best practices, including further transparency and disclosure.