THE BLOG
01/22/2015 12:47 pm ET Updated Mar 23, 2015

Prospering in Finance Without Cheating

There has been a distressing drumbeat of news about hedge fund firms using illegal means to gather insider information, or data about a company that the public is not yet aware of (think SAC Capital). Insider information can be a powerful advantage trading on the stock market, but also one that violates our securities laws. It is eternally mystifying why people put so much at risk to gather this kind of information, when so many steadfastly refuse to use all the information that is already out there. In particular, information on companies' sustainability profiles, or environmental, social and governance factors (ESG), can also give insights into future events. Anyone can gather this kind of information, but too few do.

The Brazilian company Petroleo Brasiliero S.A., known as Petrobras, saw a considerable increase in the amount of government control in 2010, and a change in the structure of the government's control over the company. This isn't necessarily an indicator of doom, but we at Pax thought that made the company's risk profile significantly worse -- so, we decided not to invest. That particular pigeon came home to roost at the end of December last year, when the Financial Times reported that the company was under investigation by Brazilian police, as well as the U.S. Securities and Exchange Commission, for former senior executives of the Rouseff administration siphoning billions of dollars from the company's contracts. The company's auditor, PwC, refused to sign off on its financials, which usually means that there's something deeply wrong in the company's accounts.

In the asset management business, we often talk of these business disasters as black swans, or tail risk. Those terms are used to connote the risk of an event that rarely happens, but has major implications -- bad ones -- when it does. It was apparent in 2010 that Petrobras might be sailing too near the wind, and in 2014 that ship ran into rocks. Sometimes the time between the warning signal and the disaster is much shorter: in mid-2011, we looked at the company Mead Johnson, which is a leading manufacturer of pediatric nutrition products. In 2010 and 2011, there were several cases of product recalls and safety violations in several of the company's product lines, indicating a company with outsize risk in product safety. Again, we decided not to invest. In December, just six months after our review, Walmart pulled a batch of the Mead Johnson's baby formula off the shelves after an infant who was fed the product died. Walmart dropping any product is news, and Mead Johnson's shares dropped 10 percent on this particular news.

Other black swans that could have been detected using ESG analysis include Tepco and Massey Energy; in both cases, the companies had long histories of significant safety problems that pointed to a much higher probability of a catastrophic failure.

The good news is that anyone with a web browser can gather this information. The tricky part is knowing which ones will turn into disasters, and distinguishing them from the false positives. Not every company with problems winds up having disasters. In the market, we tend to talk about long-term risk and short-term risk, and financial market participants are often criticized (quite appropriately, in most cases) for having the attention span of gnats. Anything that isn't likely to happen in the next year or two -- or five at most -- is considered long-term, and therefore not material to investment decision-making for today's portfolio. Investors often think of things like worker or product safety, rising seas and stronger storms due to climate change, or insider dominance of governance structures as being long-term risks, but they're not. Instead, they're what I call indeterminate-term risks. We don't know when they might happen, but we can recognize companies more likely to be vulnerable, just by using publicly available information.

Integrating ESG information into investment decision-making isn't infallible, any more than any other way of making investment decisions is. Sometimes companies look like they're cruising for a fall, and find ways to stay standing by repairing their problems, or just by being lucky. But the point is, the more we use all the information that gives insight into the quality of management, the more likely we are to be right, or at least to know when the black swans will fly.

The statements and opinions expressed are those of the author as of the date of this report. All information is historical and not indicative of future results and subject to change. This information is not a recommendation to buy or sell any security.