Socially Responsible Investment (SCI)

When companies make an investment decision the first thought that comes to mind is will it return a profit? However, many investors when investing now think about the social, environmental and ethical implications of their investment. This type of thinking has been given the name socially responsible investment (SRI) and is an ever increasing phenomenon.

Although investors take into account the social implications of their investment they do aim to make a return on their investment. Companies cannot just invest in projects because it’s nice and ethical. They have a responsibility to shareholders to maximize their returns. As many experts point out SRI will merely just be a niche market if SRI only seeks low returns.  

Research carried out by Bauer, Koedijk and Otten (2002) found that over a period from 1990-2001 looking at 103 German, US and UK mutual funds no significant difference was found between normal and SRI investments. This kind of research is promising to know and shareholders will be happy that they are investing in ethically sound companies while still returning a profit.

So, it will no longer do for a company to go quietly about its business. In these modern times when information is available so freely companies must show they are acting socially responsible. Even China is now starting to adopt SRI as it continues to conform to western business practices. SRI comes under the umbrella of corporate responsibility. Although, most companies enforce the view that they are ethically aware of their business practices there are still cases of misbehavior.

Such cases of misbehavior are regular occurrences in the news; with the most popular quoted case of unethical behavior being Primark. Receiving bad press for its use of child workers however, does not seem to have affected the chain too much. While some investors may now be deterred from investing in Primark others will not care. Fundamentally people have differing values across cultures and individuals have different values within cultures.

In a world where people are increasingly concerned with the environment and with how workers are treated SRI is only going to gain importance. Companies are increasingly incorporating ethical issues into their core strategies. In today’s world companies can no longer just think about maximizing profit they must also take into account the ethical implications of achieving returns on their investments.

Sources Used: bbc.co.uk, FT, Daily Mail, Bauer, Koedijk and Otten (2002). 

Credit Crunch!

Five years ago people were happy with a secure job and plenty of credit available to buy whatever their needs desired. Living in blissful harmony if you mentioned the word credit crunch people would have thought you were talking about some tasty new cereal.

O.K maybe the past seems a little better than what it was but compared today’s economy it was heaven!

Ahead of the budget next week Chancellor George Osborne has a difficult task coming up with a solution to end the UK’s economic plight. The UK has already been warned it could lose its AAA status within the next two years if it doesn’t sort out its public debt. There are also talks that the Chancellor may scrap the 50p tax rate. It would seem strange to give the rich a tax break when the average Joe is struggling to make ends meet. However, the argument for this is that if the rate is lowered more high earners will settle in the UK thus more tax will be raised offsetting the short term losses.

The UK economy is struggling like many of the world’s leading economies. The reason being it is still suffering the consequences of the credit crunch. The impact of the credit crunch has been so huge that in 2008 the term was accepted into the oxford English dictionary! For those of you who don’t know what is meant by a credit crunch, it is basically a severe shortage of money or credit available to lend.  

The start of the credit crunch has been pinpointed to the 9 August 2007 when BNP Paribas announced negative news causing a spike in the cost of credit. However, many people believe that the origin of the crisis which has unfolded in recent times can be traced back to the early 2000s. The dot com bubble had ended and terrorists had just attacked the twin towers, the world quite frankly was in disarray. To in store confidence back into business the US Federal Reserve slashed interest rates to just 1%. This meant credit was cheap and the economy thrived on cheap money. Banks could afford to lend cheaper and the low interest rates were carried on to the wider public through cheap mortgages. The problem was that the interest rates were held too low too long. It was not until 2004 that the US raised them unfortunately they rose too sharply and by 2006/2007 were above 5%.

This is where the problem really started and the credit crunch was about to hit home. The interest rates had been low and this meant that because more people had access to mortgages house prices began to rise due to the demand. The problem was that banks started to lend to people who they really shouldn’t have, they were undertaking subprime lending. The banks were lending to people who would have difficulty maintaining the repayment level. Due to the fact house prices were increasing, banks thought this was a safe idea. Unfortunately for them they were extremely wrong.

It was bad enough banks were lending these subprime mortgages but even worse was the fact they were trading them through collateral debt obligations (CDOs). I’ll try to explain what these are as simply as possible! Basically the mortgages the banks were lending were all bundled together. The mortgages were then given different risk classes such as AAA, BBB etc. known as tranches. The owners of the CDOs earned money from the interest mortgage owners paid each month. The riskier tranches obviously received higher interest because of the risk involved. They effectively got paid last after all the cash had been collected. The problem was that these riskier tranches were re-bundled into secondary CDOs. They were then given the same risk structure as the primary CDO. The problem being the risk structure was inaccurate. This meant investors were buying AAA tranches from the secondary CDO which should have in fact been rated as BB. When the housing market bubble burst in 2007/2008 people were unable to pay their mortgages. Therefore, owners of these CDOs at the bottom end unfortunately were not getting paid. Owners who thought they had an AAA CDO but didn’t, realised just what a mess they were about to face!

An explanation of CDOs can be better explained in the video below:

So that is how the credit crunch came about, over confidence and too much fiddling in the financial markets. Banks have gone bust, leading businesses have failed and unemployment seems to keep rising. Five years on from the credit crunch we are still living with its consequences. How long before things start to pick up again, who knows? America is showing signs of the recovery with employment improving and the dollar strengthening, however, only time will tell.

Sources Used: bbc.co.uk, youtube, FT 

Glencore and Xstrata – Will they won’t they?

In last week’s blog I touched on the fact companies carry out mergers and acquisitions as part of FDI. However, I did not go into too much detail about the benefits and drawbacks of such an activity. This blog will focus on such issues and discuss the case of Glencore International plc. and Xstrata plc.

Generally speaking it is well known that companies which acquire other companies lose money. So that begs the question why do companies go about doing such an activity when their aim should be to maximise shareholder value? It could be a number of reasons such as: Taking control of a key supplier, the quest for growth or getting quick access to a market.

The factors just described could also be reasons for mergers. Arnold (2008) however, sets out the following motives for why two companies may merge: Synergy, bargain buying, managerial motives and third party motives. Another factor to why companies may merge or acquire a company is hubris, another word for arrogance, it states managers may become over optimistic causing them to make errors. The fundamental principle of any merger and acquisition however, is: ‘Are we maximising shareholder wealth?’ If the answers no, then investors should be asking why not?

All over the news in the past few months has been the possible merger of Glencore and Xstrata. These two companies are leaders in the commodities market focusing primarily on non-renewable resources. If the companies do merge then we would describe it as a horizontal merger. Due to the fact the two companies are engaged in similar lines of activities. Mentioned in a previous post they both have their HQ’s in Barr, Switzerland and both chief executives are from South Africa. The merger sounds perfect yet the two companies are still trying to win over investors. 

Speculation of the possible merger began surfacing in early February and the share price for both companies shot up. The diagrams below show this. 

Glencore share price



Xstrata Share Price

 

However, since the speculation of a possible merger between the two companies came to the surface the share price has dropped suggesting that investors on both sides are clearly not happy. The official announcement of a possible merger was announced on the 7^th February. Glencore outline the nature of the merger below.

RECOMMENDED ALL-SHARE MERGER OF EQUALS OF

GLENCORE INTERNATIONAL PLC AND XSTRATA PLC

TO CREATE UNIQUE $90 BILLION NATURAL RESOURCES GROUP

The above statement states a merger of equals however; Xstrata earns almost double the EBITDA of Glencore at $6.4bn. This is somewhat surprising given Glencore’s revenue is over five times that of Xstrata standing at $186bn. Clearly Glencore is a bit more inefficient than Xstrata. If the merger takes place and the integration of the company’s goes smoothly then profits could sky rocket. Xstrata’s greater efficiency would help to turn Glencore’s massive revenues into more profit. A global mining and commodities powerhouse would be created.

Glencore has offered Xstrata shareholders a merger ratio of 2.8 New Glencore Shares for every Xstrata Share held. Clearly if it’s a merger of equals then why does Glencore have to pay such a premium? To the Xstrata shareholders however, they feel this figure undervalues the company and are therefore holding out. This is one of the fundamental problems with mergers and acquisitions. The agreement on the right price! The bidding company usually pays over the odds.

Will the merger of Xstrata and Glencore take place? Probably unless the regulatory bodies intervene seeing the merger as a limit of competition. Will the merger benefit shareholders? Time will tell. Hopefully increased profits will occur resulting in a higher share price and an increase in dividends. On the other hand the merger could turn out to be a disaster. Different attitudes and cultures could cause friction in the boardroom and with this will come failure.

Sources Used: Arnold: Corporate Financial management (2008), FT, The Guardian, http://www.glencore.com/, http://www.xstrata.com/, investopedia

FDI - The Good, The Bad and The Ugly

What is Foreign Direct Investment (FDI)? Moffet et al. explain it is the purchase of physical assets, such as a plant and equipment, in a foreign country, to be managed by the parent corporation. There are typically two ways a firm can go about implementing FDI. The first option can be through Greenfield investments and the second option is through merger and acquisition activity. The first type of investment is simply establishing a production or service facility starting from scratch from a green field. The latter describes how companies can opt to enter into a merger by combining their business entities under common ownership or opt to acquire a firm to gain access to a foreign market it wishes to invest in.

Of course with any kind of investment there are the pros and cons. For the country gaining FDI increased tax revenues will help contribute to their GDP. Employment and wages will increase and declining markets will be replaced. Human and technology transfer will occur with an improvement in infrastructure. For the firm investing the access to a new market offers the potential of new customers and greater profits thus maximising shareholder’s wealth.

On the negative side the domestic government may lose control in its efforts to attract FDI. MNEs are notably wealthier and more powerful than many countries. Take Proctor and Gamble for example, they state on their website that their market capitalization is greater than the GDP of many countries. They go on to say that with this stature comes both responsibility and opportunity. The opportunity is being able to influence governmental decisions. Another problem is that the benefits of FDI may only be felt by a small proportion of the nation. Especially if the FDI is in primary activities such as oil as there are little spill over effects. For the businesses investing there is the major risk of failure, thus losing the money invested. Market volatility, political issues and uncertainty help to reduce the success rates of FDI.

In order for FDI to be successful it needs to be a win/win situation benefiting both the MNC and the host country.

The good

FDI can be extremely successful when done right and I can’t write a blog on FDI without mentioning the case of Botswana and De Beers. De Beers is a family of companies that dominate the diamond mining, diamond trading and industrial diamond manufacturing sectors. In the 1970s they decided to invest in Botswana. The success was so great that over a period from 1970 to 2000 Botswana was the fastest growing economy in the world.

The bad

FDI can go badly wrong for the parent company; a classic example is the case of Enercon of Germany, one of the world’s biggest makers of wind turbines. The company has been in India since the mid-1990s however; in March 2011 it began experiencing problems. The company lost its entire Indian subsidiary, a major operation with annual sales of more than $566m. The reason was a dispute with its local partner and a run in with the Mumbai law enforcement authorities. The company then lost control of its patents in India and began to fear its technology would be copied in a country where wind energy is a growing market. Other companies also face problems from India in which joint ventures have to be entered into. RTT News says FDI in India fell 33% in December 2011.

The ugly

Things can get ugly when it comes to FDI. China is one country which in recent years has increased its FDI. The country is one of the main buyers of South Sudanese oil as well as the biggest investor in Sudan. Recently Chinese construction workers were returned by Sudanese Rebels after being kidnapped and held in captivity. This is one reason why companies tend to shy away from investing in countries such as Sudan which happen to need investment the most. Unfortunately FDI takes place the most between developing countries that need it least.

FDI can offer its advantages and when it comes good it’s great but there are also substantial risks. Therefore, companies play it safe by investing primarily in developed countries where there is less risk of kidnap!

Sources Used: Moffet et al. (2009), RTT News, FT.com