Sustainable Investing: Q1 2015 Highlights

Sustainable Investing: Q1 2015 Highlights

Published on: April 2015

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Author

Scott Knight
Senior Portfolio Manager and Head of Research, Global Equities

Your spouse’s birthday is coming up and you search a few websites on your phone for two of your gift ideas. Sometime later on your tablet at home, in doing a totally unrelated search, you are suddenly inundated with ads for coffee grinders and e-readers. This is the new targeted advertising that has come with the continuing evolution of the internet. Search engine and social network providers are gathering information about you and your activities and then using that data to sell advertising space to the product or service providers that are most interested in trying to satisfy your needs. This all serves to influence an unwitting but apparently willing consumer. Exhibit 1 on the following page highlights some of the data being collected and used.

Exhibit 1
What Personal Data are Businesses Collecting?

Sources: Company websites, Addenda Capital

Rapid innovation has helped personal data become a source of value creation for many companies in the new economy. Revelations of some of the discomforting ways our data is being handled and used have brought data privacy into the public eye: data security breaches at retailers, companies undertaking psychological experiments on their users and mass surveillance by the National Security Agency (NSA) have all been in the news recently. How consumers and regulators think about privacy has been slow to catch up. This has allowed technology companies to take the initiative, collecting data and using it to target consumers. We attempt to address two key questions: 1) how should we, as investors, think about the internet and privacy? and 2) how can we manage the investment risks around these issues?

Consumer Interactions with Businesses are Changing

The internet and other digital technologies have enabled new businesses that are providing consumers with services through variations of the advertising supported business model that rely upon personal data. Three business models are shown in exhibit 2 on the following page (in simplified form), which illustrates how personal data is used.

In a traditional model the transaction is self evident – if you perceive a product or service to be worth at least as much to you as the price requested, you will buy it.

The advertising supported model is less transparent, but still easily and intuitively understood: The content provider produces content that is compelling enough for you to want to consume it (watch, read or listen to), to which they attach advertising. The more people they can entice to consume the content, the more they can charge advertisers to attach their advertising to it. Note that in this model, consumers decide which content they feel is worth consuming, and they are only served the ads directly associated with that content. The only personal data that consumers make available to advertisers is their willingness to consume that content. This may allow advertisers to understand their audience in aggregate, but there is no specific personal information being exchanged. The transaction here is to allow you access to content in exchange for exposure to advertising.

Moving to the new digital targeted advertising supported model, the internet company inserts themselves in the middle. Here the transaction has two main components: as a consumer you are again receiving access to content or services from the internet company in exchange for exposure to advertising but you are also providing your personal data to the internet company so that the advertising can be more precisely targeted to you specifically. The internet company “sells” that consumer to the advertisers each time content is displayed to maximize the value of that advertising space. Since the advertising can be disconnected from the content, you can be served with ads targeted specifically to you regardless of the content that you choose to consume.

Many multi-billion dollar businesses have been built on the exchange of personal data for access to content and services. Other companies continue to use more traditional fee for product or service models. Exhibit 3 provides examples of companies employing each business model and how much of their revenue is from advertising (targeted and untargeted).

Exhibit 3
Proportion of Revenue from Advertising Reported by Select Information Technology Companies
 

Sources: Company reports, Addenda Capital

Internet Privacy Concerns are Mounting

The use of digital technology has expanded quickly and privacy concerns are mounting for both individuals and businesses (see exhibit 4 on the following page). The number of individuals using the internet has expanded rapidly in recent years with more than 2.5 billion users in 2014, representing about 40% of individuals, up from about 1 billion ten years ago. Digital technology has enabled a broad variety of new devices and applications that make everyday tasks easier, more convenient, more interesting and more fun. Accompanying this expanded functionality is the collection of more and more data that is harvested from our phone calls, our emails, and our use of applications and websites. The increasing functionality and usage of smartphones has further expanded the breadth of data collected.

45% of Canadians think the benefits of being online do not outweigh any possible loss of privacy.

Exhibit 4
Examples of Privacy Concerns for Individuals and Businesses

Source: Addenda Capital

These new business models provide “free” services to drive as much usage as they can. Some offer additional applications specifically for the purpose of gathering more personal information from more users. This form of relationship, where the consumer is the product, not the customer, is not new – it is the same as our earlier advertising supported model. Where it differs is that the degree of targeting, and therefore the value of that advertising has increased greatly through the use of personal data. It does not address the question of whether that degree of targeting is appropriate or acceptable to those being targeted.

80% of Americans that use social networking sites say they are concerned about third parties like advertisers or businesses accessing the data they share on these sites.

Source: Pew Research Center

Sustainable Investing

We define “sustainable investing” as an investing approach that integrates consideration of environmental, social and governance (ESG) matters into investment and stewardship activities with the objective of enhancing long-term investment performance. Our approach is based on the evidence that disciplined and meticulous consideration of ESG issues can generate added value for our clients. Our approach has three key aspects: promoting sustainable financial markets, ESG integration (which is the focus of this article) and stewardship.

Evaluating the Sustainability of Relying upon Personal Data

Our approach to evaluating the sustainability of relying upon personal data takes into consideration the business model being employed and the nature of the relationship between the company and its consumers (as shown in exhibit 5 on the following page). As internet advertising is an area of rapid innovation, our approach is based on principles rather than rigid rules. Our principles include, for example, 1) personal data should be gathered only with the knowledge and consent of the consumer and 2) the potential uses of that personal data should be disclosed before the data is collected. Our principles are aligned with the privacy principles outlined in the Organization for Economic Cooperation and Development (OECD) 2013 Privacy Guidelines.

Exhibit 5
Framework for Evaluating the Sustainability of Relying upon Personal Data
 

Source: Addenda Capital

As these targeted advertising supported business models become more common, they compete with, and may prove disruptive to, traditional business models in the short term. These aspects of competition are part of the operating environment and must be taken into account when making investments in these areas. What about the longer term implications – what are the risks in these new models?

More restrictive regulation is likely and may be temporarily disruptive, but generally manageable for many of these companies. Governments and courts, as we have seen with the European Union, may take steps to try to protect consumer privacy which will force companies to clarify or change their privacy policies.

New data collection technology has provided new possibilities for surveillance by law enforcement and governments as well. The legality of some of these practices remains in flux as legislators and courts struggle to keep up. However, we have already seen concern from consumers about government access to their personal data. This concern about government access may be an early indicator of growing consumer concern about data privacy issues in general. If concern is growing, it would pose a larger threat for companies if it were focused on corporate use of private data in addition to government use.

Continued use of a company’s products or services depends on the perceived value (what a consumer gets) being greater than the perceived cost (what the consumer gives up to gain access). The perceived cost is complex and consists of three main parts: the monetary outlay (zero for many of these new digital business models); exposure to targeted and highly persistent advertising; and finally the loss of privacy inherent in the collection and exploitation of personal data. When consumers do not consider their privacy to have much value, then the decision to use a “free” online service is simple – if it’s interesting or convenient and the advertising is not overwhelming, then use it. Should consumers suddenly start to place a greater value on their privacy, the equation could change very quickly.

It is not necessary for consumers to isolate themselves in order to protect their privacy, but they can take into account the true privacy cost when making choices about which services to use. This can be as small as a change to opting out of cookies and other tracking programs, or to paying a nominal fee for competing services. With few barriers to entry, astute competitors and start- ups, sensing a change in consumer attitudes, may quickly rush in to fill any gaps. The example of MySpace’s fate at the hands of Facebook offers a clear example of how quickly the online landscape can change.

Facebook: “We intend to invest in additional products for marketers while continuing to balance our monetization objectives with our commitment to optimizing the user experience.” 10-K for 2013

Google: “The main focus of our advertising programs is to help businesses reach people in the moments that matter across all devices with smarter ads that are relevant to their intent and context, reflecting our commitment to constantly improve their overall web experience.” 10-K for 2013

Twitter: “Our users agree that we, and the third parties with whom we partner, may place targeted advertising on our products and services.” 10-K for 2013

Conclusion

Business practices related to the gathering and use of personal data are important considerations when investing in companies in the information technology sector. New business models that rely on personal data are giving rise to new privacy concerns that could hinder growth opportunities for these businesses in the future. Given the great opportunities afforded by developments in digital technology, we will continue to look for investment opportunities using our fundamental approach. This includes evaluating the sustainability of companies’ use of personal data. The ground continues to shift quickly in these areas and therefore our approach is fluid rather than drawing hard lines. We continue to prefer models that seek to deliver value to consumers by engaging with them on a positive and transparent basis.