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How company diversity impacts financial performance

In this report we argue why paying attention to company diversity can yield value to investors. In short, we provide evidence that suggests 1) board and managerial diversity has a positive correlation to financial performance, 2) increasing regulatory requirements on diversity disclosures is set to drive the growth of diversity-based financial products, and 3) this will likely impact company valuations, as well as the ability for certain companies to raise capital.

DOES BOARD & MANAGEMENT DIVERSITY EQUAL FINANCIAL OUTPEFORMANCE?
Studies that we’ve found suggest so – particularly within national industry peer groups

A study by the MSCI found that companies with more diverse boards (3+ female directors over 3 years) and stronger labor management practices, experienced higher employee productivity growth compared to companies with a diverse board only, or strong labor management practices only. All 3 groups outperformed companies with both predominantly male boards and poor labor management practices – which have the lowest rates of employee productivity growth relative to industry peers.

In the 3 year time period of the study (2012-16), the average dividend payout ratios and return on equity figures were consistently higher for companies with 3+ women on their boards and stronger talent management practices, relative to companies with mostly male boards and lagging talent management practices.

Another study by McKinsey of 366 companies across the UK, Canada, the US and Latin America found those in the top quartile for ethnic/racial diversity were 35% more likely to have financial returns above their industry median. The top quartile for gender diversity are 15% more likely to have financial returns above their industry median.
Companies in the bottom quartile for both were more statistically likely to be laggards within their national industry group.

The study also found variations between country and industry. In the US, for example, a linear relationship exists between ethnic/racial diversity and better financial performance – having a much stronger impact than gender diversity and company performance. In the UK however, higher gender diversity on the executive team corresponds to the highest performance uplift in the global dataset.

The research suggests that there are 4 possible explanations for the correlation:

  1. Diversity leads to better decision making and innovation. A diverse mix of genders, ethnicities and career experiences have more diverse mindsets and are less likely to succumb to groupthink. They offer more problem-solving tools, broader thinking and better solutions. These companies are better positioned to identify opportunities for commercial growth and less likely to miss new threats to a company’s business model. Diversity at the leadership level is more likely to overcome biases through personal experience and act more inclusively. Through fostering a more communicative culture, employees feel more comfortable to voice unorthodox views and suggest creative solutions.
  2. Diversity better reflects an increasing heterogenous customer base. Women and minority groups are key consumer decision makers. In the UK, 80% of purchasing decisions are made by women. Companies with greater diversity will have a better understanding of their market and react more efficiently to shifting customer needs.
  3. Diversity can act as a proxy indicator for human capital quality – serving as an indicator of the attention companies pay to employee development and more formal career progression structures. Diversity also signals that a company is sourcing from a larger pool of talent. With skills shortages being reported across various markets, companies with more diverse leaders and better diversity management practices are able to attract and retain better talent.
  4. Diversity increases employee satisfaction. Higher levels of inclusion improves collaboration, strengthens loyalty and reduces conflicts between groups.
Increasing regulations on diversity disclosures could be a catalyst for ethically themed financial products

In 2017, the UK became the first country to introduce gender pay gap reporting for all organizations with more than 250+ employees. The reported figures drew public attention to gender pay gap differentials and diversity issues in the workplace. In 2018, the European Securities and Markets Authority announced that Europe’s largest companies will now have to report on their policies for achieving greater diversity on their boards.

The new rules have been compared to the 2015 Paris climate agreement, which facilitated the growth of environmentally-driven investments. Financial products that index companies based on diversity and equality criteria are still relatively niche, but have grown over the years. For example, State Street’s gender diversity fund and Pax Ellevate’s women’s index fund have reached a combined $540m.

Diversity disclosures and shifts in public opinion will likely influence share prices and a company’s ability to raise capital

Industry analysts claim that the growth of mandatory diversity reporting will have a tangible impact on investors’ stock analysis and influence capital allocation decisions. Reporting on diversity policies is designed to improve transparency, and ultimately informs the market of corporate governance practices across firms. A survey by New Financial in 2017 found that major US public pension schemes have been heavily focusing on diversity indicators.

A changing demographic landscape with more women entering the workforce, and the rise of social campaigns such as the #metoo movement, has drawn greater attention to diversity issues. Shifts in public opinion are considered to be a driving force for mandating diversity disclosures.

Public sentiment can often influence the brands that consumers buy from and the companies they work for – this has a material impact on earnings and the quality of a company’s human capital. Equileap, for example, reported in their 2018 survey that the number of companies with policies in place to combat sexual harassment had increased (this was particularly the case in North America). These findings suggest that recent publicity and advocacy around these issues is having an impact on gender-based violations in the workplace.

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Author

Julia Asri Meigh Senior Analyst (London)