Stockholm (NordSIP) – Several studies have shown already that board diversity and earnings quality or profitability have a positive correlation. In a new study, quantitative specialist AXA Rosenberg goes one step further and shows that diversity influences future profitability and reduces the effects of mean reversion in top performing companies. The team also finds explanations for this effect and put them into the traditional five-force strategic framework originally proposed by Harvard Business School Professor Michael Porter.
In a study published in June entitled “Does Diversity Provide a Profitability Moat?”, Srilatha Singh, Ph.D., Director, Earnings Forecast Models and Kathryn McDonald, Head of Sustainable Investing at Rosenberg Equities take a new look at how board diversity influences company profitability. They perform their own analysis based on data from the largest 1000 US companies over the period January 2005 to July 2017. The diversity element is based on Asset4’s board diversity variable, which assigns a percentage diversity score to companies based on gender diversity and/or evidence of foreign board members.
First, the study examines whether the companies that score the highest in diversity (top 20%) show higher profitability than the average, as well as those that have the 20% worst diversity scores, with profitability measured by the return on equity net extraordinary items (ROEX). Over the period under consideration, the researchers find that it is indeed the case: the average ROEX for top diversity companies is 22.7% (with a standard deviation of 1.2%), while the overall average ROEX for the 1000 companies is 19.9% (std. 1.5%) and those with the lowest diversity reach almost the same profitability level at 19.5% (std. 1.7%).
Second, the researchers asked if this profitability advantage remains one year on, and show that it is the case, again, with very similar profitability figures: the most diverse companies reach 22.7% (std. 1.5%), proving that historically, diversity has the procured a profitability advantage of 3% over the average, and 3.5% over the least diverse companies.
Finally, the report demonstrates that diversity can help create a profitability moat. It is hard for companies to stay at the top of their industry for long, and profitability tends to revert to the mean over time. In this context, a moat is an advantage that allows companies to maintain an advantage over thier competitors for longer than the rest of the market. The study shows that among the top ranking companies in terms of ROEX (top quartile), those that also rank high in diversity (top quintile) maintain a higher ROEX one year on than the average.
In an attempt to explain this advantage more diverse companies have to maintain their competitive position, the team looks at Porter’s five forces and point to those where previous studies have shown evidence of diversity effects. “Several studies have shown evidence of better problem solving (thanks to improved ‘collective intelligence’) among diverse teams – and problem solving is indeed at the core of the fight against the competition!” the authors say. “Specifically, we think it logical to assume that firms with more diverse strategic leadership are better able to create goods and services that engender brand and product loyalty, which may act as a barrier to entry for competitors. Similarly, more diverse companies may be able to stave off the substitution effect via consumer’s perception of product differentiation which, in the extreme, would lead consumers to believe that ‘there are no substitutes’.”
Last but not least, the authors find research from other that support the idea that diversity can reduce the threat of ‘Industry Rivalry’, through a superior capacity to innovate. Indeed, innovation is what helps companies maintain a competitive position, while those that tend to revert to the mean rest on their present success.
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