New research from Rosenberg Equities suggests that diversity can act like a protective moat, enabling some highly-profitable firms to withstand competitive forces such as pricing competition and strains on talent retention better than their peers.  Our research shows that the level of board diversity is not only associated with better current financial outcomes, but may also be a predictor of a company’s ability to protect future profits.

Why? We believe that more diverse firms most likely have an advantage when it comes to problem solving, which is at the core of the fight against competition.  Specifically, that firms with more diverse leadership (defined as a Board Diversity score of over 20%, per Asset4) are better at developing strategies that act as a barrier to entry from competitors, counter the threat of substitution to the firms’ goods and services, and foster superior innovation.

Read more: Assessing diversity – A three step approach to finding an inclusive workplace

By looking at data of the 1,000 largest US companies between January 2005 and July 2017, we sought to add to the existing body of work that highlights the benefits of diversity, and extend it into the realm of future earnings.

We found three key things:

First, more diverse companies exhibited higher contemporaneous returns on equity, as shown in Exhibit 1. Importantly, not only were more diverse companies more profitable, the variability of that profitability was lower too. This was especially evident during the global financial crisis.

Source: Rosenberg Equities. The ‘US Market’ is the largest 1,000 US stocks in the Rosenberg Equities universe over the period of analysis. Profitability is defined as return on equity net extraordinary items (ROEX). Diversity segment is determined by Asset4 Board Diversity metric. Stocks within diversity segment are weighted using square-root-market-cap (SRMC). Please note that higher ROEX does not necessarily translate to higher stock returns.

Second, as highlighted in Exhibit 2, below, companies that were more diverse ‘today’ were also likely to be more profitable ‘tomorrow’, as measured over a one-year-forward horizon. Over the period analysed, the profitability advantage for more diverse firms was 3.5%, on average.

Source: Rosenberg Equities. The ‘US Market’ is the largest 1,000 US stocks in the Rosenberg Equities universe over period of analysis. Future Profitability is defined as one-year-forward return on equity net extraordinary items (ROEX). Diversity segment is determined by Asset4 Board Diversity metric. Stocks within diversity segment are weighted using square-root-market-cap (SRMC). Please note that higher forward ROEX does not necessarily translate to higher stock returns.

The third, and our key conclusion, is that board diversity may provide a ‘profitability moat’ to those firms that are already profitable and looking to keep competitive forces at bay.

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To measure whether or not diversity could act as a shock absorber, effectively nullifying some of the competitive pressures at work against profitable companies, we specifically looked at the top 25% of large US companies in terms of profitability. While all the companies in the top 25% faced considerable downward pressure on profits over the 12 months (as is only natural), those with higher diversity scores fared significantly better than those without. This is shown in Exhibit 3.

Source: Rosenberg Equities. Universe is the largest 1000 US stocks over the period of analysis. Profitability is defined as return on equity net extraordinary items (ROEX). The top quartile is defined by ranking on profitability then isolating top 25% of stocks, by market cap. Diversity segment is determined by Asset4 Board Diversity metric. Stocks within diversity segment are weighted using square-root-market-cap (SRMC). Averages are calculated over period January 2005 – July 2017.

At a sector level, the ‘higher diversity, higher moat ratio’ rule generally held true too, indicating that our findings were more than just the result of specific sector bias. The three exceptions to the rule are Finance, Healthcare, and Industrials, though the first two appear almost equal. In all other sectors, higher diversity names appeared less subject to reversion-to-the-mean pressures (i.e. they have higher moat ratios) than lower diversity companies. Interestingly, among the most profitable group, companies in the Transport, Consumer Discretionary and Technology sectors that had higher diversity also had a moat ratio of greater than one, indicating that future profitability was actually higher than the already high current profitability.

Read more: Diversity in-depth: An interview with McKinsey’s Dame Vivian Hunt

As investors, our interest in diversity, governance, and ESG generally is grounded in the relationships we have found between ESG concepts and the fundamental drivers of risk and reward in the equity market. And, for those of us committed to diversity in the workplace, these results support the idea that diversity is not just a ‘nice to have’; we believe it is instead a ‘must have’ in the face of intense market competition.

Read more: Does diversity provide a profitability moat?