Future posts to SRINotes will be at this URL: http://sri.typepad.com
Thoughts and commentary on socially responsible investing.
Future posts to SRINotes will be at this URL: http://sri.typepad.com
One man everyone involved in SRI should pay attention to is David Swensen of Yale University. His performance has been exceptional - over the past 2o years the Yale Endowment's returns have been the best of any educational institution. His books, Pioneering Portfolio Management and Unconventional Success, are excellent. This has been accomplished despite at least some social constraints. Yale has an Advisory Committee on Investor Responsibility, and during the South Africa boycott the endowment divested its holdings in companies doing business in South Africa. Marc Gunther, a journalist at Fortune magazine and the author of the excellent Faith and Fortune, is also a Yale alum and has written this profile of Swensen for the Yale alumnae magazine. It includes commentary both on Yale's social investment policies, as well as those of other schools (notably Williams, which now has a 'Social Choice Fund' available). Swensen is not the only investor to achieve superb results despite social constraints. Sir John Templeton, widely regarded as one of the finest investors who ever lived, avoided alcohol, tobacco, and gambling stocks for religious reasons throughout his career.
I've had some questions about this December 14th press release from QED International, which states that social investors' aversion to vice industries has cost them returns. I'll start with my critical remarks, but I also have some positive comments (down near the bottom). Any time I hear about a study of historical returns, I have some basic questions: Question 1: Can I see the study? Answer: In this case the press release appears to be the study - there's no information on how to get a more detailed look at the work. LK Comment: There is a often a big gap between what the data shows and what the authors say it shows - if there's an underlying study it's good to have it. In this case we'll work from the press release, which is pretty detailed. Question 2: Has the study been reviewed by anyone else or is it likely to be published somewhere? Answer: There's no mention of a more thorough writeup, nor of any attempt to have the work reviewed or published somewhere. That doesn't mean it won't be, they just aren't telling you in the press release. LK Comment: It's a lot easier to write a press release than to publish an article in a refereed journal. Question 3: Does the study look at real portfolios, or backtests? Answer: Backtests (with the exception of Domini Index/ S&P 500 comparison). LK Comment: Hindsight is 20-20 - at any moment in time you can pick a group of stocks excluded by social investors that has performed well, and write an article about how social screens are costing investors money. (For some reason everyone wants to talk about tobacco lately but not about the auto companies, which social investors have also avoided and which have underperformed badly in recent years.) Anyway, the real test of an investment strategy is whether it works forwards, not backwards. The only analysis in the press release I could call prospective is the table at the bottom of page three. It shows their vice composite with a marginally higher estimated growth rate than the Value Line universe (9.7% vs. 9.3%), and slightly more attractive valuation ratios. Okay, that's a good point. Vice stocks are expected to grow a bit faster and look to be a little cheaper. Question 4: Do the numbers look ok? Answer: No. LK Comment: The table at the top of page 2 presenting Domini Social Index vs. the S&P 500 appears to be in error. It shows the Domini underperforming the S&P 500 for the 10 years ended September 30th, when KLD's 9/30 press release shows outperformance during that period. They show the Domini Social Index for the 10 years at an annualized 8.74%, while KLD reports 9.97%. I don't know, but I'll bet they used the Domini Social Equity Fund's performance instead of the underlying Domini Social Index, comparing a mutual fund with expenses to an index which has none. The QED press release claims the Domini Social Index is behind the S&P "for annualized periods of one, three, five, and ten years." But comparing index-to-index using KLD's reported returns, it looks like Domini is ahead on its ten-year record, about tied on its five-year record, and behind over just the past one- and three-year periods. Question 5: Are returns risk-adjusted or presented in the context of a risk model? Answer: No. LK Comment: Sometimes a study shows a significant performance difference between portfolios, but does not explain where the difference might come from. In fact, there's a well-developed literature on determinants of differences in portfolio return. The usual suspects are:
Jim Hoopes of Babson College, who teaches both History and Business Ethics, offers some additional comments on Economic Man: "The idea of rational economic man acting out of his self interest is often mistakenly attributed to Adam Smith and that wonderful 18th-century conception of a moral paradox in human society that allows private vices to become public virtues. So self-interest or, as I believe Smith called it, self-regard leads to the wealth of nations. "There's a passage in Smith's Wealth of Nations that touches on this:
It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves not to their humanity but to their self love, and never talk to them of our own necessities but of their advantages."What gets forgotten is that contrary to what one might think from the quote, Smith did not dispute the existence of "benevolence" but thought it a real force in human affairs as he made clear in his Theory of Moral Sentiments. In fact it was because of the limitations placed on the behavior of most people by their sentiment of benevolence that Smith believed freedom (including free markets) was morally justifiable. "People on average could be counted on not to be governed solely by self-regard and not to indulge in the utter ruthlessness that would result from single-minded attention to self-interest. Were it not for the sentiment of benevolence a moral society could not tolerate freedom but would require authoritarian princes, priests, etc."
In the spirit of the season (isn't it interesting that the biggest month in retail is driven by people buying things for other people?), here are some notes on altruism. Altruism and Economic Man The most persistent ideological argument against social investing is that altruism has no place in economic life. Society will work best, according to this argument, when everyone acts soley in their own economic self-interest. Leaving aside the question of whether you can be an altruist when you're not giving up returns (the historical experience of social investors), this boils down to a defense of Economic Man, the classical economic view of humans as self-interested profit-maximizers. Social investors risk wasting time and resources responding to this argument in all its forms - no matter how many times it is answered there will always be someone paid to make it one more time. But it is worth noting that Economic Man has plenty of respectable enemies, from Keynes to Richard Thaler to the Austrian School. An economic defense of social investing must be based on the idea that Economic Man is seriously incomplete. This is true on at least three levels:
PriceWaterhouseCoopers is putting some resources into looking at CSR reporting, here’s an article sent to a few of us at Domini Social Investments by the author, Ms. Alison Thomas. PwC’s ValueReporting team studied two groups of equity analysts – one with only "traditional" financial information, and another that also had CSR information. Although this study’s sample size was limited, the results are thought provoking, if not stunning. When provided with CSR information, analysts have more consistency in their estimates (the good news), however, their earnings and revenue forecasts are lower (bad news? maybe not, maybe more realistic?). The funny thing is that the group with CSR information, despite having lower forecasts, still issued more buy recommendations, perhaps suggesting more confidence in their analysis (more good news). This poses some important questions about how CSR information impacts traditional equity analysis. I have been a skeptic that it would be through altering the models used by analysts; e.g., the discounted cash flow methodology. Rather, my hunch is that it would be useful in providing analysts with more confidence in management’s growth strategy, for example. This study’s author put it best, "the fact that such sources of competitive advantage cannot be ‘valued’ does not mean that they cannot be ‘evaluated’."
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Boston College has been very active on the corporate social responsibility front through its Center for Corporate Citizenship. For the past 11 years, BC has awarded a prize for the best MBA paper on corporate citizenship. This year a Haas student won the prize - Douglas Young, for a paper on non-financial reporting by U.S. banks. An archive of recent award winners is here (under "Document Type" select "MBA Award Paper", then click "Go").
Moskowitz Prize judge Pietra Rivoli's new book, The Travels of a T-Shirt in the Global Economy, was one of six shortlisted for this year's FT/Goldman Sachs Business Book of the Year Award. Today's Financial Times includes an excerpt from the book and some quotes from Pietra (link here, but subscribers only...). Some other links:
If you have a financial background, I'd also strongly recommend the paper Pietra did with Georgetown colleague James Angel in 1997. There is a brief but good plain-English article on the study on page 5 of this issue of Georgetown Business magazine.
U.S. Chamber of Commerce President Tom Donohue will speak November 30th at the Wall Street Analyst Forum in New York (details here). According to an e-mail I received today, "Tom will challenge analysts, investors, and senior management to end the era of quarterly earnings guidance and the damaging short term outlook they encourage and instead move toward a system that more accurately values businesses and encourages long-term growth plans..." I point this out because short-termism is one of the recurring themes of this blog (it recurs here, here, and here...), and also because Donohue is no friend of social investors and governance activists (last year he criticized CalPERS for its activism and was on the receiving end of criticism as well). That Donohue and social investors see the same problem strongly suggests to me that it really is a problem.
If you a make a list of financial theorists who have 1) taken a long-term interest in social investing, 2) published numerous studies of SRI in refereed journals, and 3) engaged social investors constructively about their work, you basically get one name: Meir Statman. Since he won the Honorable Mention in this year's Moskowitz Prize competition and headlined the Journal of Investing special SRI issue with a different article, I thought I'd provide a little additional background on him and his work. Here are his studies that bear directly on SRI:
This speech by Wal-Mart President and CEO Lee Scott is drawing a lot attention from social researchers. Wal-Mart, of course, has been involved in many controversies, and is not currently represented in (for example) the Domini or Calvert social indexes. But the speech is notable for its ambition, its scope, and its detailed analysis. A brief excerpt: "Our environmental goals at Wal-Mart are simple and straightforward:
Can't be much clearer, or more ambitious, than that. Scott makes the business case for these goals, pointing out that all waste has a cost.
Although my instinct is to look at deeds vs. words, I have to say that the speech strikes me as more than a PR piece. On first reading it looks like the beginning of a meaningful effort by the company to address some difficult issues.
Others are not so impressed: Op-Ed columnist Harold Meyerson of the Washington Post offers this harsh critique of the speech and its context.
[10/27 Update: There is additional news on this today.]
I just got a note from Donald Siegel, a professor of Economics at Rensselaer Polytechnic Institute (RPI) and longtime researcher in the field of social responsibility. He and his colleagues have put the finishing touches on a special social responsibility issue of the journal Structural Change and Economic Dynamics. You can download copies of the papers here (subscription required, however). The first paper, by Paton and Siegel, summarizes the other papers in the issue. I first ran into Donald Siegel's work on corporate social responsibility in the 1990s when he and Abagail McWilliams were terrorizing researchers who, by misusing event study techniques, were reporting implausible relationships between social factors and stock prices. Their careful analysis showed that many impressive-looking studies needed to be reassessed, often reducing or eliminating claimed social impacts. Since then Dr. Siegel has played the role of informed skeptic, advocating a pragmatic theoretical view of the relationship between social responsibility and financial results. This paper provides an excellent overview of work he and McWilliams have done on social responsibility over the past 10 years. I have said in the past that to remain relevant social investors need more and better positive critics. Dr. Siegel is one of a small group of strong academics who have been willing to play that role.
I've written before about the short time horizons prevalent today. Now there is a study suggesting that the best traders are likely to be, well, psychopaths. This brings many thoughts to mind. It certainly is consistent with the increased use of computers in finance, especially for shorter-term trading. We've seen a parallel in chess, where computers can now beat the best grandmasters (although a computer plus a human is stronger than either alone). But I cannot shake the feeling that we are getting it wrong. Capital allocation is one of the most important tasks in our society. I find it hard to believe that a group of psychopaths operating on a short time horizon are going to do it in the best possible way.
I had several calls yesterday on Steven Pearlstein's Washington Post piece on social responsibility. I think the article is a solid and accurate one, written by someone who has obviously done some homework. (I should note here that Pearlstein praises Haas professor David Vogel's new book). That said, I think Pearlstein misses some important aspects of the question. Much of the article frames the question as an ideological one. A picture of Ben Cohen, a mention of Milton Friedman - that's fine, and certainly shows the philosophical side of the debate. But the question of whether social responsibility has financial impacts is an empirically testable proposition. And it has been tested. The most comprehensive work so far is Marc Orlitzky's meta-analysis (full study is here). Orlitzky finds a statistically significant positive effect, although it is much stronger at the firm level than at the stock market level. His analysis is the largest and most statistically sophisticated attack on the question to date, and one of only a very few directly addressing questions of publication effects and causality (does social responsibility drive business performance, or is it the other way around?) . Other recent studies like Tsoutsoura's find positive associations as well. There are virtually no studies showing that social responsibility hurts companies financially. Economist Arthur Laffer recently released a study intended to take the other side. Although touted as a refutation, if you read the actual study it finds "there is no correlation between how well a firm performs its traditional business roles and where it is ranked in the Business Ethics survey." That is to say, they couldn't find a cost either. But Laffer makes one point I strongly agree with. "Future efforts to evaluate the effect of CSR initiatives on profitability," he argues, "should be careful to tease out the specific financial impact of CSR initiatives..." In other word, let's narrow the focus and get specific about issues. Orlitzky argues, and successfully shows, in my opinion, that the concept of social responsibility can be expressed statistically. But it is still a very broad definition. Like Laffer, I would much rather zoom in on specific variables. Doing so will not bring much comfort to critics of corporate social responsibility, however. Mr Pearlstein, here are some people you should consider calling:
I had the pleasure last night of presenting the 2005 Moskowitz Prize to Nadja Guenster of Erasmus University in the Netherlands, who accepted on behalf of her three co-authors. (Official announcement is here.) Nadja gave a great presentation on the study this morning at the SRI in the Rockies conference in Snowbird, Utah. Here is my abstract of the study, and the full text is available here. If you are interested in the financial impact of environmental and sustainability practices, I think it is fair to say that this is a must-read. We have seen several studies showing environmental alpha in recent years, most recently Derwall(2005). But until now no one had really explained how or why this was happening. Nadja's piece is careful, thorough, and full of good judgments about methodology and data. Congratulations also to Meir Statman, who received an Honorable Mention for his article on socially responsible indexes. Meir is having a good year, as he also is headlining the just-released Journal of Investing special issue with a different piece on SRI.
The latest The Journal of Investing is a special issue dedicated entirely to socially responsible investing. If you have an interest in SRI, this is closest you are going to get to a full academic treatise on the topic. I had seen some of the articles before they went in, and they looked very strong. I'm very happy to see an article on Islamic indexes, an area that has received hardly any attention. A full table of contents is here.
Socialfunds, the leading SRI news service, now has an RSS feed. If you use an application like Bloglines to pull together your blog reading, you can now include the Socialfunds news feed. I also want to put in a plug for Philosophy Talk, the radio program that questions "everything... except your intelligence." Their blog is here.
I recommend you check out Direct Relief, based in Santa Barbara, California. This charity, operating out of a single warehouse, provides free emergency medical supplies to health organizations around the world. The American Red Cross and Doctors Without Borders are also organizations that deserve your support.
CrainsDetroit has an excellent article on ShoreBank's involvement in helping Detroit recover from what must be considered the worst urban planning disaster in American history. If you live on the coasts it's hard to conceive of what has been happening in Detroit. AFP reports that there are over 12,000 abandoned homes, and a vacated area the size of San Francisco. An online tour of the ruins of Detroit is here.
A strong challenge to responsible business behavior comes from recent work in game theory. Modern game theory is scary stuff - researchers run complex simulations in which altruistic and selfish actors compete with one another. The normative has no role here - the best strategy wins, ethical or unethical, socially responsible or not. The results are not encouraging. The good guys usually don't win. Here's one example: For 20 years researchers have held a competition to identify the best strategy for winning a form of the Iterated Prisoner's Dilemma. For many years the champion was the decidedly amoral "Tit-for-Tat". Under this strategy the actor cooperates on the first time, then reviews the behavior of its competitor. If the competitor cooperates, the actor continues to cooperate. But if the competitor cheats, the actor switches strategies and starts cheating, too. (What happens to actors who always cooperate? They lose.) In 2004 "Tit-for-Tat" was finally de-throned, by Southampton, a strategy that introduces collaborative cheating. Crime was, in effect, replaced with organized crime. This is just one example in a complex field, but the more of this stuff I look at, the more I fear that ethics is in danger of becoming a quaint artifact, a relic of a simpler time. This article on business school students suggests that this is not an idle concern. We can't all be cheaters, can we? Maybe not, but perhaps there is some equilibrium level of cheating in our society. Colman and Wilson (1997) did a very interesting game theory analysis showing that amoral behavior (sociopathy) could evolve as a survival strategy, but also suggesting that that there are limits on how many sociopaths are likely to be in a population. The Lotka-Volterra equation, also known as the predator-prey equations, may also have something to say about this. This mathematical analysis describes the dynamics of the populations of a predator species (e.g., lynx), and their prey (e.g., snowshoe hare). But it needn't describe just animals - with a little tweaking it could describe thieves and honest citizens as well. If you think of it that way, you see a couple of interesting things right away. First, an equilibrium tends to set in, and the populations oscillate around equilibrium levels unless something disrupts the equation. Second, it is possible, in some versions of the problem, for the predators to wipe out the prey and then die off, resulting in total extinction for both species. That may seem apocalyptic, but there are certainly human societies where criminal behavior becomes so rampant that there is little incentive to pursue honest labor. Interestingly, markets seem to know when a society has crossed this threshold. In a study that won the 2003 Moskowitz Prize, Charles Lee and David Ng of Cornell University showed that companies in more corrupt countries receive lower valuations from the market. So, people and markets are a little smarter than the models would suggest. Think of what sets humans apart from other species: are we stronger, faster, or gifted with superior senses than other species? No. But we are intelligent, social, and able to communicate with one another in great detail. We can use these capabilities to collaborate to our mutual benefit. Businesses and financiers who forget this do so at their peril.
Starting today, this blog will be affiliated with the Center for Responsible Business at the Haas School of Business, University of California, Berkeley. A full press release on this event, which also covers sristudies.org and the Moskowitz Prize, is here. I believe this is the first time a top 10 business school has formally acknowledged socially responsible investing as a key area of research. Thanks to Kellie McElhaney at the Center for Responsible Business for making this a reality.
Social investors are not the only ones concerned about Wall Street's increasingly short-term outlook. Alfred Rappaport of Northwestern's Kellogg School of Management has written an interesting article on short-termism. Rappaport is one of the foremost teachers of discounted cash flow analysis (he wrote the book), but finds in his review of the literature that its use is limited. Instead, investors seem to prefer earnings-based indicators, like P/E and earnings surprise. He believes the "root cause of recent corporate scandals [is] the widespread obsession with short-term performance. There is no greater impediment to good corporate governance and long-term value creation than earning obsession." It is a remarkable state of affairs when economists like Cameron Hepburn argue that DCF analysis is too short term-oriented, at the same time the chief proponent of DCF says it is under-used because it is not short-term enough! What everyone seems to agree on is that Wall Street's concern is with the next 20 minutes. If you're looking for someone to worry about the next 20 years, you've come to the wrong place. Today I read a similar sentiment from a very different source. Terrence Deal and Allan Kennedy wrote the influential Corporate Cultures in the early 80's, and updated their work with The New Corporate Cultures, which came out in 2000. The latter book ends with this comment: "We are optimistic enough to think that we may be nearing the end of a cycle emphasizing the short term over the long term and shareholders over all other valid claimants for their share of the corporate pie. As this troublesome cycle abates, management decisions will show more balance, shaking off some of the recent excesses."
One longstanding concern of mine has been that Wall Street and most investors focus on the short-term, while social and environmental issues typically play out over long (sometimes multigenerational) time horizons. It's hard to believe that analytical techniques that are designed for short-term trading will be equally optimal for long-term decision-making. It turns out that there is a growing academic debate around this question, particularly over the use of discount rates. The process of discounting has been cricized by some as understating the value of future environmental cleanups and other socially beneficial activities. Martin Weitzman, a professor of Economics at Harvard, has said "to think about the distant future in terms of standard discounting is to have an uneasy intuitive feeling that something is wrong somewhere." This documentary on the BBC's Radio 4 does a nice job outlining the issues. Pay particular attention to the comments of economist Cameron Hepburn. I'm not usually a fan of theoretical economics, but this stuff is really good - Hepburn co-authored a very interesting paper on this that is worth looking at.
Jim Collins has detailed the dangers of superstar CEO in his excellent management book Good to Great. Now a new study by Ulrike Malmendier of Stanford and Geoffrey Tate of Wharton provides a ton of color and interesting detail around this phenomenon. They find that superstar CEOs tend to have subpar performance (more than would be expected from mere mean-reversion), and that the worst situations are those where governance is weak. These guys are serious - their regressions include a variable for whether the CEO was writing a book at the time! Someone should cross-reference this with the social/sustainability ratings. I've beaten this to death already, but I'll bet that superstar CEOs underperform on social as well as financial metrics.
And interesting article this week questions whether the government could afford to indict one of the remaining Big Four firms. If KPMG (which has already admitted culpability in a major tax case) were indicted and (inevitably) fired by most clients, who would replace them? Here are two choice quotes:
Of course the minute I write a note saying the sell side will never do much social responsibility research, Merrill Lynch comes out with a new report on clean cars, prepared in cooperation with the World Resources Institute.
A good, tough question from a conference I attended Friday. Since we have an established infrastructure to track corporate financial performance (the accounting profession) and investment characteristics (Wall Street), why not let them handle corporate social responsibility reporting? After all, the accountants and Street analysts probably know the company better than anyone else. It's a thought-provoking question. Why do we need all this CSR infrastructure? But if you think about it, I don't think CSR reporting can be handled by accountants and analysts. Let's take them in turn. Accounting Instead of GAAP, we could have GASP (Generally Accepted Social Procedures). Just as accounting firms have broadened their brief to include Sarbanes-Oxley, they could also pick up the social reporting requirements as well. Here are my objections:
So maybe the accountants are busy with other things. What about Wall Street? Surely they have the broad-based business knowledge and systems to facilitate social responsibility reporting?
By Wall Street I mean the 'sell side' of the investment business, the brokerage firms and investment banks. These organizations are incredible repositories of knowledge about specific businesses and industries. Want to know more about the EVP in charge of a company's largest division? The one person who can probably give you that color, and more besides, is a sell-side analyst. There have been superb individual reports from sell-siders on CSR issues. When I worked for KLD in the early 1990s the single best source of environmental information on Dupont was an extraordinarily thorough sell-side report. And I would single out Amar Gill's piece on corporate governance in developing countries as one of the best CSR reports I have seen from any source.
But I think reports like Gill's will be the exception rather than the rule, for three reasons:
Given where its incentives are, I seriously doubt if Wall Street will ever play more than a peripheral role in corporate social responsibility.
I was pleasantly surprised to see FAJ publish this piece on the portfolio management implications (via backtesting) of using Innovest ratings. "The Eco-Efficiency Premium Puzzle" (Derwall, Guenster, Bauer, and Koedijk) is another decent article to contribute to our growing body of literature showing the legitimacy of using non-traditional data in stock picking. Moreover, I think the authors are correct is raising the possibility of "mispricing" based on the degree of outperformance and their use of a multifactor model to control for several traditional financial factors. Here's the abstract: Does socially responsible investing (SRI) lead to inferior or superior portfolio performance? This study focused on the concept of "eco-efficiency," which can be thought of as the economic value a company creates relative to the waste it generates, and found that SRI produced superior performance. Based on Innovest Strategic Value Advisors' corporate eco-efficiency scores, the study constructed and evaluated two equity portfolios that differed in eco-efficiency. The high-ranked portfolio provided substantially higher average returns than its low-ranked counterpart over the 1995–2003 period. This performance differential could not be explained by differences in market sensitivity, investment style, or industry-specific factors. Moreover, the results remained significant for all levels of transaction costs, suggesting that the incremental benefits of SRI can be substantial.
Not really a secret as it moves up the best-seller lists, but Freakonomics deserves the praise it's received. At least two chapters - one on the finances of a Chicago crack gang, the other an account of the rise and fall of the Ku Klux Klan - could be books themselves. The praise is not unanimous. Some economists have criticized Levitt's methods as imprecise or worse. Salon complains that he doesn't offer solutions to the problems he identifies. For my own part, I can't say I'm comfortable with the breathless attempts to turn him into a celebrity. And the title is...not good. But Levitt's work is very important to social investing. Several of his studies demonstrate that cheating pays in some professions. And he has pioneered analytical techniques (mainly of question framing) that make it possible to detect cheaters in situations you might not have expected. Social investors would do well to borrow some of those tricks. And yes, there is a blog. Levitt and co-author Dubner helpfully give a list of their negative reviews here.
I read your entry “Nice update on the performance debate” in your SRI blog. One comment to your reasoning for why there will never be a final answer to whether SRI outperforms the overall market:
Isn't there a possibility that as we speak (or some time in the future) when investors observe the potential gain from investing in social responsible firms they will invest to the degree where the social responsible firms only generate an average profit.
I would draw the comparison to the diminishing "January-effect" we've seen in financial markets lately. Could investors learn about the SRI effect the same way, and in turn, make future SRI-studies show no superprofit for social responsible firms?
Hi there, I personally believe that the effect you suggest has already happened to some degree. If there were a consistent, reliable SRI effect, it would almost certainly attract the attention of investors. With large mutual funds and even SRI hedge funds out there, it's hard to argue that no one in markets is paying attention to this possibility. There is a little hard evidence that investors are bidding up socially responsible stocks. If you look at Marc Orlitzky's study, you'll see that social responsibility correlated more strongly with accounting-based measures of performance than with market-based measures. That strongly implies that the market is already discounting some of the benefit of social responsibility by corporations. Dowell, Hart and Yeung also show evidence that environmental policies are incorporated into the structure of global price/book ratios. If that's right, it means the market is already bidding up stocks likely to have superior environmental performance. Investors buying those stocks at higher valuations, anticipating an environmental return, may be disappointed. One final thought. 15 years ago, when we started the Domini Social Index, I ran an analysis showing that its P/E was attractive relative to its reinvestment rate when compared with the S&P (you can find the math in Chapter #25 of The Social Investment Almanac). If you repeat that same analysis today, the Domini Social Index does not have the same advantage. So the idea that there was a positive effect, but investors have caught on to it, is not unfounded. Hope that's helpful. - LK
Over the past eighteen months, energy stocks have taken over the market. Here is a chart of the performance of the Amex Oil Index vs. the S&P 500: Not coincidentally, several social indexes have lagged the S&P 500 over this period. The broad-based social indexes typically hold 1-3% of their investments in energy stocks, far less than the 7% or so held by the S&P 500. The oil sensitivity of the social indexes has not been a secret - Dan Dibartolomeo and I wrote about it in a Journal of Investing article in 1996. But in those days the energy sector was delivering indifferent performance, giving social indexes a performance boost. Today that dynamic is working in reverse. An analyst at Goldman Sachs has famously predicted that oil could reach $105 a barrel. Performance-minded investors in social indexes should hope it doesn't. But isn't that a little odd? From an environmental perspective, higher oil prices would probably be beneficial: expensive energy encourages conservation and the development of alternative fuels. This is one instance where active investors may have an advantage over passive ones. An active manager can choose to manage this risk by buying more energy stocks - an unmanaged index can't.
Jeff makes the point that when you see one of these corporate disasters, there's usually an executive pay issue lurking in the background. If I had to pick one indicator of the strength of a company's corporate governance, it would be executive pay, simply because it's where the temptation is greatest. For many years Graef Crystal was a voice in the wilderness on this issue, but now mainstream academics are documenting some of his claims. In November Lucian Bebchuk of Harvard Law School and Jesse Fried of Boalt published a book version of their academic work on executive pay. Like Crystal, they find that levels of executive pay don't correlate with observable measures of performance. They also find a trend of rising pay as a percentage of earnings: They calculate the top five executives at the average company got pay equal to 4.8% of earnings in 1993-1995. By 2001-2003 that figure had more than doubled, to 10.3%. They have also written a paper criticizing Raines's pay at Fannie Mae. Since Fannnie Mae is a large holding for social investors (#22 in the Domini Fund, #7 in KLD Social Select), this should be more than a passing concern. I'm voting proxies at the moment and see plenty of resolutions on executive pay, but they usually have significant flaws. Many are overly prescriptive or punitive, others would be easily circumvented. Governance experts and social investors need a better plan for dealing with this important issue. The Christian Science Monitor has an interesting article on this, including some commentary on Calvert's recent initiatives, here.
Maybe a lot, according to a new book by Kurt Eichenwald. He argues that Skilling and Lay may not have committed crimes, although Fastow almost certainly did. One reviewer comments:
OK, the reviewer's Henry Blodget, who brings his own...perspective...on that era. But I think the point is well-taken. Understanding exactly what happened at Enron is really important. The name has become synonymous with corporate malfeasance and anyone who ever touched the company has been tarnished (ask Paul Krugman). But hardly anyone can tell you what really caused the collapse. Blodget correctly notes that it wasn't the executive pay or the corporate jet. My take is that the company's senior management confused its business with its stock price - or perhaps more accurately, they made the stock price the company business. With their balance sheet massively levered to the stock, a significant correction turned into a fatal liquidity trap. Blodget says Fastow, incredibly, did not even have a debt maturity sheet. It probably would have been helpful, as things got out of hand, to know exactly how much money the company owed and when it was due. Another interesting review of the book is here.
Enron's executives made mistakes, and some committed serious crimes, but today's near-universal depiction of the company as a gang of evil crooks obscures the most important lesson of the saga: The differences between Enron and today's corporate success stories are smaller and more complex than they seem... Eichenwald's Enron, in other words, was neither a teeming hive of crooks, nor, equally ludicrous, a convent of gentle innocents mugged by senior management thieves. Rather, it was a Petri dish designed to nourish hyper-growth, for better and for worse. In Enron's fast and loose culture, engineered by Skilling, blessed by Lay, revenue producers were deified and managers stiffed. Finance and accounting were transformed from bean-counting functions to profit centers (a terrible idea). Business development executives were paid not on value created but on contracts signed, with execution left to dull managerial types. In the 1990s, with the economy and stock-market booming, this culture allowed the company to vault from being an obscure operator of gas pipelines to a global trading powerhouse. It also created a testosterone-charged, me-first atmosphere in which mistakes, risks, and early-warning signs were trampled in a hungry stampede. But these problems affect other companies, too, especially during a boom. So even with this potent fuel, Enron needed a catalyst to become a fireball. As Eichenwald tells it, his name was Andy Fastow...
Having already sung his praises, just a note to let you know Steven Lydenberg is now a contributor.
Here are some blogs I've found useful, some SRI-related and some not. One good way to organize your blog reading is bloglines.com, which also allows convenient access to news services like the BBC.
Jeff MacDonagh, the third of our triumvirate of social researchers, joins the blog. Jeff is a portfolio manager for socially responsible investors at Loring Wolcott & Coolidge Office and holds the CFA designation. Like Paul Hilton and Steve Lippman, he is an organizer and member of the Social Investment Forum's Social Investment Research Analyst Network. According to his bio, "in his former life, he invented a new energy efficient lighting technology. Jeff grew up in Midland, Michigan, home of Dow Chemical, where the acrid smell of chemical plants was celebrated as progress." Welcome, Jeff!
I had breakfast this morning with Steven Lydenberg, my boss when I worked at KLD and now the Chief Investment Officer for Domini Social Investments. It's hard to overstate Steve's importance to social investing. He was arguably the first person to make a full career of social research on corporations. Over the years he played leadership roles in social research at the Council on Economic Priorities, Trillium, KLD, and now Domini. If you pick a moment in Steve's career and look at what he was doing, you usually see that: 1) he was one of only a few people doing it; 2) it was something everyone in SRI was doing a few years later. When Steven started work on the Domini Social Index there were no broad-based equity benchmarks for social investors. Today there are at least a dozen. Dylan Thomas once said of Thomas Hardy's poems that people should "read all of it, the whole damn lot," and I feel the same way about Steve's writing on social research. It's all good. Go onto Amazon and pick up a used copy of his Rating America's Corporate Conscience. Read his chapter in the 1992 Social Investment Almanac. Take a look at Investing for Good, which he co-authored with Amy Domini and Peter Kinder. But first read his new book, Corporations and the Public Interest: Guiding the Invisible Hand. "I think Hawley and Williams are really onto something with their Universal Owner concept," Steve says as we eat. "We have to think about the broader impacts of corporate behavior. Adam Smith said poor countries have very profitable companies. He meant there's not enough competition to drive innovation. He called them 'monopolies at the expense of their countrymen.' "There's been a secular shift in our society to corporations since at least the 1980s. The pendulum has been swinging away from government, and now governments feel maybe it's swung too far. Tony Blair has a Minister of Social Responsibility. France requires social disclosures on corporate financial statements. Uruguay has passed a constitutional amendment that forbids privatization of water. Even the Wall Street Journal editorial page says 'markets need adult supervision.' "And that creates a dilemma - how do you do that? How do you direct corporations to the public interest? We need new vocabulary to do that, new data. And I think SRI can bring great value to universal investors. We can bring fresh perspectives to risk, intangible assets, and wealth creation. "Social investors have a lot to say about risk, especially long-term risk, because we're used to looking at things the mainstream is resistant to examining. Asbestos, tobacco, global warming: social investors were talking about these things long before the mainstream took notice. We need to take that forward, look at risks, and try to quantify the true costs to society of these activities. "Investment in all stakeholders creates an intangible asset, but the mainstream doesn't know how to value it. Look at the study Epstein and Schnietz did of the market impact of the WTO protests. There's value to a good corporate reputation, even if the market doesn't always reflect it. "And social initiatives can create value. Jed Emerson's blended value concept is a really useful way to think about it. "I think those are the things that will bring social investment more into the mainstream. The pieces are on the table, but they still have to be sorted out and assembled. That's the work we have ahead of us."
Steve Lippman, the senior analyst on Trillium's Social Research and Advocacy Team, has joined. Like Paul Hilton, Steve is part of a new generation of social researchers who are helping take SRI to the next level. Corporate social research for investors has historically been done by a relatively small cadre of people, and as recently as the early 90's there were no more than a dozen people who were able to make a career of it. Today there are probably hundreds, and social research is taking on the hallmarks of a profession in its own right. Grist magazine recently interviewed Steve - you can read it here. Welcome Steve!
No author is credited, but there is a concise and balanced review of recent evidence on SRI performance at the website of Phillips, Hager & North, a Canadian investment firm. In addition to the more widely-known evidence, they cite several Canadian studies I hadn't seen, and reach the usual conclusion that no cost to SRI has been observed. But the anonymous writer finishes with an important point:
"The question of whether or not SRI reduces investment returns will never be laid to rest. One reason is that this is a difficult empirical question and there will always be legitimate disputes over the quality of the data and the most appropriate methodology to use. Perhaps more importantly, this question will never be answered to everyone's satisfaction because many of the people engaged in this debate carry with them strong ideological baggage. Opponents of SRI are so against the notion of anything other than financial factors affecting the value of a security that, in their view, 'hell will freeze over' before they accept that this is not the case. Likewise, some proponents of SRI are so steeped in their own moral superiority that they cannot fathom the possibility that the integration of social and environmental factors does not have a beneficial effect on investment returns. The challenge for the rest of us is to ignore the rhetorical noise emanating from these extreme views and focus on the facts."There's one other reason why we'll never have a final answer - the social screens themselves change over time. When the Domini Index was first developed in the late 1980s, South Africa was a key issue. In the early 1990s the emphasis shifted to the environment. Later on international labor standards moved to the forefront, and then corporate governance. So even if the ideological noise could be set entirely aside, we still would never have a final answer. This is a familiar problem in finance. A physicist friend once told me that physicists tend to have a hard time on Wall Street. "Gravity has worked the same way for millions of years," he explained, but the markets are not so cooperative.
A friend recommended Marc Gunther's Faith and Fortune, and (after learning I was quoted in it) I dashed to the bookstore to have a look. It's excellent. Gunther is a senior writer at Fortune (he wrote the article on SRI funds mentioned below), and he writes well. This matters because many authors have trouble with this topic. Some fall into a dry academic style, others let the diversity of the topic muddle their thinking, and still others get up on the soapbox and preach. Gunther avoids all of these and his clear prose and storytelling skill set Faith and Fortune apart. He focuses for the most part on CEOs, delivering chapters on Southwest Airlines, Timberland, and Tom's of Maine. These stories have been told, but not as thoroughly or as well as Gunther tells them. The same is true of his chapter on Amy Domini. But he also honors Barbara Waugh at Hewlett-Packard, noting that "more than anyone I know, Waugh has found a way to change corporate America from within." And he introduces us to Ricardo Levy, a man I'd never heard of, but whom everyone interested in this topic should know about. Gunther also investigates the spiritual aspect of corporate social responsibility, and notes a broad revival of religious interest in this country:
The spiritual revival in the workplace reflects, in part, a broader religious reawakening in America, which remains one of the world's most observant nations. (Depending on how the question is asked, as many as 95% of Americans say they believe in God; in much of Western Europe, the figure is closer to 50%.) The Princeton Religious Research Index, which has tracked the strength of organized religion in America since World War II, reports a sharp increase in religious beliefs and practices since the mid-1990s. When the Gallup Poll asked Americans in 1999 if they felt a need to experience spiritual growth, 78% said yes, up from 20% in 1994; nearly half said they'd had occasion to talk about their faith in the workplace in the past 24 hours.He might be onto something here. Jim Collins found in his acclaimed Good to Great project that the best leaders were quite humble. He reported on the success of Kenneth Mockler of Gillette, a deeply committed Christian who sought to bring his values to the workplace. Gunther interviews Collins for the book and finds that several of the Good to Great CEOs were deeply religious. Still, I have wonder: despite this religious revival, the last ten years will go down in history as among the most scandalous in the history of American business - what were all these people doing at the office? Refreshingly, Gunther saves the question of whether social responsibility pays for the last chapter. And he concludes that the question is unanswered and perhaps doesn't even need to be answered. This intellectual honesty is so refreshing - I wish other books had more of it. Faith and Fortune is carefully researched, clearly written, never boring, and often instructive. Highly recommended.
I finally tracked down a quote I first heard a few years ago at a conference of financial leaders of religious institutions. A nun was giving a speech on the Church's role in economic life, and said, with heavy emphasis: "we...are on the side...of the poor." I have wondered about this phrase. Her delivery suggested that she was quoting, but I didn't know the source. The earliest use of it I can find is from an article by Dorothy Day from 1950:
"It is not avoiding the question, and it is being eminently realistic and practical to repeat, to affirm, that we are on the side of the poor. And who would not want to be?"In 1999 Duncan MacLaren, secretary-general of the Catholic charity Caritas Internationalis, echoed Day's line:
"You are unlikely to find a government or International Monetary Fund official who would be able to distinguish scripture from a Morris West novel, but those values we stand for say something truthful about the human condition which resonates with everyone. It also says whose side we are on - the side of the poor and marginalised, the ones excluded by society but loved by God. A major reason why we are taken seriously by what people in the World Bank like to call the 'real world' is because they know what we stand for."
Pietra Rivoli, a Georgetown economist and expert on corporate social responsibility, has written a new book which is getting great advance reviews. Read an excerpt here. Pietra's also very knowledgeable about SRI - she's been a Moskowitz Prize judge for many years, and wrote a thoughtful defense of the industry in Business Ethics Quarterly in 2003.
The latest issue of Fortune has a pretty good update on SRI mutual funds. The toughest criticism the industry has seen in recent years is that funds are not green enough, and that even though Best Buy, Outback Steakhouses, and Hershey pass the screens, what's truly responsible about them? Glad you asked, at least about Hershey. Hershey's controlling shareholder is the Milton Hershey School for disadvantaged kids, which is one of the worthiest causes I can think of. Age and decrepitude have forced me to curtail my candy bar consumption, but when I indulge I make sure it's a Hershey product. The larger point is well-taken, however. SRI so far has been more about avoiding/boycotting bad companies than aggressively looking for great ones. Give credit to KLD and Barclays, who are today introducing an exchange-traded fund that weights companies, in part, according to their social scores and virtually abandons the old exclusion approach. The product, which is then optimized to the Russell 1000, will be a interesting test of whether social screens can, in and of themselves, add value.
This week's Economist includes a survey of corporate social responsibility. On seeing the news, my reaction was one of both hope and fear: Hope because critics of corporate social responsibility tend to be ideological, and The Economist typically tries to focus on the facts. Fear, because the magazine's snippy black-or-white writing style, while clear and entertaining, risks oversimplification. But hope and fear were replaced by mere disappointment. The survey's a disaster, unfortunately. The magazine's leader, "The Good Company" states "all companies, but especially big ones, are enjoined from every side to worry less about profits and be socially responsible instead." Nonsense. The net profit margin for the S&P 500 over the past four quarters was 8.5%, the highest level seen in over 20 years (source: Baseline). The implication that corporate gadflies are draining away profitability has no basis in fact. It continues "companies at every opportunity now pay elaborate obeisance to the principles of corporate responsibility." Twaddle. Corporate social behavior is, on most dimensions, worse than in the past. Executive compensation as a percentage of sales is at historically high levels, despite no apparent commensurate increase in management competence. Charitable giving accounted for a greater percentage of corporate pretax earnings 15 years ago than it does today. And, of course, there are the scandals. It is extraordinary that, after Enron, Worldcom, Tyco, and Parmalat, otherwise intelligent people can claim the level of corporate social responsibility has gone up. Marc Orlitzky recently published a comprehensive and thoughtful statistical review of the academic work done on corporate responsibility over the past 30 years. The survey does not appear to mention it. A shame, as Orlitzky provides hard evidence that contradicts The Economist's arguments. Speaking of evidence, there's not a lot presented. Looking through the survey, I see no charts (ok, one quadrant chart illustrating a concept). No statistics, no quantitative studies, no detailed presentation of successes and failures. And more straw men than a scarecrow factory. What a shame. The Economist had a chance to write a strong piece on a timely topic, as it did with environmental issues in the early 90's. Instead we get a 22 page op-ed piece. Don't waste your time.
Here is a list of tsunami charities recommended by the American Institute of Philanthropy and the Better Business Bureau.
The latest list of "The 100 Best Companies to Work For in America" is available now at Fortune's website (subscription required). For more information on this list, see the Great Place to Work Insititute's website - they do the underlying research. There are many lists of great companies, but this is one of my favorites. It is one of the longest-lived (the first book came out in 1987) and is based on thoughtful and original research, not impressionistic analysis or press clippings. And it feels intuitively right to me - I have visited many of these companies, and they really do seem to be superior workplaces, and, often, superior business franchises. In 2002 Chris Luck and I did a study and found an equal-weighted portfolio of the publicly-traded companies on the list would have had returns a little better than those of the S&P 500, even after accounting for valuation disparities, industry exposures, and other risk factors.
In today's Financial Times, management columnist Michael Skapinker (subscription required) recounts a story from Temple business professor Robert Giacalone:
...[He] asked students whether they would dump carcinogens. On this the class reached consensus: they would do it, because if they did not, someone else would. Prof Giacolone asked whether they wanted to live in such a cynical world. 'We already do,' they replied.Other business professors feel the same way. Joshua Margolis (co-author of People and Profits) argues that too little attention has been paid to social issues in business. This is striking to me because I have never seen social responsibility treated as seriously in major business schools as it is today. It is now taught and discussed in dedicated programs at Harvard, Stanford, and Wharton. (In 2000 Wharton even convened a conference on social investing, although no major school has done so since.) Will it do much good? I doubt it. I don't believe unethical behavior is pervasive among corporate managements. Most of the senior managers I have met have been pretty well-intentioned people. Highly-focused, results-oriented - but not unethical or malicious. But there are exceptions. The worst corporate behavior, in my opinion, is caused by a relatively small percentage of people who have talent, drive, and no moral compass. Robert Hare of the University of British Columbia, an expert in sociopaths, believes that the corporate world is fertile ground for them. (I Googled "Ken Lay" and charming - 8770 hits.) You can send these people to ethics courses: they'll probably be star pupils - and then deceive people anyway. I believe the disillusionment of the Temple students comes from a conviction that the business world is now dominated by people like this. I don't believe it has gone that far, but there certainly seem to be more amoral people in charge than there used to be. My guess is that this is coming from two powerful management trends. First, Jack Welch's General Electric taught the business world that the numbers come first, and everything else is a pretty poor second. It's easy to forget that American business in the 70's and even the early 80's had a strong institutional mindset and often espoused long-term management values. Welch demonstrated that a single-minded focus on business results (with a corresponding campaign against bureaucracy and paper-pushing) could revitalize even an enormous company. The lesson wasn't lost on anyone. Welch openly wondered about the risks of the approach in his 1991 Letter to Shareholders:
"Then there's the fourth type [of manager] - the most difficult for many of us to deal with. That leader delivers on commitments, makes all the numbers, but doesn't share the values we must have. This is the individual who typically forces performance out of people rather than inspires it: the autocrat, the big shot, the tyrant. Too often all of us have looked the other way - tolerated these 'Type 4' managers because 'they always deliver' - at least in the short term."Welch saw the risks, but tolerating the misbehavior of those who 'always deliver' is now a fundamental part of our business culture. No one had a problem with Ken Lay or Dennis Koslowski when their stocks were working. The second trend has been around a lot longer, and is perhaps the greater problem. That is the cult of personality that surrounds some CEOs. CEOs are celebrities in this country, and as with all celebrities, we're willing to overlook a lot in their behavior. (It is bizarre to me that Donald Trump is now one of the most admired business leaders in America, and even more bizarre that my alma mater, Babson, is teaching a course based on elements of his show). What really bothers me about the CEO-as-star mentality is that the best CEOs aren't big self-promoters. Jim Collins's book Good to Great explores this issue in depth, and finds that the most effective leaders are exceedingly modest and continually deflect attention and recognition toward their colleagues. I've seen it many times in my career - quiet purposeful CEOs who get the job done, and self-promoters who disappoint. And yet we continue to glamorize the second category. So the first step in improving corporate behavior, in my opinion, is not to give everyone an ethics class (well, ok, it can't hurt). A better first step would be to stop giving a free ride to the glib CEO who's hitting the short-term numbers but not doing the things he needs to do to build his company for the long term. That's the situation where we've seen the worst behavior from corporations. Things won't get better until boards of directors learn to recognize it and intervene before things get out of hand.