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Swensen and SRI

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.

Vice is Nice, but Not Indispensable

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:

• Risk (beta)
• Size (market capitalization)
• Valuation (price/book ratio)
• Momentum (relative price strength)

Usually, these factors explain most of the differences in historical investment performance among portfolios. If you use the variables listed above you're using a Carhart model, if you drop momentum you're using a Fama & French model. The authors of this press release appear to have used neither. And that's a problem. Their argument is: the Domini Social Index left returns on the table - given the data problems it is clearly not true for all the time periods they list, but it certainly has been true over the past one and three years. The authors would like to show that this shortfall was because of the failure to own vice stocks. But maybe it was just a failure to own value stocks or small stocks, both of which have had great performance lately. The authors include some commentary on this, but without a risk model we can't know the answer with any precision. And it's really important to know that answer: if the Domini Social Index is underperforming because it doesn't own value stocks, that's a solvable problem (investors can supplement it with a value fund, or pursue other diversification strategies). But if there's something really special about vice stocks, that makes it impossible to create diversified portfolios without them - well, that would be big news, and a big problem for social investors. So those would be my questions, and after looking at the press release they haven't persuaded me. To show that social investors are making a BIG MISTAKE by not owning vice stocks, they need to show that that excluding them creates unavoidable diversification costs. And I'm not seeing it here. From that perspective I'm a lot more concerned about Energy than the sectors they presented in this study. Let me finish with a positive comment. In addition to their retrospective analysis, the authors do some APT analysis of the excluded sectors (there is a good explanation of APT here). This is new and useful work and deserves attention - I have not seen APT analysis of specific excluded sectors before. Dan Dibartolomeo and I did an overall APT analysis of the Domini Social Index ten years ago (we used a different model than the one used here) and found that its macroeconomic bets differed significantly from the S&P 500 (see Kurtz, Lloyd and Dan DiBartolomeo, "Socially Screened Portfolios: An Attribution Analysis of Relative Performance." Journal of Investing, Fall 1996). Dan updated this work in 1999 and that paper ("Managing Risk Exposures of Socially Screened Accounts") is available on the Northfield website. Our analysis suggested the Domini index was particularly oil price-sensitive, and could underperform during a period of rising oil prices. And we have certainly seen that. Hopefully QED will follow this up with a more detailed white paper, or better, a journal article. I think the APT aspect of this work could be a journal article in itself, particularly if the authors computed the APT coefficients for the Vice Composite they present on page three.

James Hoopes Comments

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."

Some Notes on Altruism at Year-End

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:

• It is incomplete as an explanatory concept because people don't behave rationally - they misjudge risk, they buy lottery tickets, they pay high premiums for small marginal gains in convenience - so a model assuming rational behavior is bound to produce disappointing results.
• It is incomplete as an investment approach because Economic Man doesn't have to deal with the emotional implications of his decisions. As markets become more efficient it is likely that successful investment strategies will entail considerable psychological costs. For a hugely entertaining riff on this theme in the investment world see Malcolm Gladwell's brilliant New Yorker article on Nassim Taleb, or better yet, read Taleb's book, Fooled by Randomness, in which he described the excruciating psychological pain of his winning investment strategy.
• Most importantly, it is incomplete because Economic Man is not cognizant of the environmental impacts of his decisions. Economic Man seeks the highest return, but no rational person would accept a high return on investment if it meant permanent severe damage to his health and wellbeing. Let's say it's 100 years from now and there's no potable water in the state of California. Their first question about us is not going to be "did they seek the highest possible investment returns?"

Altruism and Evolution In an earlier post I mentioned that experiments in game theory have not found altruism to be a successful strategy, raising a serious intellectual challenge to those who practice it (game theory is basically Economic Man on steroids). In trying to formulate a response I turned to evolutionary theory (which is arguably game theory on steroids). The final chapter of Ernst Mayr's This is Biology asks "how could any ethics develop [from evolution] that is based on altruism and on a sense of responsibility for the welfare of the community as a whole?" Mayr, who passed away earlier this year, says "my own values are rather close to Julian Huxley's evolutionary humanism. 'It is a belief in mankind, a feeling of solidarity with mankind, and a loyalty toward mankind. Man is the result of millions of years of evolution, and our most basic ethical principle should be to do everything toward enhancing the future of mankind. All other ethical norms can be derived from this baseline.' Evolutionary humanism is a demanding ethics, because it tells every individual that somehow he or she shares a repsonsibility for the future of our species, and that this responsibility for the larger group should be just as much a part of cultural ethics as concern for the individual." For the truly committed, there is Elliot Sober and David Sloan Wilson's Unto Others: The Evolution and Psychology of Unselfish Behavior, who argue that "the case against evolutionary altruism has already crumbled when judged by normal scientific criteria." This is a hard book, but I think an important one for people who are trying to think clearly about these things. There is an article on biological altruism in the Stanford Encyclopedia of Philosophy, here. So what should we do? Enjoy the holidays! We'll come back next year and figure all this stuff out. If you are feeling altruistic and would like to get some additional deductions before AMT sets in next year, here are some places where your donation would be likely to have a significant lasting impact:

• Accion International - Microloans to entrepreneurs around the world
• Ashoka - Venture capital for the bottom of the pyramid
• Heifer International - Provides livestock and training in organic farming

PriceWaterhouseCoopers looks at CSR information and analyst estimates

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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BC's Best MBA Paper Award

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").

Recognition for Pietra

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:

• Last spring NPR did a series of reports based on the book, including a cool map.
• Here is a transcript of a presentation Pietra gave to an audience at the IMF.
• You can read an excerpt from the book here.

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.

Short-Termism Makes Strange Bedfellows

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.

Meir Statman

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:

• Doing Well While Doing Good?, Financial Analysts Journal, 1993
• Socially Responsible Mutual Funds, Financial Analysts Journal, 2000
• The Religions of Social Responsibility, Journal of Investing, 2005
• Socially Responsible Indexes: Composition and Performance, forthcoming, 2005

I first ran across Meir's work when I was studying the diversification impact of social screens in the late 1980s and early 90s. In those days conventional wisdom held that 30 stocks should be enough to adequately diversify a portfolio. But in 1987 Meir's "How Many Stocks Make a Diversified Portfolio" showed that the number was much higher, possibly in the hundreds. I figured that finding was good for a social index - it strongly suggested that broad indexes could offer a risk advantage over more concentrated portfolios. But it was also a cautionary note for social investors who were counting on the "Rule of 30" to protect them from diversification costs introduced by the social screens. It convinced me that social investors needed to be really careful about diversification, a conviction I still hold today. (A brief abstract of this study appears at sristudies.org.) Meir's best-recognized work is not in the SRI field, however. He is regarded as one of the pioneers of Behavioral Finance, and his most-cited work is a Journal of Finance article, about the tendency of investors to sell winners too soon and hold losers too long. The full citation for Shefrin and Statman (1985) can be found here. Social investors should take careful note of Meir's work, because many of his papers go well beyond the bounds of traditional finance and raise questions about the interplay of markets and human psychology. I am thinking particularly of his paper on fair trading, which has ethical and moral significance well beyond its contribution to the financial literature. I asked Meir which of his writings he thought newcomers should look at, and he suggested "Normal Investors, Then and Now", which recently appeared in Financial Analysts Journal. There is a good interview with him here. Meir has made a serious study of social investors. Social investors would be wise to return the favor.

Wal-Mart Speech

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:

1. To be supplied by 100% renewal energy.
2. To create zero waste.
3. To sell products that sustain our resources and environment."

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.]

More Research on Corporate Responsibility

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.

Crystal's CFO Pay List

Graef Cystal, Bloomberg's executive compensation columnist, has put up his list of the most underpaid and overpaid CFOs.

The Best of All Possible Worlds?

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.

Article on Social Responsibility

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:

• Nadja Guenster at Erasmus University in the Netherlands finds a positive association between environmental performance and operating performance over a long time period (see post below).
• Marc Orlitzky, who is linked above.
• You could call Charles Lee and David Ng at Cornell University. They find that global securities markets take corruption levels into account when valuing stocks.
• Paul Gompers at the Harvard Business School has shown that good corporate governance was associated with superior investment performance over time.
• Or Stuart Hart, whose work has shown that environmental policies matter for stock market valuations, and whose recent book is a careful and thoughtful analysis of the issue.

I would like to show you counterexamples: carefully-done studies that call these findings into question. But I have looked, and I cannot find them. Corporate social responsibility is not gaining momentum because of some ideological debate. It is gaining momentum because there is considerable empirical evidence that it matters. I should also note that none of this suggests social investors have a performance advantage over other investors. Social investment studies show competitive performance, not outperformance over time (although the folks at KLD might disagree). If anything, the studies cited above suggest that markets are already aware of at least some of these issues, which would make it tough for a social approach to add performance on its own.

2005 Moskowitz Prize Winner

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.

Journal of Investing Special Issue

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.

Now With RSS Goodness

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.

Good Charitable Organization

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.

ShoreBank's Biggest Job

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.

Dangerous Games

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.

Now Affiliated With...

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.

More on Time Horizons

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."

Discounting the Future

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.

Beware The Superstar CEO

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.

Corporate Crime Blog

Just discovered this excellent corporate crime blog, written by two law professors. It includes some recent commentary on KPMG, Tyco, and other cases.

The Economist on Accounting Firms

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:

• "Still, most believe an indictment is unlikely... Boards would be loth to retain an indicted auditor, especially after seeing former directors of Worldcom and Enron pay millions of dollars out of their own pockets to settle investors' lawsuits stemming from accounting scandals."
• "Already, regulators worry that there are to few auditors for the industry to be competitive. The Big Four dominate the audit of big, listed multinational companies because second tier firms lack the capacity and the international networks needed for the job. In certain industries, such as oil and gas, concentration is especially acute, with only two or three auditors ruling the market."

We live in peculiar times.

Instant Feedback

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.

Why Can't Accountants and Wall Street Handle Corporate Social Responsibility?

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:

• The accounting profession is itself in crisis, with one of the big firms (Andersen) now virtually extinct following its role in the Enron scandal and the others all involved in major scandals or frauds in recent years. An incomplete list of these would include Worldcom (Andersen again), Rite-Aid (KPMG), Adelphia (Deloitte and Touche), and AOL/Time-Warner (Ernst & Young). PriceWaterhouse Coopers has avoided the worst problems, but was the auditor when Bristol-Myers overstated revenues by $2.5 billion over a three-year period due to "inappropriate accounting" for inventories, an unwelcome event I experienced firsthand as a buyside analyst.
• I'm not sure that GAAP is a good example for anyone. Who, exactly, uses it? Not Wall Street analysts, who prefer operating earnings. Not most buy-siders - we use proprietary models that are more likely to incorporate Wall Street estimates, cash flows, and other indicators. Not academics - most I have met believe cash flows or metrics such as Stern Stewart's EVA are better indicators. Alfred Rappaport of Northwestern has famously said that "earnings are an opinion, but cash is a fact."
• The GAAP process, despite many denials, is highly politicized. One need look no further than the accounting profession's decades of refusal to count stock options as an expense. As Warren Buffett repeatedly pointed out in the 1980s and 1990s, they are a cost to shareholders. The argument that they have no value is absurd (if they're free, give me some).

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?

Wall Street

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:

• Hostile culture: Wall Street is almost religiously single-minded about money. Wall Streeters go there to make money and when they want to do something else they leave. It is the dominant aspect of the culture. For most, CSR is a way to lose focus and fall behind in the race. Wait a minute, you might argue, some of these things have real impact on the bottom line. True, and you might be surprised at how carefully Wall Street analysts have evaluated social issues likely to impact earnings in the near term. But they're not doing it out of social conscience.
• Investment banking: One of Wall Street's most lucrative businesses is investment banking. And investment bankers hate it when people say bad things about firms they're trying to do deals with. In 1997 Martin Fridson, then the chief high-yield strategist at Merrill, cited "screaming fits by investment bankers" as a key obstacle to getting good quality of earnings information. Advocates of corporate social responsibility can expect the same treatment.
• Time horizons. Social issues like asbestos, tobacco, and the environment are not one- or two-year challenges. They may take 20 years or more to unfold. Yet Wall Street is built for short-term thinking. On the brokerage side, the most valuable client is the one who trades a lot, and that client has, by definition, the shortest time horizon. This short-termism reflects the broader client base - according to Benartzi and Thaler, the average institutional investor's time horizon is about a year.

Given where its incentives are, I seriously doubt if Wall Street will ever play more than a peripheral role in corporate social responsibility.

Financial Analysts Journal on the Eco-Efficiency Premium

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.

Recommended

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.

An Exchange

Dear Sir,

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?

Vegard Vik

Student, Norwegian School of Economics and Business Adm.

-------------

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

The Energy Problem

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.

Strong Study on Executive Pay

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.

What We Don't Know About Enron

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:

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...

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.