SRI Notes

When Stakeholder Theory Meets Financial Theory

Studying corporate social responsibility and social investing is hard because it's so interdisciplinary.  People in Management, Finance, and Economics start from such different places that it's hard to get them to agree even on basic premises.

For example, is the company run solely for the benefit of shareholders, as finance students are taught?  Or should shareholders be viewed as just one of a constellation of competing interests, as stakeholder theory assumes?

But financial theory is increasingly starting to look a lot like stakeholder theory.  Miller & Modigliani's famous theorem opened the doors to a broader view of capital - a view in which shareholders are not 'owners' but suppliers of a commodity known as equity capital.  Like all suppliers they have to be paid...but getting paid is not the same as having every activity of the enterprise dedicated to your enrichment.

Some practitioners seem to believe this now.  Arnott and Bernstein's work in the early part of this decade was deeply influential and, as I read it, advocates radical skepticism.  It implies that most returns have historically come from dividends, and shareholders should therefore be primarily focused on dividends when looking forward. 

Now theoretically this is ok - in theory, all earnings are ultimately paid out as dividends.  But in practice it doesn't seem to work out that way.  For the past four quarters S&P 500 companies paid out only about 30% of their earnings in dividends (23.43 in dividends per S&P share vs. 82.10 in EPS, according to Baseline/FirstCall). 

So where are the rest of those earnings going?  They're supposed to be reinvested for the benefit of shareholders, through profitable investment in plant and equipment, acquisitions, or share repurchase.  But Arnott & Bernstein believe these retained funds will generate low incremental returns for shareholders:

"[R]etained earnings are often not reinvested at a return that rivals externally available investments; earnings and dividend growth are faster when payout ratios are high than when they are low, perhaps because corporate managers are then forced to be more selective about reinvestment alternatives."

So what stakeholder theorists predict, Arnott and Bernstein confirm.  Shareholders do not rule the roost:  they are a supplier to be compensated, but they do not, in aggregate, claim the full distributable earnings of the firm.

So should social investors cheer or boo?  We certainly use the language of stakeholder theory a lot - when we want a company to behave better we cite the interests of non-financial stakeholders such as employees and the community.  And we don't like it when someone invokes shareholders'  interests to argue against social proposals.

But we should be careful what we wish for.  Do we really want shareholders to to have less influence?  This is what Hawley and Williams are talking about - over the past generation ownership of large corporations has changed dramatically, and there are often chains of intermediaries between the investor and corporate management - they view the resulting loss of influence as a significant problem.  Robert Monks would, I'm sure, agree.

So I think the work of Arnott and Bernstein confirms the intuition of stakeholder theorists in a really interesting way.  But it leaves us with two big questions:

1)  E - D= ?

2)  Is that good?

Update to sritudies.org

I've done my annual update on the sristudies.org bibiliography page.  Sorry, time doesn't permit a list of recent additions, but you can find them easily enough - just go to the web page, and using the search function in your browser (the "Find" command on the "Edit" menu in Firefox), look for "2006" or "2005".

One reason I've never put much directory functionality into sristudies.org is that Google is so powerful.  Try this - go to Google and type in:

site:www.sristudies.org 2004

That gives you a list of every instance of 2004 on sristudies.org.  When Google gets around to indexing the updated site (next week?  next month?) you can use this command to get a comprehensive list of more recent studies.

If you notice typos etc...I know, I know...anyone know a good proofreader?

Jeff MacDonagh on Sin Stocks

Jeff MacDonagh of Domini offers the following response to my note on sin stocks:

"Our take is that they [alcohol, tobacco, and gambling] are all addictive and harmful.  We seek to invest in companies that do not produce addictive and harmful products, as they necessarily harm the customer.  The more that is produced and consumed, the worse off society is.

"You note correctly that alcohol is only potentially harmful, and in fact, may be beneficial in small amounts.  Our concern, in part, reflects how we see publicly traded companies operating – maximizing efficiency, innovation, and product distribution.  Public companies, in general (but not always), act more aggressively in these three ways than private companies, sole proprietorships, etc.  Our screen is not about a boutique vineyard or microbrewery, it is about Budweiser and other publicly traded (large) producers.

"Gambling and tobacco are much easier one to understand – you always lose when consuming this product on a regular, or even fairly occasional, basis. "I think this is an overdue conversation in our world.  I would be happy if the term 'sin stock' was relegated to a historical comment on Wesley’s sermon.  In fact, if you read into 'The Use of Money' – one can interpret 'sin stock' to mean investing in things that are counterproductive, a much more capitalist interpretation than the 'sin stock' term suggests."

Sin Stocks, version 2.0

There is a small contradiction in widely-used social screens that is starting to be noticed. 

Most SRI mutual funds in the U.S. automatically exclude the 'sin stocks'.  Sin stocks are usually defined as alcohol, tobacco, and gambling, although pornography and firearms are sometimes put into this category as well.  The sin screen is appealing because it is consistent with the teaching of many religions, it is easy to implement, and the excluded sectors are small enough as a percentage of the overall market that performance impact is not likely to be severe even if these stocks perform well (which they historically have).

But there are some odd things about this view of sin stocks.  First of all, lumping alcohol, tobacco, and gambling together implies some kind of moral equivalency that really isn't there.  It's not clear that alcohol and gambling, in moderation, are harmful to most people, while tobacco clearly is.  The CDC classifies tobacco as the "leading preventable cause of death" in the U.S.  Alcohol and gambling have their downsides, but they aren't in the same league.

And social investment practitioners do not always practice what they preach.  I've been to many social investment conferences.  Drinks are often served, and consumed enthusiastically.

So it must have been difficult last year for the folks at Pax World to drop Starbucks, an otherwise exemplary social performer (I have it as one of the top 8 U.S. companies), because of a relatively small liqueur deal.  Now Pax is asking shareholders to approve a less restrictive policy (thanks to Lorne Abramson for the heads-up on this).

Pax's proposal strikes me as sensible, although not all religious investors will accept it.  This seems to be a case where the perfect can be the enemy of the good.  Why delete Starbucks for minor involvement in a product that is unlikely to be abused ("hurt anyone in his substance" as John Wesley would say)?  I think many clients would be open to owning shares in a wine company run on sustainabity principles (think of Fetzer when Paul Dolan was at the helm), but this option is foreclosed by the zero tolerance policy.

There are risks to opening the door a little bit, though.  Harley-Davidson got into a similar situation a few years ago, when it licensed its name to Lorillard for a cigarette product.  It went badly, litigation ensued.  As great a company as Harley-Davidson is, I would not have considered including it in an SRI portfolio while this was going on, even though the product was economically insignificant.  (With the situation well in the past, HDI is now on both the Domini and Calvert social indexes.)

I would correct one bit of speculation you see in the news stories - I'm certain this has nothing to do with performance.  Pax World's Balanced Fund is well-managed with a superb long-term track record and four stars from Morningstar.  They don't have to lower the bar to pump up their results.

CSM: Companies Becoming More Proactive

Jeffrey MacDonald at The Christian Science Monitor has made corporate social responsibility his beat.  His latest piece, on how companies are acting more quickly to address social and environmental concerns before they get out of hand, is excellent.

The Monitor's website has an 'Ethical Investing' section, with an archive of his past stories and a series of video interviews (by Laurent Belsie) with social investment practitioners.