SRI Notes

Harvard Draws a Line

Accoring to this article in The Harvard Crimson, the University's panel on social investment (known as the Corporation Committee on Shareholder Responsibility) affirmed avoidance of direct investment in companies involved in Sudan.  But the panel also decided not divest from holdings that indirectly hold Sudan-related investments.  If I understand this correctly, it means Harvard can continue to own Berkshire Hathaway shares (as discussed here) despite Berkshire's PetroChina holdings.

Who Gets the Spoils?

I cannot resist linking to this post from William Bernstein at Efficient Frontier.  Bernstein is a consistently insightful commentator on issues in modern investment, but here his analysis takes him into executive pay and governance issues as well.  For the first time in my career, leading thinkers in finance and management are saying the same thing:  the rewards system is confused.  We're chasing the wrong carrots, and getting the wrong results.

The Man With the Iron Face

In the midst of this excellent article on the Chinese banking system, there is a pretty inspiring profile of Li Jinhua, China's Auditor-general.  There is so much interesting material hinted at in this article (e.g., a brief mention of a jailhouse interview in Las Vegas with accused embezzlers from Kaiping) I hope the authors, William Mellor and Le-Min Lim are considering writing it up as a book. 

Update on Universal Owners

Thestreet.com's mutual fund columnist, Brett Arends, has an interesting (and strident) take today on the Home Depot controversy. 

"...[T]he people who should be right at the center of the scandal aren't the executives who are taking the loot or even the directors who gave it to them. It's the managers of some of America's biggest mutual funds, including Vanguard and Fidelity. Instead, so far, they're getting a pass."

That's the first time I've seen that said in the business media, although this criticism has been circulating in academia for some time.  In their excellent book, The Rise of Fiduciary Capitalism, Hawley and Williams warn of a society in which owners are separated from the companies they own by chains of agents (fund managers, directors, etc.), who ultimately do not do a good job of representing their interests.  That's what Arends sees going on at Home Depot:

"Bob Nardelli didn't really do anything wrong. He just asked for, and received, a massive amount of money. Wouldn't you?

"The problem lies with those on the other side of the trade -- the people hiring the executives. The people who are involved in the negotiations, namely the directors, aren't particularly motivated. They don't get paid very much, at least by heavy-hitter standards. And it isn't their money that's involved. No wonder they just outsource the calculations to "consultants" whose biggest interest is in keeping the executive class happy.

"Meanwhile, the people who are motivated to get the best price, namely the shareholders, aren't really involved. Which is why attention should turn to those who are supposed to represent them. Mutual fund managers have a fiduciary responsibility to their investors. "

It's an interesting article.  Did you know Fidelity voted against half of the stock option compensation plans that came up for a vote last year?  I sure didn't.

Hawley and Williams' site has much more on the universal owner concept.

More on Owners, Managers, and Socially Responsible Investors

The Financial Times got a great quote Wednesday (link via MSNBC) from executive headhunter John Challenger:  "The pressure is not going to relent on CEOs in 2007.  The days of the imperial chief executive are over."

One reason is the growing influence of private equity.  Reporter Francesco Guerrera got another great quote from Steve Ellis of Bain & Co.:  "One of the messages for 2007 is:  whether you like it or not, your company is for sale."

It seems that society's view of the CEO is becoming increasingly bi-polar.  We assume CEOs are extraordinarily gifted, as evidenced by their robust pay packages.  But we are simultaneously become less tolerant of underperformance, as evidenced by the Ellis quote and Mr. Nardelli's recent exit from Home Depot.  One could wonder if this fire and ice approach will deliver the best results.  It brings to mind something Warren Buffett wrote in another context in his 1990 Letter to Shareholders:

"Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. We'll acknowledge that such an attention-getter would produce a very alert driver. But another certain consequence would be a deadly - and unnecessary - accident if the car hit even the tiniest pothole or sliver of ice."

Like excessive debt, the current policy toward CEOs raises the stakes without doing much to improve prospective performance.  If one of our biggest problems is short-termism (past commentaries here), putting the CEO in a position where the only options are immediate positive results or termination seems to me ill-advised. 

But what is the alternative?  In his excellent update of Benjamin Graham's The Intelligent Investor, Jason Zweig observes that in early editions of the book Graham wrote extensively about management quality.  But he reduced the section over time, ultimately limiting it to a few paragraphs on dividend policy.

Perhaps no other part of The Intelligent Investor was more drastically changed by Graham than this...  Why did Graham cut away more than three quarters of his original argument?  After decades of exhortation, he evidently had given up hope that investors would ever take any interest in monitoring the behavior of corporate managers.

...Graham wants you to realize something basic but incredibly profound:  When you buy a stock, you become an owner of the company.  Its managers, all the way up to CEO work for you.  Its board of directors must answer to you.  Its cash belongs to you.  Its businesses are your property.  If you don't like how your company is managed, you have a right to demand that the managers be fired, the directors be changed, or the property sold.  "Stockholders," declares Graham, "should wake up."

So perhaps they are.  For those who believe, as Graham did (and as Robert Monks does today) that shareholders should rule the company, there is plenty to rebel against (see, for example, my September post on stakeholder theory).

But investor attention is, um...intermittent.  Scandals make headlines, but it's hard to show that governance improves.  Graef Crystal observes that even after the scandals and reform of the first half of this decade, there's still not much rhyme or reason to how top executives are paid.  That won't change until shareholders give the matter sustained rational attention. 

But how likely is that?  Home Depot co-founder Bernie Marcus doesn't seem to think it's about to happen.  In the AP story he is quoted as saying:  "It’s like the old story, if the stock goes up 10 points, who’s going to care?" 

By the way, there is an interesting new paper on CEO tenure and firm performance here.  I particularly like their distinction between 'owner' and 'manager' CEOs. 

Governance: Show Me the Money

The dialogue about the performance of socially responsible investments is full of mixed messages and mixed motivations.  Recent developments and data on corporate governance are likely to bring on a fresh wave of intellectual dissonance.

Corporate governance has been kind of a stepchild for social investors.  Although attention has been paid, and the most egregious violators are usually excluded from SRI portfolios, I would argue it has not been a central criterion for inclusion or exclusion - activist social investors have been more interested in things like South Africa, climate change, and Darfur, while less-activist ones have often delegated corporate governance due diligence to their money managers.  Still, everyone says governance is important.

It doesn't help that we don't have a good consensus definition of corporate governance.  ISS, Morningstar, and others provide rating services, but there are major differences in both definitions and ratings of individual companies.  CalPERS has its own take, which is different again - it has managed to both add value and annoy Warren Buffett, another mixed message for returns-focused investors.

But governance has special significance because it's one of the social or quasi-social variables where there's been academic support for the idea of a performance benefit.  It makes sense conceptually, and there's data.  The best data so far cam from Gompers et al, which showed that companies with corporate governance they didn't like underperformed materially in the 1990s.  For the most part, the Gompers governance metrics focused on takeover defenses - the more anti-takeover defenses, the lower your rating.  This raised the question of what we were measuring because large acquirors (the firms most likely to have strong anti-takeover defenses) underperformed materially in the 1990s.  But in the 2000s acquirors have done well, as takeover premiums became smaller and investors rejected big deals resembling the ugly stories of the 90s.

And simultaneously, a study by Empirical Research Partners ('Does Corporate Governance Matter?')finds that companies with high scores on the 'Gompers index' of corporate governance have significantly underperformed low-rated companies since 2000.  Empirical is a strong sell-side quant shop, and I have no reason to doubt their results.  Author Michael Goldstein (formerly a strategist for Sanford Bernstein) writes:

"There was, over the entire 15-year period, some payoff to good governance in holding periods beyond a year, but it wasn't impressive...  We also considered whether the governance score could help us distinguish winners from losers among the best- and worst-ranked stocks in our core model and its earnings quality module.  We found thre was an advantage conveyed by paying attention to governance when avoiding losers but only in the 1990s and not thereafter."

This is unpleasant news for governance advocates who have ridden the Gompers data a long way.  Goldstein goes on to argue that governance shouldn't matter much for stock prices since it's easily observable and tends to change slowly.  I disagree there - I don't know that we've perfected the art of measuring it, but one of the few points on which Ben Graham and Amy Domini would both agree that investing with a management you can't trust is a fool's game.

Private Equity and SRI

Michael Lewis has a dark article today ("Coach Class of Capitalism") about how the growth of private equity is affecting the structure of the investment world.  There are two kinds of investors today, he says - regular people, who get mutual funds that have average return prospects, and the very rich, who get private equity with outstanding return prospects.  His commentary comes as private equity funds continue to set records for both fund size and deal size.

Social investors shouldn't be thrilled with the rise of private equity, simply because these investments move the corporate world toward less disclosure and less transparency.  Social research depends heavily on required corporate disclosures, such as 10-K and 10-Q reports - these go away when companies go private.  Shareholder activism depends on the shareholder resolution process in place at public companies - there is no comparable forum for engagement with private firms.

From the private equity investor's perspective, that's all good.  One of the key benefits of doing an LBO is strategic flexibility.  In theory, at least, management can escape the constraints of public ownership and simply do what needs to be done to maximize the value of the business.  (In practice the short-term accountability often just transfers from stock investors to bond investors, as the company piles on leverage to finance the deal.)

Lewis sees all of this as just another way for the rich to circumvent rules, but I think it's a little more complex than that.  This surge in private equity would not be possible without attractively-priced stocks.  There can't be a big LBO industry unless a lot of stocks are too cheap.

So who is selling?  Well, mutual funds managers and institutions, mostly.  The typical private equity deal takes years to work out - the returns will be there, on average, but you have to live with illiquidity and 'dead money' for awhile.  By contrast, the typical money manager is measured quarterly and operates on a horizon of perhaps a year (as discussed here many times). 

In a world where 5-star funds attract most of the investment flows, few mutual fund managers feel they can afford the luxury of long-term investments.  So they sell 'dead money' investments to private equity investors, who resuscitate them and, after a decent interval, sell them back.

This seems to be another manifestation of the disease described by Hawley and Williams in The Rise of Fiduciary Capitalism.  Individual investors have hired intermediaries (mutual fund managers and pension funds) to manage their wealth, and the evaluation/compensation cycle for these intermediaries turns out to be far shorter than that of the investors themselves.  All this would imply that speculators could arbitrage time horizons, buying long-term investments at good prices.  And that seems to be exactly what's happening.

Certainly a long-term orientation is no guarantee of success.  It is a kind of a curse among my hedge fund friends - for them an investment is a trade that didn't work out.  At dinner the other night one denounced a stock idea I presented on the grounds that "it hasn't worked all year."

And bad investors learn quickly to point to the long term.  If you're a bad investor you want to be sure to convince your client of the merits of a long-term outlook because the sooner she evaluates you, the sooner you'll be fired. 

Still, if you look at who's been successful in markets over the decades, my impression is that the long-term types have gotten a disproportionate share of the spoils:

• David Swensen at Yale posted a terrific track record over the past decade, partly by collecting liquidity premiums on 'alternative' investments such as timber and private equity.
• Warren Buffett has become the world's 2nd-richest man while maintaining a core equity strategy that has extremely low turnover.  In his 1987 Chairman's Letter, he wrote:  "Of Wall Street maxims the most foolish may be "You can't go broke taking a profit...  We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business."  Buffett is widely-read and many people say this, but it is completely incompatible with the kind of trading most managers actually do.
• The Dodge & Cox Stock Fund has managed to build a 5-star track record with 11% annual turnover. 
• Even index funds based on the S&P 500 have performed quite well, despite portfolio turnover of less than 10% per year.  Historically, the majority of mutual fund managers have not been able to keep up with this index, despite all their trading.

So the fault is not in our stars, but ourselves.  When yours or my mutual fund gets behind, we tend to go hunting for one that's working better.  The fund managers know they need good numbers to raise money, so they do something - anything - to get back on track quickly.  Since about half of them are screwing up at any given time, there's a crowd at the exit and a lot of competition for hot new ideas.  The net result is too much trading, too much renting of stocks, and not enough ownership. 

I'm not thrilled about the rise private equity, but I think it's a symptom of a much deeper illness.  If we were doing a better job of being owners, there'd be no need for private equity to step in and do the job for us.

By the way, friends tell me Lewis's latest book, The Blind Side, is an excellent read.

2006 Moskowitz Prize

I had the pleasure last night of awarding the 2006 Moskowitz Prize to Brad Barber of Cal Davis for his excellent study of the CalPERS corporate governance focus list.  The Center for Responsible Business at Haas has issued a press release on the award, which is here.

Two other papers received Honorable Mention, the first time the judges have recognized more than one runner up.  Both are interesting and very much worth your time:

Harrison Hong and Marcin Kacperczyk did a terrific retrospective analysis of tobacco stock returns, using state-of-the-art risk models and going back to the 1920s.  Social investors won't be thrilled to hear that this one class of sin stocks has delivered significantly superior risk-adjusted performance for most of that time period.

The judges also awaded an Honorable Mentionn to Baruch Lev, Christine Petrovits, and Suresh Radhakrishnan for their paper on the relationship between corporate charitable giving and firm growth.  This is the first study of this topic I have seen since Navarro's Journal of Business study back in 1988, and one that will be of great interest to SRI clients.

I have posted abstracts of all of these studies in the bibliography section of sristudies.org.

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?

The CalPERS Effect Re-Re-Re-Visited

There have been many studies of the impact of CalPERS' corporate governance program on stock prices.  Studies from CalPERS staff and consultants have argued that the program added significant value (see discussion here).  But other studies have found a less powerful effect (example here), and still others question whether there is a 'CalPERS Effect' at all (example here).

Now Brad Barber at Cal Davis has done what appears to be a careful and comprehensive study of stocks named on the CalPERS Focus List, 1992-2004.  He finds a small-looking 25 basis point positive benefit.  Small, until you realize those 25 basis points translates into wealth creation of $3.1 bn.