SRI Notes

Daniel Fermon and the CEO

I've expressed skepticism in the past that the sell side could add much to the social investment world, but there is a lot going on now, some of it very interesting.

Daniel Fermon, Senior Europe Strategist at Société Générale, is doing work that incorporates  traditional financial research, social/governance research (from Société Générale's SRI researchers, Sarbjit Nahal and Valéry Lucas-Leclin), and his own innovative views on the role of the CEO in investment returns.  There is a brief but interesting interview with him here.

In coming years I believe markets will gradually grow more efficient with respect to traditional investment variables such as valuation and momentum, making it tougher for traditional investment strategies to add value.  As that happens, researchers will have to dig deeper into predictors of sustainable value creation, such as management quality and governance.  Fermon's work shows how this type of analysis can be done.

A Pleasant Surprise

I was voting proxies today and saw something I don't believe I've ever seen before.  A company endorsed a shareholder resolution.  I had to look twice - I rubbed my eyes and checked again.  It was still there.

I've been reading proxy statements for 15 years, and for most of the past 10 I've been involved in voting them.  After you've been through a few cycles the ritual takes on the character of a kabuki play.  Some shareholder brings a resolution forward, carefully crafting it so that it clears a tricky double hurdle:  it must be relevant (otherwise why waste shareholders' time), but must not fall under the heading of "ordinary business" (otherwise the problem can be left to the firm's professional management team).

And then, management opposes the proposal.  It appears to be a matter of honor.  Even innocuous proposals are opposed.  It doesn't seem to matter who brought the proposal - a union, an environmental group, a social investment fund, a  gadfly - there is always a staff lawyer at the ready to draft a tightly reasoned account of how producing a report about, say, minority hiring, could bring the company to its knees. 

I have read thousands of these, and not once have I seen management reply, in writing - "hey, that's a good idea."

Until today!  The Green Century Funds this year submitted the following proposal to the Amgen board:

RESOLVED, that the shareholders of Amgen ("Company") hereby request that the company provide a report, updated semi-annually, disclosing the Company's:

1.  Policies and procedures for political contributions (both direct and indirect) made with corporate funds.

2.  Monetary and non-monetary contributions to political candidates, political parties, political committees and other political entities organized and operating under 26 USC Sec. 527 of the Internal Revenue Code including the following:

a.  An accounting of the Company's funds contributed to any of the persons or organizations described above;

b.  Identification of the person or persons in the Company who participated in making the decisions to contribute.

c.  The internal guidelines or policies, if any, governing the Company's political contributions.

This report shall be presented to the board of directors' audit committee or other relevant oversight committee, and posted on the company's website to reduce costs to shareholders.

And Amgen's board of directors said:  Yes.  And, "we urge your support for this critical corporate governance reform."

Here is a good article on this issue from the LA Times (via the Chicago Tribune website).  Here is a press release from the Interfaith Center for Corporate Responsibility, which reports that Bristol-Myers and Staples have also agreed to disclose and have their directors oversee political contributions.

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.

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.

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.

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.

Salon Article

Ellie Winninghoff, who is writing a book on SRI, has put up an excellent article on SRI at Salon.com (sorry, have to watch an ad to read it, but it's worth it). 

It's particularly great that she tracked down Jim Hawley, who co-authoredThe Rise of Fiduciary Capitalism.  The book explains that the balance of power has shifted among the owners of American corporations.  In the old days (the 1970's), most stock was owned by individuals in brokerage accounts.  Today, most stock is owned by large pension funds.  These intermediaries now hold de facto control over most of America's publicly traded companies.  The only problem is they don't know it, or act like they don't know it.

Robert Monks, who is also mentioned in the article, is the leading voice for corporate governance reform in the U.S.