SRI Notes

Book Recommendation

I've just finished Dan Ariely's Predictably Irrational, and recommend it to anyone who wants to learn more about behavioral economics.  Ariely is a leader in challenging conventional economic wisdom, and provides empirical evidence of many situations where conventional economic analysis doesn't work well.

I was going to write in this post about the similarities and dissimilarities between this book and Freakonomics, which we've discussed here in the past.  But, procrastination pays once again - Ariely yesterday wrote a note on this himself (read it here). 

The books are similar in many ways, but taken together they frame a multi-disciplinary debate about how far economic analysis takes us.  Behavioral economists are challenging some fundamental assumptions economists like to make about human behavior.  It seems to me they are winning some and losing some, depending on the situation being analyzed - reading both of these books will give you a good sense of whose model might be better in a given situation.

A nice summary of the rise of behavioral finance can be found at Robert Shiller's website.

Costing the Atmosphere

I'm a bit behind in my reading, but enojyed this piece from The Economist's special report on business and climate change, particularly the graph (sourced from the Swedish utility Vattenfall). 

The Economist correspondent drily observes that "people buy houses not because they have good insulation but because they have pretty views."  One might say the same thing about why (most) people buy stocks and mutual funds - which might, in turn, explain their results (the mutual fund version is here). 

Oil Prices and Alternative Energy

Social investors and oil company CEOs agree:  high oil prices are good.

Jack Robinson, who manages the Winslow Green Growth Fund, tempts fate in the latest CFA Institute Conference Proceedings Quarterly (link to abstract is here), quoting the most dangerous words in investing:  "it's different this time."

Robinson focuses particularly on alternative energy, noting that "at times in the past [it] has seen an explosion of [investment] interest only to have it evaporate as oil prices declined.  This time, however, unique circumstances may make green investing in general, and the search for alternative sources of energy in particular, a permanent recipient of investment capital."

Calvert seems to agree, and this month launched its own alternative energy fund.

I can't resist also linking to a slightly different view - this Fortune article explains why Exxon Mobil CEO Rex Tillerson has no interest in alternative energy investments.

Maybe everyone is right.  High oil prices would be a boon to both alternative energy companies (by making alternative more attractive when compared to oil), and to Exxon Mobil (by allowing the company to continue to earn stellar returns on equity).

The futures markets have been predicting sustained higher oil prices for some time.  This interview with Fatih Birol, chief economist of the International Energy Agency, certainly seems to support that view as well.

Two things bother me about all this.  First, high oil prices are good for oil companies and alternative energy companies, but bad for consumers - especially poor ones.  Birol argues that Africa is being hurt the most by the current high price environment.  Second, former Exxon Mobil CEO Lee Raymond, who knows something about oil supply, last year predicted a decline in oil prices over the coming decade as the global industry catches up on the underinvestment of the prior decade.

Whomever is right, oil seems to be running everything right now.  Last week Starbucks announced it would be very difficult for the company to hit the high end of earnings guidance.  One key culprit:  the price of milk.  So why are milk prices so high?  This article from Monday's Wall Street Journal offers several explanations - a cut in EU subsidies for export, a drought in Australia - and higher corn prices (feed for the cows).

So why are corn prices so high?  Well, corn is an important ingredient in ethanol, although some experts had predicted that this would not have a major effect.  (This is reminiscent of a headline from The Onion's history book, Our Dumb Century.  After the 1929 market crash the headline reads:  "Experts Blameless, Say Experts" ...)

As for the Australian drought?  It's bad.  Really bad.  And unlikely to end any time soon.

My favorite part of all this is that today, the Fed Open Market Committee commented that "readings on core inflation have improved modestly in recent months," as they left the Fed Funds rate unchanged.  And the core inflation numbers certainly are reassuring. 

But the core numbers don't include oil, corn, and milk, three commodities that in recent years have stubbornly refused to regress to the mean.

The Owner vs. The Boss

Who controls the corporation?  Most economists and investors would say "the shareholders."  Even proponents of stakeholder theory agree that shareholders should have a significant say in how a firm conducts itself.  In 2005 Jean-Paul Page wrote an excellent little book entitled Corporate Governance and Value Creation for the CFA Research Institute.  It's a think piece on the role of corporations in society, written from first principles ("corporate governance begins with power") and a deep awareness of the contending schools of thought in the field.  After much deliberation Page concludes that this should be the first commandment of corporate governance: 

The ultimate power in a company must rest with its shareholders.

It's not hard to come up with an illustration for why this must be so:

Let's say you own an apartment building, and have hired a management company to run it.  You're planning to sell the building in a year or so, so you decide to only do cosmetic maintenance.  You authorize minimal repairs, but instruct the manager to put off major issues, if possible, for the next owner to deal with.  Seeing this, the management company decides to hold back a portion of the rent payments you receive and 1) gives itself a raise and 2) begins managing the property as if they, not you, were the owner.

What would you do in this situation? 

It is not an academic or hypothetical example.  It is an almost exact description of what is happening in corporate America today.  Enthused by the prospects of a sale (to private equity, perhaps), and pressured by performance-driven compensation structures, shareholders are becoming more short term-oriented than ever.  As discussed many times here, time horizons have shortened to microscopic levels - the average turnover on the New York Stock Exchange is 100%, suggesting the average investor is looking out about one-year.  Since many shares never trade (think of all that low cost-basis stock in bank trust accounts), the de facto time horizon for a given trade is even shorter than that.  People don't own stocks anymore, they rent them.

And the managers hired to run the business are increasingly treating the owners like tenants.  Let me rephrase the story I just told you:

Let's say you manage an apartment building for an absentee landlord.  Inattentive, fickle, and unsophisticated, this person is trying to sell the building for a quick profit.  You've been authorized to do only cosmetic maintenance - putting off major issues for the next owner to deal with.  After thinking it over, you decide to hold back a portion of the rent payments you receive and 1) give yourself a raise (you need to get more money up front - who knows what the next owner will think of you?) and 2) begin managing the property from a longer-term perspective (the owner may not care if the building falls down the day after the sale, but you do).

In the latest Business Week, Clayton Christensen and Scott Anthony present the clearest defense I have seen of management's perspective ("Put Investors in Their Place").  "Why," they ask, should management "pander to people who now hold shares, on average, less than 10 months?  Should managers really regard such investors, whose investment horizons are shorter than the most nearsighted of managers, as stakeholders whose value they ought to maximize?"

Well, game on.  The battle for control of the corporation is now clearly out in the open.  Large pools of equity capital, sophisticated investment banks, and leading management consultants are offering alternatives to the longstanding model of public ownership of U.S. corporations.  If that model cannot be fixed, and soon, society will face a significant loss of corporate transparency and accountability, as companies are taken private.  Christensen and Anthony point out that companies in Asia, such as Tata (India) and Li & Fung (Hong Kong) are doing exceptionally well without the help of day traders and corporate governance activists. 

Christensen and Anthony argue that this will come with social benefits.  Their script for managers reads:  "Our responsibility is to maximize the long-term value of this company.  We will therefore act in the interest of those whose interests coincide with our long-term prospects, namely employees, customers, the communities in which our employees live, and the minority of investors who plan to hold our securities for several years."

It is a noble goal.  But the choice is not a simple one.  Should social investors be prepared to sign away Page's "ultimate power" to get the social benefits (which, after all, are just a promise)?  Or is it time to start looking for a new management company?

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.

Michael Porter and Gerstenfeld's Law of Trying

And the 2006 McKinsey Award goes to...Michael Porter for his outstanding article on the role of corporate social responsibility in corporate strategy.  Socialfunds has the story.

Most management articles on corporate social responsibility can be safely ignored.  CSR tends to bring out the worst vices of some management consultants - their reliance on platitudes, sloppiness around definitional issues, and especially their reluctance to quantify.

But Porter's piece strikes me as worthwhile.  On its own merits, it makes good points about which of the myriad social and environmental issues a firm should be most concerned with (those it understands well and has a stake in).  And Porter points out that old-school stakeholder theory (take care of customers, employees, and shareholders and your job is done) doesn't fly anymore.

I suppose I'm also happy to see a prominent management consultant and academic say "when a well-run business applies its vast resources, expertise, and management talent to problems that it understands and in which it has a stake, it can have a greater impact on social good than any other institution or philanthropic organization." 

This is a constructive rejoinder to the CEOs who say "it's not my job".  As Steven Lydenberg has pointed out, the great corporate success of the past 20 years comes with greater corporate obligations.  Porter argues effectively, I think, that corporations are well-equipped to meet them. 

What's missing now, is trying.  Most companies still act as corporate social responsibility is too hard or too expensive.  They are convenient things to say, but come on.  In his classic text on forecasting (available online here) J. Scott Armstrong of the Wharton School invokes Gerstenfeld's law of trying.

It was discovered one night by my friend, Art Gerstenfeld, upon returning home from work.  Gerstenfeld's son met him at the door, and the following exchange took place between the two:

"Daddy, fix my bike for me."

"I don't know anything about bikes."

"Daddy, please fix my bike."

"I don't know how to fix your bike!"

"Daddy, please fix my bike!"

"I don't know how to fix your bike!"

PAUSE

"But, Daddy, you can try, can't you?"

ANOTHER PAUSE

"Yes, I suppose that I can try."

And then he fixed the bike. 

With Porter on board, the time is right to spread the word on Gerstenfeld.

Some Weekend Reading

Thanks to MIT's remarkable OpenCourseware project, complete lecture notes for the school's course on behavioral economics and finance are here. 

The Economics of Happiness

If you don't like The Economist, wait a week. After the ill-tempered comments of the last post, the latest issue offers this excellent article on happiness and economics.  This is a great piece, offering plenty of historical context, going back to Carlyle and Hume, and giving critical attention to many different points of view.  I was especially happy to see acknowledgement of the contributions of Kahneman, who introduced the radical concept of asking people if they were happy.  And I had not been familiar with the work of Layard (if his new book seems a bit daunting, this article looks like an easier way to get started).

On a somewhat related note, I have been meaning to point out a series of good postings by Macroblog on economists and their critics (here, here, and here).  It is worth looking at these to get a sense of how it feels from the economists' side of of things.

A Notable Abdication

The King of Bhutan, the BBC reports, has abdicated as part of the process of transitioning the country to a parliamentary democracy.  I believe his contribution to the debate about social capital - his concept of Gross National Happiness - deserves far more attention than it has received (Time magazine article is here).

In the U.S. and Europe GDP reports and national income accounts are watched almost obsessively, with significant deviations from trend provoking almost instantaneous policy responses.  The same is not always true for important indicators of happiness and well-being, however.

Bhutan's experiments with the implementation of this concept are widely regarded as successful, but I hasten to add that this success came in a society with one religion (Buddhism) and a leadership with absolute power (although this is now changing). 

A set of discussion papers from a think tank in Bhutan is here.  It is nice, but it is not nearly enough.  Scholars in the social sciences need to do more, collaborating across traditional disciplinary boundaries, to develop a richer understanding of the strengths and weaknesses of this concept.

It won't be easy.  In a recent issue The Economist questioned the value of 'fair trade' and  characterized the challenges of organic food production as a political problem.  The Economist argument wasn't very good economics in the first place (externalities, anyone?), but never mind that.  If they're on form, the political scientists will bat the ball back, saying that the political forces in play are heavily mediated by economic questions, and therefore not their problem either. 

I have no problem with The Economist generally (they once inaccurately called me an economist, doing my career a world of good).  But there's no place for this kind of cop-out anymore.  Bhutan has made a brave start - its up to the rest of us to carry it further.

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.