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?

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.

Economic Determinism vs. Biological Determinism

I've argued before that the underlying intellectual tension in social investing is the rejection by social investors of the idea that people are, or should be, primarily motivated by economic factors (as discussed in last year's Christmas post and Jim Hoopes' reply).

Frans de Waal has written a new book, Primates and Philosophers:  How Morality Evolved.  It is based on a series of lectures he gave at Princeton, and Princeton University Press lets you read chapter 1 free, here.  In a nutshell, de Waal believes morality is a result of human evolution, and is to some degree hard-wired in us. 

This challenges economic determinism with a kind of biological determinism.  On one level I'm happy to see it - economic analysis of human behavior can be frustratingly superficial, so it is nice to see someone push back and argue persuasively that something else - anything else - matters.

But careful what you wish for - if you accept de Waal's account, a host of new questions arise.  If human ethics and morality evolved, what does that say about the philosophy of ethics, which is supposed to be derived from reason - or religion?  I suspect Mr. de Waal will find his share of detractors.

Well, no one said it was going to be simple.  Primates and Philosophers offers good new reasons to pay attention to questions of ethics and morality.  Extra credit for getting a blurb from the estimable Robert Sapolsky:

"Frans de Waal has achieved that state of grace for a scientist--doing research that is both rigorous and wildly creative, and in the process has redefined how we think about the most interesting realms of behavior among nonhuman primates--cooperation, reconciliation, a sense of fairness, and even the rudiments of morality...This is superb and greatly challenging thinking."

Feedback on 'Who is Good?'

Jeff MacDonagh of Domini offers these comments on my 'Who is Good?' post...

Hi Lloyd,

Two points might help explain (or spread!) the confusion.

1) SRI evaluations are primarily derived from a backward-looking description, whereas most people's ideas of "socially responsible companies" are forward-looking prescriptions. I hear people say, "a responsible utility gets electricity from wind, a responsible grocery sells organic, etc."

The opposite is the case for non-SRI! Financial evaluations are primarily about future projections, whereas most non-professionals definition of a "hot stock" is based off of its 12 month chart.

I'm not 100% sure what this means, except that popular conceptions of SRI sets it apart from traditional stock analysis.

2) SRI evaluations don't lend themselves to single variable continuous quantification. Unlike PE ratio or other financial factors, it is very difficult to produce a continuum of SRI scores. Intuitively, this would seem to make it more difficult to link SRI scores to stock valuation.

- Jeff

Levitt on Social Responsibility

Steven Levitt, author of Freakonomics, spoke earlier this spring at Boston College's International Corporate Citizenship conference.  A brief account of his remarks is here.

I point this out because Levitt is exactly the kind of person we need to get more involved in the global exchange of views on corporate social responsibility (CSR) and socially responsible investing (SRI). 

I have come to believe that CSR and SRI have too many normative critics, and not enough positive ones.  That is, there is a good supply of people to criticize social investors for holding the values they hold, or for the way they act on those values  (examples here and here).  But there are not enough who bring quantitative sophistication and fresh perspectives to the study of these problems. 

Good positive critics can be scary - they question your assumptions about how things work, they make you look at uncomfortable facts, they present analysis that doesn't fit your world view.  But that kind of engagement can also be transformative - it may be the only way CSR and SRI can move meaningfully forward from their current practices. 

Levitt has what it takes to be a valuable positive critic - he is curious about how things work, he is not afraid to tackle difficult or controversial subject matter, and he is brilliant at question-framing. 

Hats off to BC for inviting him.

Who is Good?

Since I have other writing obligations and it will be a few months before I can write this up properly, I want to make a note about definitional problems and a study I did earlier this year.

I've been bothered for some time by the definitional issues around corporate social responsibility and socially responsible investing.  I don't agree with Hawken that the term SRI is "so broad it is meaningless", but it is a very general concept.

This matters for quantitative work, because many studies of CSR and SRI have the following logic:
    1)  Be socially responsible
    2)  ???                                    <---explanation of this joke is here
    3)  Profit!   

If we can't define the  variable in Step 1 clearly, the work is worthless.  No amount of ingenuity in Steps 2 and 3 can save it.

So how do we define corporate social responsibility?  The definition game is a hard one, and there are many strategies.  Depending on your pain threshold you could consult Webster's, Wittgenstein, or Ramsey.  I only seriously considered two strategies, however.

First, you can create a description of the concept, like a dictionary definition.  This fellow in the UK offers his own definition, as well as definitions from other sources.  I ultimately decided not to pursue this strategy. My main problem with the descriptive approach is that many readers will feel no wiser after reading the definition than they did before.  Ok, it's about "social responsiveness," "the continuing commitment of businesses to behave ethically," "capacity building for sustainable livelihoods," and  "giving back to society."  What does that really mean?

So this spring I took a different tack.  Instead of trying to say what social responsibility is, I tried to identify companies that were viewed as superior social performers.  If I can't describe it, I thought, I can at least find some companies that exemplify the concept.  Then, when someone asks "what is social responsibility?" I can point to those companies.

Many researchers have done this by using the membership of social indexes.  That's ok, but I think  it can be improved on.  I believe the majority of the companies in those indexes are there because of an absence of disqualifying characteristics, as opposed to the presence of notably positive ones.

So my objective was to compile a list of truly exceptional companies.  I am a big believer in Armstrong's eclectic research approach, so I decided to make two lists using two different methodologies:

• The Poll:  I sent an e-mail to the membership of SIRAN asking them to name a few companies they thought had notably strong social responsibility records.  I received many responses, and after sorting through them I had the names of exactly 20 publicly-traded U.S. companies.  (I excluded non-U.S. companies because my financial database is only complete for the U.S. firms.  Also, three of these were coffee companies...not quite sure what to make of that.)
• The Quantitative Ranking:  I consulted the social investment research firm KLD, and asked them to share from their database the top 20 raw social scores of companies in the Russell 1000 (these scores are used in the construction of the KLD Select Social Index).

Then I cross-referenced the lists.  Eight companies appear on both.  They are:

• Dell
• Gap
• General Mills
• Hewlett-Packard
• Intel
• Southwest Airlines
• Starbucks
• Timberland

Finally, I applied an infallible test to determine if these companies were, in fact, socially responsible:  I asked Steven Lydenberg.  He said: "yes".

So I think this is a pretty good list.  Whatever CSR is, you can show by both hard data and expert opinion that these companies have a lot of it. 

A few superficial observations:

1. All of the companies are consumer-facing, and all have strong brand names.
2. Four of the companies are in consumer sectors, three in high-tech, one in transportation.  The energy, materials, healthcare, finance, capital goods, telecommunications, and utilities sectors are not represented.
3. For virtually all of these companies, historical growth rates, reinvestment rates, and market expectations for future growth (P/E and P/B ratios) are above market averages.  This accords with the theoretical work done by Angel and Rivoli (1997).
4. These are big companies.  This again agrees with the work of of Angel and Rivoli.
5. Of this group, I believe only Southwest has a unionized workforce.

So that's a start, anyway.  If you believe social responsibility pays, it should pay best at these firms, arguably the most socially resposible publicly traded companies in America.

Deirdre and the Economists

I had a chance over the past two weeks to spend some time reading Deirdre McCloskey's How to Be Human* : *Though an Economist, a collection of her essays from the 1990s, many of which were first published in the Eastern Economics Review.  I recommend the book.  It is readable and informative, but, for reasons that will become apparent, also poses significant challenges to the reader.

The first thing to know about McCloskey is that she writes well, well enough to have authored an influential writing text for economists.  If you believe clear writing reflects clear thinking, McCloskey  is one of the clearest thinkers alive.  But, she says, this is not typical in her profession:

The main cause of bad writing in economics is that economists don't read good writing.  If economists would read Jane Austen or George Orwell, or even Adam Smith or JM Keynes or Thomas Schelling, in bulk, daily, habitually, they would improve. (p 131)

The second point to make about Deirdre is that, until 1995, she was Donald McCloskey, a prominent economist at the University of Iowa (following stints at Harvard and the University of Chicago).  The Economist, in its excellent 2004 article on her recent work, never mentions this - an impressive indication of how different that magazine is from its more sensational competitors.  But McCloskey herself thinks it is important, and chapter one of How to Be Human* describes some elements of what must have been an extraordinarily stressful period in her life.

No, I am not gay.  I am cross-gendered, and at age 53, having been a good soldier for over four decades, I am doing something about it... I'm going to become a tall and ugly but indubitably female economist.  I go full time in November 1995...  Why would anyone do such a thing?  The "why" question has the usual answer we give in economics:  stop asking it, since you might as well ask people why they like chococate ice cream.  (p 3)

McCloskey is, unsurprisingly, very alert to gender issues in economics, as this commentary on Lester Thurow's The Zero Sum Society suggests:

Thurow's football trope is not innocent.  Instead of trade as a sport in which everyone benefits, like aerobic dancing, the metaphor invites us to think of it as yardage extracted from one's trading partners.  The path is short - a path taken by England and Germany 1890-1914 - from sporting metaphor to the guns of August.  Stories matter.  (p 122)

I understand The Economist's reluctance to even mention McCloskey's gender status - it is the sort of thing that will lead many people to dismiss her arguments out of hand.  That is a major loss, because McCloskey is one of the most important critics of economics as it is practiced today.

Simply put, McCloskey thinks most modern economics has been done wrong and will have to be re-done.  She believes that economists' obsession with statistical significance (as opposed to real economic significance, or "oomph"), abstract analysis ("blackboard economics"), and social engineering have severely undermined the field's practical significance.

The late Richard Feynman, a Nobel laureate in physics, introduced a few simple theorems in matrix algebra into his first year class at California Institute of Technology with considerable embarrassment:  "What is mathematics doing in a physics lecture?... Mathematicians are mainly interested in how various mathematical facts are demonstrated...  They are not so interested in the result of what they prove."  Feynman's rhetorical question startles an economist.  In advanced economics it would be:  "What besides mathematics should be in an economics lecture? (p 216)

Her 1997 book The Vices of Economists; The Virtues of the Bourgeoisie gives a careful and detailed exposition of this argument, but How to Be Human* includes an excellent summary, entitled "Ask What the Boys in the Sandbox Will Have".  Unlike others who have been in her intellectual position, she takes little delight in what she believes are the misfortunes of economists.

The sadness is that economists, mainly men, are confident that their mechanical methods are correct and produce correct results.  The men stride about offering advice to governments and criticisms of each others' work as though they were doing real science...  They are of goodwill and have good minds.  They do not deserve to end up with a science lacking scientific findings.  No one with an ounce of human pity would be happy that such a good group of men are so wrong.

The scene is like an aunt watching her three-year-old nephew and his friends playing in a sandbox...  Yes, David, you are building a great fort in the sand.  My, how wonderful.  Yes, Gerard my dearest, yes. (pp 234-235)

Social investors, who protest that the assumptions of economic models are simplistic and incomplete, may take McCloskey to be an ally.  In this fight she certainly is.  But nothing I have read of hers suggests a left/liberal world view.  She is a self-described libertarian, and deeply suspicious of government programs that meddle in the economy.  But when she says "we have learned that one cannot solve great social questions standing at blackboard," many of us will say Amen.

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