SRI Notes

Moskowitz Prize - The New Trend

Last Sunday we had the pleasure of awarding the Moskowitz Prize to Alex Edmans of the Wharton School for his outstanding study of the 100 Best Companies to Work For.  Alex's study covers the entire period that these ratings have been published in Fortune.  His presentations at SRI in the Rockies were superb (see links below).  If you're going to Wharton, get signed up for this guy's classes - he is a great lecturer, and he is rock solid on financial theory and his knowledge of the recent literature.

• The Haas press release is here
• Alex's study can be downloaded here
• An audio recording of Alex's talk at SRI in the Rockies is here, and his slides are here

The winners of the Moskowitz Prize are taking on a different character, and I wanted to take note of it here.  In the 'old days' (pre-2004), studies tended to focus on the broad concepts - social responsibility, sustainability, etc.  In retrospect, Marc Orlitzky's study was the culmination of this line of thought.  He demonstrated that the concept of social responsibility was not just conceptually valid, but could also be framed as a valid statistical construct.  He then argued that social responsibility had been positively associated with financial outcomes (although the effects he found were much stronger for accounting-based than for market-based measures).

If Orlitzky was right that social policies have been financially beneficial (and there is still plenty of debate about that), the question becomes one of how the mechanism operates.  It's probably true that some social policies are good for financial results while others are bad.  But which policies contribute positively and which contribute negatively?

The three most recent winners have zoomed in on a single issue and tried to answer these questions.  Nadja Guenster looked at the impact of Innovest environmental ratings on fundamentals and returns.  Brad Barber examined the impact of the CalPERS corporate governance program on stock valuations.  And Alex's study looks at how employee relations policies impact portfolio performance.

In each case, the analyst focused on a measurable and important subcategory, and demonstrated that there was a positive historical association with returns.  Each study focused on a social variable that was well-specified, and used state-of-the-art risk models to assess performance.

Before we get too excited about these performance studies, however, it's important to remember last year's Honorable Mention paper by Harrison Hong and Marcin Kacperczyk, which showed that sin stocks have had exceptional returns over the years.  Like Gunster, Barber, and Edmans, this study zooms in on an important social variable and looks at returns through the prism of a modern risk model.

This trend strikes me as a very healthy development for social investment research.  Academics are moving away from general conceptions of social responsibility and doing detailed analysis of the individual stakeholder categories.  The results have generally been happy, so far, but, as the case of sin stocks show, social investors should be ready for unpleasant surprises as well. 

We know that, in aggregate, social screens haven't added value over the past 20 years.  Now we know some have been positive and some have been negative.  As we go further down this path, social investors will increasingly be challenged with hard data to re-consider some of their portfolio construction decisions.  That will be healthy, but it will not be comfortable.

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?

100 Good Investments (So Far)

In general, I think we have to be very careful about claiming performance benefits from social screening.  Many studies show that social screening, as it is usually practiced, has little or no impact on risk-adjusted returns over the long term.  This annoys both social investing's proponents (it's good to be good, but outperformance would clinch the deal) - and critics (who have long predicted disaster).

But there are a few variables where I think a close look is at least in order.  The environment and corporate governance have attracted some attention, and good research is being done in these areas.  But I also believe security analysts could improve their work by doing research in the area of employee relations.

Back in 1998 Chris Luck and I took look at the performance of the companies mentioned in the book The 100 Best Companies to Work for in America.  Looking at both the original 1984 edition and the updated 1994 list, we concluded that these companies were performing, as a group, better than their risk profiles would lead you to expect.  We updated the analysis in 2002, and I gave a talk on our findings at the Northfield quantitative conference that year (that presentation is here).

So I was delighted to learn last week that Alex Edmans, a researcher at MIT's Sloan School of Management, had done a careful analysis of the performance of the "100 Best" list and come to the same conclusion (Alex says the latest version of the paper will always be here).  The study has many points to recommend it - Alex's introductory discussion is excellent, the returns analysis covers a long time period (1998-2005), and a multi-factor risk model (Carhart) is used to filter out style, size, and momentum effects.

Highly recommended.

File Under: Stakholder Relations

With corporate balance sheets flush and housing affordability low in many developed countries, it was only a matter of time before someone started building homes for their workforce.  The UK retailer Tesco is subsidizing an affordable housing development intended to benefit its staff.  Expect to see more of this if both housing and labor markets remain tight.

Housing affordability is becoming a major constraint for businesses in California, where only about 24% of people have enough income to buy the median-priced home, down from 49% at the start of 2003.  Data from the California Association of Realtors is here - these numbers used to look even worse, but they appear to have changed the method of calculation and have moved to quarterly, rather than monthly reporting. 

Wal-Mart Speech

This speech by Wal-Mart President and CEO Lee Scott is drawing a lot attention from social researchers. Wal-Mart, of course, has been involved in many controversies, and is not currently represented in (for example) the Domini or Calvert social indexes. But the speech is notable for its ambition, its scope, and its detailed analysis. A brief excerpt:

"Our environmental goals at Wal-Mart are simple and straightforward:

1. To be supplied by 100% renewal energy.
2. To create zero waste.
3. To sell products that sustain our resources and environment."

Can't be much clearer, or more ambitious, than that. Scott makes the business case for these goals, pointing out that all waste has a cost.

Although my instinct is to look at deeds vs. words, I have to say that the speech strikes me as more than a PR piece. On first reading it looks like the beginning of a meaningful effort by the company to address some difficult issues.

Others are not so impressed: Op-Ed columnist Harold Meyerson of the Washington Post offers this harsh critique of the speech and its context.

[10/27 Update:  There is additional news on this today.]

100 Best Companies to Work For

The latest list of "The 100 Best Companies to Work For in America" is available now at Fortune's website (subscription required). For more information on this list, see the Great Place to Work Insititute's website - they do the underlying research.

There are many lists of great companies, but this is one of my favorites. It is one of the longest-lived (the first book came out in 1987) and is based on thoughtful and original research, not impressionistic analysis or press clippings. And it feels intuitively right to me - I have visited many of these companies, and they really do seem to be superior workplaces, and, often, superior business franchises.

In 2002 Chris Luck and I did a study and found an equal-weighted portfolio of the publicly-traded companies on the list would have had returns a little better than those of the S&P 500, even after accounting for valuation disparities, industry exposures, and other risk factors.