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.

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.

Warren, Charlie, and Bill Are Not Social Investors

A few times over the years, I've heard proponents of social investing invoke the teachings of Warren Buffett in support of their activities (the most comprehensive argument along these lines is Patrick McVeigh's chapter in the old The Social Investment Almanac).

It's an attractive idea.  Buffett's a great investor, and he not only has strong views on ethics and integrity, he expresses them with flair (even in cartoon form).  Then you notice him saying things like "we have never made a good deal with a bad person," and it's kind of natural to think he's on board with the social investment concept.

Natural, but wrong.  Buffett has sometimes owned securities that social investors would find objectionable.  Although I believe most of its holdings pass typical social screens, Berkshire has owned tobacco securities, and is now drawing fire for PetroChina.  Reuters reports today that "Berkshire Hathaway Inc. is keeping its PetroChina Co. shares amid growing criticism from Harvard University and others about investing in companies that might be linked to genocide in Sudan."  Berkshire's official comment is here.

I have read an unofficial shareholder meeting transcript (all disclaimers apply) in which Buffett's partner, Charles Munger, was asked about PetroChina.  He reportedly said "it would be hard to invest in oil without finding companies that are doing something we wouldn't do...  I'm glad I don't have to take responsibility.  If we had those standards we couldn't invest in anything.  Every big oil company is involved somewhere in a country which is doing something we wouldn't do."

The news on Berkshire follows the Gates Foundation's decision to not implement social constraints, despite some fairly obvious issues raised by the Los Angeles Times.

I am two minds about this.  On the one hand, I do think Buffett, Gates, and Munger are wrong if they think a stock certificate creates immunity from moral responsibility.  A stock certificate can do miraculous things, but that is not one of them.  In most ethical systems you have to consider the consequences of your actions, including financial ones.  I think this is particularly true when we're talking about the richest people in the world.  These people are not desperate for returns.  It wouldn't kill them to pick a different name.

Or maybe it would.  For all his folksy charm and rhetorical brilliance, Warren Buffett is a pretty specialized animal.  He identifies superior investment opportunities, passionately, single-mindedly, and to the exclusion of many other things he could do with his time.  Maybe asking Warren Buffett to do ethical investing is like asking Bobby Fischer to play ethical chess.  Other people could, or could at least try - but perhaps, precisely because of who he is, he can't.

And that's an important point about social investing - how you do it depends on who you are.  For Warren Buffett to be a social investor he doesn't have to do what I think is right, or what anyone else thinks is right.  He has to do what he thinks is right.  If more people just did that, I believe the world would be a better place.  I have read everything Buffett has written, and found nothing there that contradicts this belief.

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Postscript: I can't resist adding two words about Buffett's investment writings:  read them!  If you invest in equities for the long term, or plan to, you should go to the Berkshire Hathaway website and read every single Chairman's Letter.  This will not make you as good an investor as Buffett, any more than reading Bobby Fischer's My 60 Memorable Games will make you a grandmaster.  But in either case you will be way ahead of your neighbor.

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. 

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. 

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.

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.

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?

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