SRI Notes

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

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.

Swensen and SRI

One man everyone involved in SRI should pay attention to is David Swensen of Yale University. His performance has been exceptional - over the past 2o years the Yale Endowment's returns have been the best of any educational institution. His books, Pioneering Portfolio Management and Unconventional Success, are excellent.

This has been accomplished despite at least some social constraints. Yale has an Advisory Committee on Investor Responsibility, and during the South Africa boycott the endowment divested its holdings in companies doing business in South Africa.

Marc Gunther, a journalist at Fortune magazine and the author of the excellent Faith and Fortune, is also a Yale alum and has written this profile of Swensen for the Yale alumnae magazine. It includes commentary both on Yale's social investment policies, as well as those of other schools (notably Williams, which now has a 'Social Choice Fund' available).

Swensen is not the only investor to achieve superb results despite social constraints. Sir John Templeton, widely regarded as one of the finest investors who ever lived, avoided alcohol, tobacco, and gambling stocks for religious reasons throughout his career.

Vice is Nice, but Not Indispensable

I've had some questions about this December 14th press release from QED International, which states that social investors' aversion to vice industries has cost them returns.  I'll start with my critical remarks, but I also have some positive comments (down near the bottom).

Any time I hear about a study of historical returns, I have some basic questions:

Question 1:  Can I see the study?
Answer:  In this case the press release appears to be the study - there's no information on how to get a more detailed look at the work.
LK Comment:  There is a often a big gap between what the data shows and what the authors say it shows - if there's an underlying study it's good to have it.  In this case we'll work from the press release, which is pretty detailed.

Question 2:  Has the study been reviewed by anyone else or is it likely to be published somewhere?
Answer:  There's no mention of a more thorough writeup, nor of any attempt to have the work reviewed or published somewhere.  That doesn't mean it won't be, they just aren't telling you in the press release.
LK Comment:  It's a lot easier to write a press release than to publish an article in a refereed journal.

Question 3:  Does the study look at real portfolios, or backtests?
Answer:  Backtests (with the exception of Domini Index/ S&P 500 comparison).
LK Comment:  Hindsight is 20-20 - at any moment in time you can pick a group of stocks excluded by social investors that has performed well, and write an article about how social screens are costing investors money.  (For some reason everyone wants to talk about tobacco lately but not about the auto companies, which social investors have also avoided and which have underperformed badly in recent years.)

  Anyway, the real test of an investment strategy is whether it works forwards, not backwards.  The only analysis in the press release I could call prospective is the table at the bottom of page three.  It shows their vice composite with a marginally higher estimated growth rate than the Value Line universe (9.7% vs. 9.3%), and slightly more attractive valuation ratios.  Okay, that's a good point.  Vice stocks are expected to grow a bit faster and look to be a little cheaper.

Question 4:  Do the numbers look ok?
Answer:  No.
LK Comment:  The table at the top of page 2 presenting Domini Social Index vs. the S&P 500 appears to be in error.  It shows the Domini underperforming the S&P 500 for the 10 years ended September 30th, when KLD's 9/30 press release shows outperformance during that period.  They show the Domini Social Index for the 10 years at an annualized 8.74%, while KLD reports 9.97%.  I don't know, but I'll bet they used the Domini Social Equity Fund's performance instead of the underlying Domini Social Index, comparing a mutual fund with expenses to an index which has none.

  The QED press release claims the Domini Social Index is behind the S&P "for annualized periods of one, three, five, and ten years."  But comparing index-to-index using KLD's reported returns, it looks like Domini is ahead on its ten-year record, about tied on its five-year record, and behind over just the past one- and three-year periods.

Question 5:  Are returns risk-adjusted or presented in the context of a risk model?
Answer:  No.
LK Comment: Sometimes a study shows a significant performance difference between portfolios, but does not explain where the difference might come from.  In fact, there's a well-developed literature on determinants of differences in portfolio return.  The usual suspects are:

• Risk (beta)
• Size (market capitalization)
• Valuation (price/book ratio)
• Momentum (relative price strength)

Usually, these factors explain most of the differences in historical investment performance among portfolios.  If you use the variables listed above you're using a Carhart model, if you drop momentum you're using a Fama & French model.  The authors of this press release appear to have used neither.

And that's a problem.  Their argument is:  the Domini Social Index left returns on the table - given the data problems it is clearly not true for all the time periods they list, but it certainly has been true over the past one and three years.  The authors would like to show that this shortfall was because of the failure to own vice stocks.

But maybe it was just a failure to own value stocks or small stocks, both of which have had great performance lately.   The authors include some commentary on this, but without a risk model we can't know the answer with any precision.  And it's really important to know that answer:  if the Domini Social Index is underperforming because it doesn't own value stocks, that's a solvable problem (investors can supplement it with a value fund, or pursue other diversification strategies).  But if there's something really special about vice stocks, that makes it impossible to create diversified portfolios without them - well, that would be big news, and a big problem for social investors.

So those would be my questions, and after looking at the press release they haven't persuaded me.  To show that social investors are making a BIG MISTAKE by not owning vice stocks, they need to show that that excluding them creates unavoidable diversification costs.  And I'm not seeing it here.  From that perspective I'm a lot more concerned about Energy than the sectors they presented in this study.

Let me finish with a positive comment.  In addition to their retrospective analysis, the authors do some APT analysis of the excluded sectors (there is a good explanation of APT here).  This is new and useful work and deserves attention - I have not seen APT analysis of specific excluded sectors before.  Dan Dibartolomeo and I did an overall APT analysis of the Domini Social Index ten years ago (we used a different model than the one used here) and found that its macroeconomic bets differed significantly from the S&P 500 (see Kurtz,  Lloyd and Dan DiBartolomeo, "Socially Screened Portfolios: An Attribution  Analysis of Relative Performance." Journal of Investing, Fall 1996).  Dan updated this work in 1999 and that paper ("Managing Risk Exposures of Socially Screened Accounts") is available on the Northfield website.  Our analysis suggested the Domini index was particularly oil price-sensitive, and could underperform during a period of rising oil prices.  And we have certainly seen that.

Hopefully QED will follow this up with a more detailed white paper, or better, a journal article.  I think the APT aspect of this work could be a journal article in itself, particularly if the authors computed the APT coefficients for the Vice Composite they present on page three.

Ben Bernanke's Favorite Stock

posted by Jeff MacDonagh

Here’s some interesting commentary by Jeremy Siegel about our new Fed chair’s one and only publicly traded stock investment, Altria.  Two points worth considering:

1)     Mr. Seigel points out why social investors may actually contribute to creating stock buying opportunities for other investors.

2)     Altria’s appeal as a “long-term investment” flies in the face of what social investors claim, namely, that “what comes around goes around.”  A company that externalizes costs onto society to the tune of hundreds of billions of dollars cannot continue to do so indefinitely.  Maybe not, time will tell…

PriceWaterhouseCoopers looks at CSR information and analyst estimates

posted by Jeff MacDonagh

PriceWaterhouseCoopers is putting some resources into looking at CSR reporting, here’s an article sent to a few of us at Domini Social Investments by the author, Ms. Alison Thomas. PwC’s ValueReporting team studied two groups of equity analysts – one with only "traditional" financial information, and another that also had CSR information. Although this study’s sample size was limited, the results are thought provoking, if not stunning. When provided with CSR information, analysts have more consistency in their estimates (the good news), however, their earnings and revenue forecasts are lower (bad news? maybe not, maybe more realistic?). The funny thing is that the group with CSR information, despite having lower forecasts, still issued more buy recommendations, perhaps suggesting more confidence in their analysis (more good news).

This poses some important questions about how CSR information impacts traditional equity analysis. I have been a skeptic that it would be through altering the models used by analysts; e.g., the discounted cash flow methodology. Rather, my hunch is that it would be useful in providing analysts with more confidence in management’s growth strategy, for example. This study’s author put it best, "the fact that such sources of competitive advantage cannot be ‘valued’ does not mean that they cannot be ‘evaluated’."

Meir Statman

If you a make a list of financial theorists who have 1) taken a long-term interest in social investing, 2) published numerous studies of SRI in refereed journals, and 3) engaged social investors constructively about their work, you basically get one name: Meir Statman.

Since he won the Honorable Mention in this year's Moskowitz Prize competition and headlined the Journal of Investing special SRI issue with a different article, I thought I'd provide a little additional background on him and his work. Here are his studies that bear directly on SRI:

• Doing Well While Doing Good?, Financial Analysts Journal, 1993
• Socially Responsible Mutual Funds, Financial Analysts Journal, 2000
• The Religions of Social Responsibility, Journal of Investing, 2005
• Socially Responsible Indexes: Composition and Performance, forthcoming, 2005
  

I first ran across Meir's work when I was studying the diversification impact of social screens in the late 1980s and early 90s. In those days conventional wisdom held that 30 stocks should be enough to adequately diversify a portfolio. But in 1987 Meir's "How Many Stocks Make a Diversified Portfolio" showed that the number was much higher, possibly in the hundreds.

I figured that finding was good for a social index - it strongly suggested that broad indexes could offer a risk advantage over more concentrated portfolios. But it was also a cautionary note for social investors who were counting on the "Rule of 30" to protect them from diversification costs introduced by the social screens. It convinced me that social investors needed to be really careful about diversification, a conviction I still hold today. (A brief abstract of this study appears at sristudies.org.)

Meir's best-recognized work is not in the SRI field, however. He is regarded as one of the pioneers of Behavioral Finance, and his most-cited work is a Journal of Finance article, about the tendency of investors to sell winners too soon and hold losers too long. The full citation for Shefrin and Statman (1985) can be found here.

Social investors should take careful note of Meir's work, because many of his papers go well beyond the bounds of traditional finance and raise questions about the interplay of markets and human psychology. I am thinking particularly of his paper on fair trading, which has ethical and moral significance well beyond its contribution to the financial literature.

I asked Meir which of his writings he thought newcomers should look at, and he suggested "Normal Investors, Then and Now", which recently appeared in Financial Analysts Journal.  There is a good interview with him here.

Meir has made a serious study of social investors. Social investors would be wise to return the favor.

The Best of All Possible Worlds?

I've written before about the short time horizons prevalent today.  Now there is a study suggesting that the best traders are likely to be, well, psychopaths.

This brings many thoughts to mind.  It certainly is consistent with the increased use of computers in finance, especially for shorter-term trading.  We've seen a parallel in chess, where computers can now beat the best grandmasters (although a computer plus a human is stronger than either alone).

But I cannot shake the feeling that we are getting it wrong.  Capital allocation is one of the most important tasks in our society.  I find it hard to believe that a group of psychopaths operating on a short time horizon are going to do it in the best possible way.

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.

2005 Moskowitz Prize Winner

I had the pleasure last night of presenting the 2005 Moskowitz Prize to Nadja Guenster of Erasmus University in the Netherlands, who accepted on behalf of her three co-authors. (Official announcement is here.)

Nadja gave a great presentation on the study this morning at the SRI in the Rockies conference in Snowbird, Utah. Here is my abstract of the study, and the full text is available here.

If you are interested in the financial impact of environmental and sustainability practices, I think it is fair to say that this is a must-read. We have seen several studies showing environmental alpha in recent years, most recently Derwall(2005). But until now no one had really explained how or why this was happening. Nadja's piece is careful, thorough, and full of good judgments about methodology and data.

Congratulations also to Meir Statman, who received an Honorable Mention for his article on socially responsible indexes.  Meir is having a good year, as he also is headlining the just-released Journal of Investing special issue with a different piece on SRI.