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.

Putting a Price on Reputation

Steve Miller, former CEO of Waste Management, once commented that "a reputation is an incredible asset, one you can't appreciate it until you lose it." 

There are still plenty of people in the financial profession who are somewhat dismissive of the impact of reputational effects, despite many cautionary examples.  The negative impact is greatest for firms in competitive businesses where the consumer is willing to pay up for quality or safety.  Perrier, once the #1 vendor of bottled water, never fully recovered after having to recall the product due to benzene contamination.

I have not seen a good study of these things recently, but it's not hard to see recent examples in the market.  (Let me pause here to say that I do not own or cover either of the two stocks that I am about to discuss, nor do I have any views on their investment prospects.)

One timely example is Mattel, which is down today after recalling millions of toys that might be contaminated with lead paint. 

This comes on the heels of a similar recall of toys sold by RC2.  The RC2 situation has been going on longer, so we have a little more information on which to make inferences about reputational impact.  The first thing I'd note is that the stock didn't crack down much right away (the original press release is dated June 15), despite the fact that millions of toys would have to be recalled.  The stock's high for the year was $46...it dropped to $40 in the weeks following the announcement.  It fell from $40 to $36 yesterday, and after a weak quarter and guidance cut yesterday, it's $29.

I know there are many factors in play here, but the slowdown in sales and the safety recall may not be entirely unconnected.  Another data point - some outlets are discounting the premium priced 'Thomas' toys, something I haven't seen before.

And, of course, there are lawsuits.

For those interested in studying this situation (I think it would make a great case study), The New York Times has covered the RC2 story aggressively.  A Times reporter was actually detained at the factory where some of the toys were made for nine hours, as described here.  It appears that RC2 has since cut all ties with the vendor - a Times update story is here.

One final comment, a quote from the Book of Buffett.  Warren Buffett has been known to pay close attention to financial matters.  But when he took over Salomon following their bond trading scandal, he didn't emphasize the numbers.  He told employees:  "If you lose dollars for the firm by bad decisions, I will be understanding.  If you lose reputation for the firm, I will be ruthless."

Who Are These Guys?

A bit of a shock from Financial Times this morning:  "Large ethical companies consistently outperform the market, according to a survey of corporate social responsibility by Goldman Sachs, the investment bank."

Well, not really.  The report actually asserts that SRI indexes have historically underperformed, and offers this comment:  "one explanation for the historical relative underperformance of various SRI and/or ethical investment indices is the lack of integration with financial analysis". 

I'm sympathetic with the thought - social factors do need to be better-integrated with mainstream securities analysis.  But there's actually not much evidence to support what they're saying about performance.  Social investments haven't historically underperformed (for a long discussion of this see my 2005 Journal of Investing paper), and despite a rough three years the Domini Index is still ahead of the S&P 500 from inception.  If you're keeping score, it's currently Domini +12.1% (annualized return) vs. S&P 500 +11.5% from inception (5/90).  Major variations in performance appear to be explained by the Fama & French factors.  When you adjust for those factors, the big problem is explaining why the Domini index seems to have positive alpha. 

[Non quantitative readers can skip this note.  But if you're quantitatively inclined you can do your own analysis of the Domini numbers using the Fama & French factors from Ken French's website.  William Bernstein gives excellent step-by-step instructions here.  If you're in business school, ask your finance professor why the intercept is positive.  You'll get some interesting answers.]

The report is saying that certain companies Goldman Sachs likes have outperformed, and it introduces the GS SUSTAIN methodology to identify these companies going forward.  The report says that "our methodology is not designed to be comprehensive, nor is it designed to be prescriptive in judging what is good or bad practice."  (If you don't have access to Goldman research, this Associated Press article is a good backgrounder on the report.)

Peter Kinder has usefully divided social investors into three groups:

• Values-based investors - investors whose values drive portfolio construction with relatively little attention to the financial impact of those decisions
• Value-seeking investors - investors seeking to improve investment performance through the use of social or environmental variables
• Value-enhancing investors - investors that use shareholder engagement to increase shareholder value, but do not otherwise view themselves as 'socially responsible'

The Goldman report falls under the second heading.  They are not trying to make distinctions about what is right or wrong, or to serve a particular type of social or environmental investor.  The SUSTAIN project instead represents a serious effort to integrate stakeholder analysis with securities analysis, with a view toward improving investment returns.  That's a smart thing to do, and mainstream portfolio managers should take a hard look at it.

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.

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.

Update on Universal Owners

Thestreet.com's mutual fund columnist, Brett Arends, has an interesting (and strident) take today on the Home Depot controversy. 

"...[T]he people who should be right at the center of the scandal aren't the executives who are taking the loot or even the directors who gave it to them. It's the managers of some of America's biggest mutual funds, including Vanguard and Fidelity. Instead, so far, they're getting a pass."

That's the first time I've seen that said in the business media, although this criticism has been circulating in academia for some time.  In their excellent book, The Rise of Fiduciary Capitalism, Hawley and Williams warn of a society in which owners are separated from the companies they own by chains of agents (fund managers, directors, etc.), who ultimately do not do a good job of representing their interests.  That's what Arends sees going on at Home Depot:

"Bob Nardelli didn't really do anything wrong. He just asked for, and received, a massive amount of money. Wouldn't you?

"The problem lies with those on the other side of the trade -- the people hiring the executives. The people who are involved in the negotiations, namely the directors, aren't particularly motivated. They don't get paid very much, at least by heavy-hitter standards. And it isn't their money that's involved. No wonder they just outsource the calculations to "consultants" whose biggest interest is in keeping the executive class happy.

"Meanwhile, the people who are motivated to get the best price, namely the shareholders, aren't really involved. Which is why attention should turn to those who are supposed to represent them. Mutual fund managers have a fiduciary responsibility to their investors. "

It's an interesting article.  Did you know Fidelity voted against half of the stock option compensation plans that came up for a vote last year?  I sure didn't.

Hawley and Williams' site has much more on the universal owner concept.

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. 

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.