SRI Notes

Governance: Show Me the Money

The dialogue about the performance of socially responsible investments is full of mixed messages and mixed motivations.  Recent developments and data on corporate governance are likely to bring on a fresh wave of intellectual dissonance.

Corporate governance has been kind of a stepchild for social investors.  Although attention has been paid, and the most egregious violators are usually excluded from SRI portfolios, I would argue it has not been a central criterion for inclusion or exclusion - activist social investors have been more interested in things like South Africa, climate change, and Darfur, while less-activist ones have often delegated corporate governance due diligence to their money managers.  Still, everyone says governance is important.

It doesn't help that we don't have a good consensus definition of corporate governance.  ISS, Morningstar, and others provide rating services, but there are major differences in both definitions and ratings of individual companies.  CalPERS has its own take, which is different again - it has managed to both add value and annoy Warren Buffett, another mixed message for returns-focused investors.

But governance has special significance because it's one of the social or quasi-social variables where there's been academic support for the idea of a performance benefit.  It makes sense conceptually, and there's data.  The best data so far cam from Gompers et al, which showed that companies with corporate governance they didn't like underperformed materially in the 1990s.  For the most part, the Gompers governance metrics focused on takeover defenses - the more anti-takeover defenses, the lower your rating.  This raised the question of what we were measuring because large acquirors (the firms most likely to have strong anti-takeover defenses) underperformed materially in the 1990s.  But in the 2000s acquirors have done well, as takeover premiums became smaller and investors rejected big deals resembling the ugly stories of the 90s.

And simultaneously, a study by Empirical Research Partners ('Does Corporate Governance Matter?')finds that companies with high scores on the 'Gompers index' of corporate governance have significantly underperformed low-rated companies since 2000.  Empirical is a strong sell-side quant shop, and I have no reason to doubt their results.  Author Michael Goldstein (formerly a strategist for Sanford Bernstein) writes:

"There was, over the entire 15-year period, some payoff to good governance in holding periods beyond a year, but it wasn't impressive...  We also considered whether the governance score could help us distinguish winners from losers among the best- and worst-ranked stocks in our core model and its earnings quality module.  We found thre was an advantage conveyed by paying attention to governance when avoiding losers but only in the 1990s and not thereafter."

This is unpleasant news for governance advocates who have ridden the Gompers data a long way.  Goldstein goes on to argue that governance shouldn't matter much for stock prices since it's easily observable and tends to change slowly.  I disagree there - I don't know that we've perfected the art of measuring it, but one of the few points on which Ben Graham and Amy Domini would both agree that investing with a management you can't trust is a fool's game.

A Strong Study on Corporate Philanthrophy

I was happy to see Barron's this week recognize (link here, sub required) a strong study of corporate charitable giving from NYU that won an Honorable Mention in this year's Moskowitz Prize competition. 

This is one of those topics that raises all sorts of interesting questions, but where there has been virtually no empirical work (the only other decent study I'm aware of is Navarro's 1988 paper).  One of the most important aspects of this paper is the work they did trying to sort out causality.  Of course rich companies give money to charity - but do they derive a business benefit from doing so?  Consistent with Orlitzky, they find the answer is 'yes'. 

Does that flow through to stock prices?  Don't know.  More work is needed!  But this team is to be commended for exploring this neglected but important area.

A full copy of the NYU study is available here.  My sristudies.org abstract of it is here.

A Good Chart

Several colleagues have sent me a link to this chart from McKinsey.  My first reaction, before I even read it, was:  that's a heck of a chart. 

But the message they are sending here is a useful one.  Most social investors have had the experience of meeting an idealistic management team, only to find that the company didn't live up to the ideals.  So I certainly agree with this: "a company should identify emerging trends and develop coherent organization-wide responses—an approach that requires it to integrate social issues into all dimensions of the business, not just the making of strategy."

It also reminds me of a point the late Robert Townsend used to make - some jobs are too important to be left to staff, particularly those relating to strategic direction or external communication.  Townsend had no love for consultants, but I think he'd approve of how McKinsey puts the CEO at the center of the chart.  It's certainly consistent with what I've seen over the years.  Corporate social records tend to be pretty stable.  You typically see rapid change only when a new CEO comes in and makes social responsibility a priority.

A commemorative edition of Townsend's entertaining and instructive Up the Organization is coming in May (details here).  Time magazine's original (1970) review of the book is here.

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.

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.

Short-Termism Makes Strange Bedfellows

U.S. Chamber of Commerce President Tom Donohue will speak November 30th at the Wall Street Analyst Forum in New York (details here).  According to an e-mail I received today, "Tom will challenge analysts, investors, and senior management to end the era of quarterly earnings guidance and the damaging short term outlook they encourage and instead move toward a system that more accurately values businesses and encourages long-term growth plans..."

I point this out because short-termism is one of the recurring themes of this blog (it recurs here, here, and here...), and also because Donohue is no friend of social investors and governance activists (last year he criticized CalPERS for its activism and was on the receiving end of criticism as well).

That Donohue and social investors see the same problem strongly suggests to me that it really is a problem.

More Research on Corporate Responsibility

I just got a note from Donald Siegel, a professor of Economics at Rensselaer Polytechnic Institute (RPI) and longtime researcher in the field of social responsibility. He and his colleagues have put the finishing touches on a special social responsibility issue of the journal Structural Change and Economic Dynamics. You can download copies of the papers here (subscription required, however). The first paper, by Paton and Siegel, summarizes the other papers in the issue.

I first ran into Donald Siegel's work on corporate social responsibility in the 1990s when he and Abagail McWilliams were terrorizing researchers who, by misusing event study techniques, were reporting implausible relationships between social factors and stock prices. Their careful analysis showed that many impressive-looking studies needed to be reassessed, often reducing or eliminating claimed social impacts.

Since then Dr. Siegel has played the role of informed skeptic, advocating a pragmatic theoretical view of the relationship between social responsibility and financial results.  This paper provides an excellent overview of work he and McWilliams have done on social responsibility over the past 10 years.

I have said in the past that to remain relevant social investors need more and better positive critics. Dr. Siegel is one of a small group of strong academics who have been willing to play that role.