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.

Oil Prices and Alternative Energy

Social investors and oil company CEOs agree:  high oil prices are good.

Jack Robinson, who manages the Winslow Green Growth Fund, tempts fate in the latest CFA Institute Conference Proceedings Quarterly (link to abstract is here), quoting the most dangerous words in investing:  "it's different this time."

Robinson focuses particularly on alternative energy, noting that "at times in the past [it] has seen an explosion of [investment] interest only to have it evaporate as oil prices declined.  This time, however, unique circumstances may make green investing in general, and the search for alternative sources of energy in particular, a permanent recipient of investment capital."

Calvert seems to agree, and this month launched its own alternative energy fund.

I can't resist also linking to a slightly different view - this Fortune article explains why Exxon Mobil CEO Rex Tillerson has no interest in alternative energy investments.

Maybe everyone is right.  High oil prices would be a boon to both alternative energy companies (by making alternative more attractive when compared to oil), and to Exxon Mobil (by allowing the company to continue to earn stellar returns on equity).

The futures markets have been predicting sustained higher oil prices for some time.  This interview with Fatih Birol, chief economist of the International Energy Agency, certainly seems to support that view as well.

Two things bother me about all this.  First, high oil prices are good for oil companies and alternative energy companies, but bad for consumers - especially poor ones.  Birol argues that Africa is being hurt the most by the current high price environment.  Second, former Exxon Mobil CEO Lee Raymond, who knows something about oil supply, last year predicted a decline in oil prices over the coming decade as the global industry catches up on the underinvestment of the prior decade.

Whomever is right, oil seems to be running everything right now.  Last week Starbucks announced it would be very difficult for the company to hit the high end of earnings guidance.  One key culprit:  the price of milk.  So why are milk prices so high?  This article from Monday's Wall Street Journal offers several explanations - a cut in EU subsidies for export, a drought in Australia - and higher corn prices (feed for the cows).

So why are corn prices so high?  Well, corn is an important ingredient in ethanol, although some experts had predicted that this would not have a major effect.  (This is reminiscent of a headline from The Onion's history book, Our Dumb Century.  After the 1929 market crash the headline reads:  "Experts Blameless, Say Experts" ...)

As for the Australian drought?  It's bad.  Really bad.  And unlikely to end any time soon.

My favorite part of all this is that today, the Fed Open Market Committee commented that "readings on core inflation have improved modestly in recent months," as they left the Fed Funds rate unchanged.  And the core inflation numbers certainly are reassuring. 

But the core numbers don't include oil, corn, and milk, three commodities that in recent years have stubbornly refused to regress to the mean.

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.

Fortune on Green Funds

The latest issue of Fortune has a pretty good update on SRI mutual funds.  The toughest criticism the industry has seen in recent years is that funds are not green enough, and that even though Best Buy, Outback Steakhouses, and Hershey pass the screens, what's truly responsible about them?

Glad you asked, at least about Hershey.  Hershey's controlling shareholder is the Milton Hershey School for disadvantaged kids, which is one of the worthiest causes I can think of.  Age and decrepitude have forced me to curtail my candy bar consumption, but when I indulge I make sure it's a Hershey product.

The larger point is well-taken, however.  SRI so far has been more about avoiding/boycotting bad companies than aggressively looking for great ones.  Give credit to KLD and Barclays, who are today introducing an exchange-traded fund that weights companies, in part, according to their social scores and virtually abandons the old exclusion approach.  The product, which is then optimized to the Russell 1000, will be a interesting test of whether social screens can, in and of themselves, add value.