SRI Notes

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.

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.

Daniel Fermon and the CEO

I've expressed skepticism in the past that the sell side could add much to the social investment world, but there is a lot going on now, some of it very interesting.

Daniel Fermon, Senior Europe Strategist at Société Générale, is doing work that incorporates  traditional financial research, social/governance research (from Société Générale's SRI researchers, Sarbjit Nahal and Valéry Lucas-Leclin), and his own innovative views on the role of the CEO in investment returns.  There is a brief but interesting interview with him here.

In coming years I believe markets will gradually grow more efficient with respect to traditional investment variables such as valuation and momentum, making it tougher for traditional investment strategies to add value.  As that happens, researchers will have to dig deeper into predictors of sustainable value creation, such as management quality and governance.  Fermon's work shows how this type of analysis can be done.

Instant Feedback

Of course the minute I write a note saying the sell side will never do much social responsibility research, Merrill Lynch comes out with a new report on clean cars, prepared in cooperation with the World Resources Institute.

Why Can't Accountants and Wall Street Handle Corporate Social Responsibility?

A good, tough question from a conference I attended Friday. Since we have an established infrastructure to track corporate financial performance (the accounting profession) and investment characteristics (Wall Street), why not let them handle corporate social responsibility reporting? After all, the accountants and Street analysts probably know the company better than anyone else.

It's a thought-provoking question. Why do we need all this CSR infrastructure? But if you think about it, I don't think CSR reporting can be handled by accountants and analysts. Let's take them in turn.

Accounting

Instead of GAAP, we could have GASP (Generally Accepted Social Procedures). Just as accounting firms have broadened their brief to include Sarbanes-Oxley, they could also pick up the social reporting requirements as well. Here are my objections:

• The accounting profession is itself in crisis, with one of the big firms (Andersen) now virtually extinct following its role in the Enron scandal and the others all involved in major scandals or frauds in recent years. An incomplete list of these would include Worldcom (Andersen again), Rite-Aid (KPMG), Adelphia (Deloitte and Touche), and AOL/Time-Warner (Ernst & Young). PriceWaterhouse Coopers has avoided the worst problems, but was the auditor when Bristol-Myers overstated revenues by $2.5 billion over a three-year period due to "inappropriate accounting" for inventories, an unwelcome event I experienced firsthand as a buyside analyst.
• I'm not sure that GAAP is a good example for anyone. Who, exactly, uses it? Not Wall Street analysts, who prefer operating earnings. Not most buy-siders - we use proprietary models that are more likely to incorporate Wall Street estimates, cash flows, and other indicators. Not academics - most I have met believe cash flows or metrics such as Stern Stewart's EVA are better indicators. Alfred Rappaport of Northwestern has famously said that "earnings are an opinion, but cash is a fact."
• The GAAP process, despite many denials, is highly politicized. One need look no further than the accounting profession's decades of refusal to count stock options as an expense. As Warren Buffett repeatedly pointed out in the 1980s and 1990s, they are a cost to shareholders. The argument that they have no value is absurd (if they're free, give me some).

So maybe the accountants are busy with other things. What about Wall Street? Surely they have the broad-based business knowledge and systems to facilitate social responsibility reporting?

Wall Street

By Wall Street I mean the 'sell side' of the investment business, the brokerage firms and investment banks. These organizations are incredible repositories of knowledge about specific businesses and industries. Want to know more about the EVP in charge of a company's largest division? The one person who can probably give you that color, and more besides, is a sell-side analyst. There have been superb individual reports from sell-siders on CSR issues. When I worked for KLD in the early 1990s the single best source of environmental information on Dupont was an extraordinarily thorough sell-side report. And I would single out Amar Gill's piece on corporate governance in developing countries as one of the best CSR reports I have seen from any source.

But I think reports like Gill's will be the exception rather than the rule, for three reasons:

• Hostile culture: Wall Street is almost religiously single-minded about money. Wall Streeters go there to make money and when they want to do something else they leave. It is the dominant aspect of the culture. For most, CSR is a way to lose focus and fall behind in the race. Wait a minute, you might argue, some of these things have real impact on the bottom line. True, and you might be surprised at how carefully Wall Street analysts have evaluated social issues likely to impact earnings in the near term. But they're not doing it out of social conscience.
• Investment banking: One of Wall Street's most lucrative businesses is investment banking. And investment bankers hate it when people say bad things about firms they're trying to do deals with. In 1997 Martin Fridson, then the chief high-yield strategist at Merrill, cited "screaming fits by investment bankers" as a key obstacle to getting good quality of earnings information. Advocates of corporate social responsibility can expect the same treatment.
• Time horizons. Social issues like asbestos, tobacco, and the environment are not one- or two-year challenges. They may take 20 years or more to unfold. Yet Wall Street is built for short-term thinking. On the brokerage side, the most valuable client is the one who trades a lot, and that client has, by definition, the shortest time horizon. This short-termism reflects the broader client base - according to Benartzi and Thaler, the average institutional investor's time horizon is about a year.

Given where its incentives are, I seriously doubt if Wall Street will ever play more than a peripheral role in corporate social responsibility.