SRI Notes

More Reputational Effects

Mattel is announcing today the recall of 9.58 million more toys due to safety issues, following the recall two weeks ago of 1.5 mm.  On Monday an executive for a Chinese manufacturing company working with Mattel committed suicide. 

Mattel stock seems to be holding up reasonably well.  It is down -2.4% today, and has been a weak performer with the Consumer Discretionary sector over the past month, but has actually outperformed the market over the past five days.  So initial impact seems contained - it will be interesting to see what happens on their next earnings release.

(Note - These are just my observations on the market's reactions to recent news...  I don't own MAT, haven't analyzed it, and have no opinion on its investment merits...!)

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.

Two Perspectives on Our Significance

If you're over thirty, you're accustomed to a world in which the U.S. was a dominant, or even the dominant economic player.  For all the talk about the emergence of economies like India and China, on official statistics, they still pale in comparison to the U.S., as this intriguing map shows.

But the standard GDP comparison is flawed for many purposes.  By most intuitive measures of wealth, China and India should rank higher than they do on that map.  It turns out that one reason for the discrepancy is exchange rates.  If you compare apples to apples using purchasing power parity (a nice apartment in Beijing vs. one in San Francisco, for example), you get a very different picture, as this list from the CIA World Factbook shows.

I suppose there are important reasons why a dollar should buy three times more stuff in, say, Malaysia, than it does here.  Many Asian governments don't mind a weak currency vs. the dollar because it's good for exports.  America, meanwhile, has a lot of rich older consumers who like buying good stuff cheap.  So, in an odd sense, even though cities like Singapore, Hong Kong, and Kuala Lumpur are as 'developed" as, say, Albany, we set our terms of trade as if they were not (if you haven't seen it lately, here is a fairly recent picture of Kuala Lumpur). 

Economists have taken to calling this state of affairs "Bretton Woods II" - a reference to the de facto fixed exchange rate system of the post-WW II era.

The world view you choose to believe depends a lot on how long you think the Bretton Woods II arrangement will last.  Some view it as benign, even optimal (as this paper suggests).  Others have a darker view.  I  believe it is unravelling gradually - most Asian countries have already abandoned their dollar pegs (China and Hong Kong are big exceptions).  And a money manager we know recently reported that a nice house in downtown Hanoi is running about $1 mm.

We Americans are used to being listened to.  Other countries benchmark against us and look to us for value-added products and know-how they have not yet developed.  As things progress, it's unlikely we'll remain the largest economy in the world.  We may retain our technological edge, but the gap will likely narrow.  And in some instances, the rest of the world will get ahead of us, and we will find that we have something to learn.

Independence Day is a good time to think hard about what we understand well and what we don't - what we have to teach the world, and what the world has to teach us.  But I wouldn't take that map too seriously.  As the proverb goes, "do not make yourself so big, you are not so small."

Costing the Atmosphere

I'm a bit behind in my reading, but enojyed this piece from The Economist's special report on business and climate change, particularly the graph (sourced from the Swedish utility Vattenfall). 

The Economist correspondent drily observes that "people buy houses not because they have good insulation but because they have pretty views."  One might say the same thing about why (most) people buy stocks and mutual funds - which might, in turn, explain their results (the mutual fund version is here). 

Harvard Draws a Line

Accoring to this article in The Harvard Crimson, the University's panel on social investment (known as the Corporation Committee on Shareholder Responsibility) affirmed avoidance of direct investment in companies involved in Sudan.  But the panel also decided not divest from holdings that indirectly hold Sudan-related investments.  If I understand this correctly, it means Harvard can continue to own Berkshire Hathaway shares (as discussed here) despite Berkshire's PetroChina holdings.

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.

KLD Blog

I'm happy to report that the SRI research firm, KLD, is starting a firm blog that will offer insights and commentary on SRI.  Peter Kinder, CEO and co-founder of the company has the first post. 

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.