Conventional wisdom about SRI, which can mean either socially responsible investing or sustainably responsible investing, is that adding an overlay of social screens to investment decisions will have an adverse effect on investment returns. Like much conventional wisdom, that convention may contain a kernel of truth, but it is by no means always the case.

As more advisors consider SRI because of personal interest or prodded by clients’ personal interests (see sidebars below for profiles of four such advisors), there is a need for serious research on SRI.

Luckily, questions like “Is there a causal relationship between corporate social performance and corporate financial performance?” and “Do investors have to give up returns in order to invest according to their personal values?” have been taken up in the academic world, and we are beginning to get some answers.

One of the primary vehicles for fostering such research is the annual Moskowitz Prize, which is awarded by the Haas School of Business at the University of California at Berkeley. The award is given in cooperation with the Social Investment Forum, promoting the concept, practice, and growth of responsible investing, and is named for Milton Moskowitz, one of the first investigators to publish comparisons of the financial performance of screened and unscreened portfolios.

Presented on October 26 at the annual SRI in the Rockies Conference, this year’s recipient was David Baron, professor of political economy and strategy at Stanford University’s Graduate School of Business, for his paper, The Economics and Politics of Corporate Social Performance.

“This year’s winning paper takes a more nuanced view of a firm and its interactions with society than most academic studies,” wrote Lloyd Kurtz, Moskowitz Prize administrator and senior portfolio manager at Nelson Capital Management. “Baron and his colleagues hypothesize that firms attempt to meet demands not only for financial performance, but also for social performance in general, and for social action specifically.”

Managing Editor Bob Keane discussed with Baron his research and its implications for investing by telephone in late October.

Is there a connection between a company’s level of corporate social responsibility and its overall profit picture? There’s a lot of controversy about that. Scholars don’t agree. One question is whether it’s beneficial for firms to pay attention to social issues, and by beneficial I mean in terms of increasing their market value. There could be several answers to that.

Associated with social issues is social pressure, and social pressure on firms could be harmful in a lot of ways. And notice that this all “could be” harmful.

Social pressure could affect the demand for your products because consumers might be pro the social issue and concerned about your performance on that dimension because of the social pressure itself. The extreme case of that is a boycott. We don’t play up boycotts, because it’s not clear that boycotts make much of a difference. The evidence isn’t there.

Social pressure on you could affect how much investors are willing to pay for your shares. It could be that some investors will shun your stock and buy shares of other firms, but it could be that those investors anticipate that the social pressure you’re under could lead to other activities, such as regulatory activities.

What’s even harder to measure is [whether social pressure] affects your employees and their morale and productivity.

You’re saying social pressure could be harmful to a firm? It’s hard to see how it could be beneficial, but it could be harmful. These days I think that most enlightened firms understand that social pressure and try to mitigate it to the extent they can.

Are there things that a firm can do, proactively, that will improve its performance? How might the firm be rewarded for its own social activities or performance?

They could be rewarded by consumers. A second way they could be rewarded is by investors. Some investors like the social performance and want to hold shares in those firms. The third is that the employees may like these things and like working for the firm and be more productive.

So by acting responsibly a company might win over consumers and succeed in the marketplace? It could be that a company does all these things right and is rewarded by consumers, but it could be that there’s enough competition in that industry that it drives prices way down. If prices get driven way down, the company may not perform well, even though it may have these beneficial social dimensions. It depends on the competitiveness of the industry. It could be that there are these effects, but they just get competed away in the marketplace.

We can’t determine if there’s a causal effect of corporate social responsibility on corporate financial performance.

Suppose you’re an investor, you’re interested in a fund and you look at the data and you run various kinds of correlations or regressions of corporate social responsibility and corporate financial performance. How should I understand that relation? If we look across the firms [in the study we find] corporate financial performance is unrelated to corporate social performance, but it’s negatively related to social pressure.

So this says those firms that are under more social pressure have lower financial performance, and that’s in the data–it’s statistically significant.

Do you have any examples? Let’s take the grocery industry. Whole Foods is a company that sells high-priced food to wealthy people, let’s just posit that. They also engage in a lot of things that you would refer to as corporate social performance. It may be that they have identified a responsiveness of their clientele to these social performance activities and that they maximize their profits by doing a lot of corporate social performance because they know they’ll get rewarded for it and they make a certain profit as a consequence of that. That’s case number one.

Let’s make case two be WalMart and its grocery business, and let’s think about it prior to its [recent and highly publicized] corporate greening. Think of WalMart as being relatively low on the corporate social performance level: its costs are low, its sells at low prices, and it sells to lower-income people. Now which of those two firms is more profitable on the grocery business? Is it clear? No.

It could be that WalMart is much more profitable than Whole Foods, or it could be the other way. My guess is that, talking only about the grocery business, that it’s WalMart. It’s the one that’s more profitable and it has very low corporate social performance.

Is there another explanation? In finance there’s a theory called Modigliani-Miller that supposes there were no taxes in the world. Suppose you looked across all firms and on the horizontal axis you put either the amount of debt in their capital structure, and on the vertical axis you put their market value. The theory says that the graph should be a flat horizontal line. Why? Because if a firm has a lot of debt, the investors who hold shares in that company will essentially change their own personal portfolio, that is the debt/equity ratio in their own portfolios, and they do that in equilibrium and it results in the debt/equity ratio having no effect on the market value. The same thing could be true here.

There’s kind of a social Modigliani-Miller that operates in a theory I’ve developed. It says that it’s possible that corporate social financial performance is constant in corporate social performance because if I’m an investor and I invest in some kind of socially responsible firm, then I know I’m doing good through that firm and maybe I’ll contribute less myself to social causes. But if I invested in WalMart, for example, or Exxon, then I know I’m not doing as much perhaps in terms of social performance through corporations, and I’ll contribute more personally to social causes. If investors work in that manner, it could be that the relation between corporate financial performance and corporate social performance is a flat line.

The two companies you just named, WalMart and Exxon, have both taken steps in the last couple of years to position themselves in “greener” light. It seems that’s a combination of pragmatism and taking a proactive stance which helps negate social pressures, but might it just be greenwashing? I think in terms of WalMart it is actually greening itself. I think it’s real. When WalMart greens itself, it will at least partially be rewarded. It will save some energy, it will attract some consumers that it didn’t attract before, though whether it covers the costs or not, who knows? Indeed it will relieve some of the social pressure. The NGOs (non-governmental organizations) have called off their campaign [against WalMart], for example.

What does the paper say about the relation between corporate social performance and social pressure? If I’m a firm and I understand that there’s social pressure out there and some of it is directed to me, what should I do? I could increase my corporate social performance, and I may do that in direct response to that pressure. The data that we have and the estimates that we have conducted support that [conjecture]; indeed there is a response by firms to the social pressure that they face.

A second aspect of is that when they take this corporate social performance, does it relieve the social pressure or does it attract social pressure? This is testing what one would refer to as the pressure release hypothesis, which says that when I do corporate social performance, there’s less social pressure. The alternative hypothesis, which we refer to as the soft target hypothesis, says that if I do more in social performance, that shows that I’m willing to be responsive to social pressure, and the NGOs that are out there and putting social pressure on us, may find us an attractive target because they can get us to do more.

So taking action to counter your critics could end up hurting you more in the long run? The data tend to support that. Social pressure tends to be directed to those firms that have higher levels of corporate social performance. It’s also the case that firms that are financially weaker tend to face more social pressure.

Are there areas where a company can ignore social pressure? Now let’s take the 2,000 firms in the study and divide them up into two categories. One category would be firms that face the consumer, what we would generally refer to as consumer products companies. Let’s call the other firms, those that generally sell to other businesses, industrial products companies.

When we do our regression analysis on those two groups separately we find quite a difference in the relation between corporate financial performance and corporate social performance. For the consumer goods companies, the relation between corporate financial performance and corporate social performance is an increasing function. If you looked across all those consumer products firms, the ones that had the highest corporate social performance tend to have the highest corporate financial performance as well, and vice versa. If you looked at industrial products companies, that line goes down. Firms that have the highest social performance tend to have the worst corporate financial performance. Again we can’t really say if that’s causal or not, but it is a striking difference. This is consistent with the story that consumer goods companies are able to advertise their good deeds and be rewarded by employees, or consumers, or investors, and industrial products companies that try to do the same things don’t find rewards.

You say the data can’t show why that is, but do you have an opinion on why that might be? I think the basic difference between these two industries is that consumers can reward firms for their activities in the consumer products companies, but they can’t do that in the industrial products companies. It may be, though, that this is all changing because, for example, WalMart has these energy efficiency goals for itself, but it also tries to impose those energy efficiency goals on its suppliers. To the extent that firms begin to do more of that,then we might find a difference over time.

WEB EXTRA

Download a copy of David Baron’s paper, The Economics and Politics of Corporate Social Performance here.


E-mail Managing Editor Robert F. Keane at bkeane@investmentadvisor.com.