Socially Responsible Investing

Last year this column examined the major investment styles; income, growth, value and garp. We concluded that most other strategies will be a combination of these and investors will at times switch between styles depending on their view of equity markets. Increasingly investors are also, consistent with their investment style, screening stocks for their corporate social responsibility or CSR. This week we look at what defines corporate social responsibility and how this is adding a premium to the share prices of companies that make the grade.

What is it and who defines it?
Corporate social responsibility is generally seen to include the best practices related to the environment, human rights, work force relations, community service and corporate citizenship as well as honest financial management and accounting. In the aftermath of Enron and World Comm. the U.S. Congress through the Sarbanes – Oxley Act of 2002 tightened corporate accounting standards. The (U.S.) Securities and Exchange Commission (S.E.C.) established new rules for corporate boards, as did the NYSE and NASDAQ exchanges. In August 2002 the ASX established the Corporate Governance Council as a central point of reference to promote and restore investor confidence. Its purpose was to develop recommendations, which reflected international best practice. The result was list of 10 principles of good governance and best practice. ASX listed companies are now required to provide a statement in their annual reports disclosing the extent to which they have followed the best practice recommendations. Where companies have not followed all the recommendations, they must identify those that have not been followed and give reasons for not following them.

Some willing, others less so
In the U.S. Starbucks (SBUX), and Gap Inc. (GPS) publish special reports on their social responsibility. Starbucks most recent report “Living our Values”, highlights six elements of the company’s corporate social responsibility platform – corporate culture, work force and supplier diversity, coffee cultivation, customer service, community, a category that includes environmental stewardship, and profitability which includes corporate governance. The Gap is another company that publishes a report on its business overseas and its efforts to improve. For readers not familiar with Gap they are a U.S. clothing retailer that has been the subject of litigation, boycotts and bad press surrounding the use of sweatshop labor in the manufacture of its garments. In Australia all ASX listed companies now address the 10 principles of ASX good governance principles unlike in the US where reporting is voluntary and Starbucks and Gap are setting the trend. Ultimately however, no matter what the level of reporting, investors must assess the conduct of companies against financial performance and balance their own beliefs and principles.  In some cases that means avoiding stocks in certain industries for example tobacco, armaments manufacture etc., although in most cases, provided these companies act responsibly and within the law, they can be considered for investment.

Socially responsible opportunities expand
In the US investments that have been screened for social and environmental criteria grew 7 % in 2001 and 2002 compared with a 4% downturn in the investment market overall during the same period, according to the Social Investment Forum, a membership organisation for financial professionals involved in socially responsible investing (SRI). In its most recent trends report published in 2003 the Forum notes that SRI accounted for $1 of every $9 under the care of professional asset management in 2001 and 2002.That “...accounts for, $2.26 trillion or 11.3% of the total $19.2 trillion under professional management,” the biennial report states. With a market this size new investment funds based on SRI have followed. The Australian market can also be expected to see more funds that have SRI principles included in their investment style with fund managers selecting stocks that adhere to such principles and discarding those that don’t.

Performance
A key issue is whether SRI results in lower returns for investors.  A key reason for the relatively low take-up of SRI in Australia has been the perceived poor performance of screened investments by mainstream financial analysts. Their thinking relates partly to experience and partly to the logic of the screening process, (i.e. that exclusions from the investable universe of stocks should, if other things are equal, increase risk - impairing risk adjusted performance). Increasingly, however, overseas research is beginning to counter this argument, suggesting that such funds are often superior, as they account for additional indicators of a firm’s future potential. For example, companies adopting a more pro-active approach to environmental management reduce operating costs together with “a significant and favourable impact on the perceived risk to investors and, accordingly, the cost of equity capital and value in the marketplace”. It is suggested that this could increase a company’s stock price by as much as 5 per cent.  

Although little performance research has been conducted in Australia, what has been done suggests that some SRI funds have performed well compared to the mainstream. However, a key challenge in judging the performance of SRI funds is the difficulty in comparing like with like - as the comparison of a screened fund with the broader market may be misleading. For example, the types of screens used would tend to increase weightings of ‘new economy’ stocks that have performed better than the wider market over recent years but may not do so in some future periods.

Only a matter of time
Many fund managers in Australia now offer funds with SRI as part of the investment process. Indeed a 2001 Rothschild report into ethical and socially responsible investing predicted, “with the present level of interest, ethical investing is undoubtedly going to become an accepted part of the Australian investment landscape in the very near future.”

Four years later that future has probably arrived and investors should pay attention to companies and their adherence to good governance principles. A good starting point is the annual report; another is to ensure your managed fund investments screen for corporate social responsibility. Taking an interest in your investments in this way alerts you to future opportunities / threats and can help add several percentage points to returns.  

© All rights reserved 2004. This material is educational and it is not intended to constitute financial advice.

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