WORKPLACE: November 2000
SOCIAL TOPICS (Archive): WORKPLACE
Investing in Innovators
The Next Generation of Socially Screened Portfolios
Published, November 2000
Microsoft, Cisco, Intel, Home Depot, Coca-Cola. Throw a dart at a random sample of socially responsive investment (SRI) portfolios, or for that matter conventional portfolios, and you are likely to see these names among the top holdings. While each company has noteworthy social attributes, none offers a product or management that directly addresses social issues important to the typical SRI investor. Indeed, some are embroiled in social controversy.
Can’t an SRI portfolio invest in alternative energy, community banks, natural foods, women-run businesses, and other innovators that offer a direct social benefit? Walden’s experience is that such portfolios can indeed be developed and included prudently as part of the social investor’s asset allocation strategy. The challenge for the portfolio manager is not whether her picks meet the client’s social objectives, but which picks meet the client’s social objectives.
Consider the following social leaders:
Ballard Power Systems, based in British Columbia, is developing fuel cells for use in the transportation market. Fuel cells generate power through chemical reactions, rather than through combustion, making them virtually pollution free. In 1999, Ford Motor Company debuted a Ballard fuel cell-powered concept sedan (P2000) and a Ballard fuel cell-powered sport utility vehicle (P2000 SUV).
Horizon Organic Dairy, based in Colorado, is the only national distributor of organic dairy products. The company’s products are available in more than 5,000 stores. All of Horizon’s products are free of antibiotics, hormones, and pesticides.
Keystone Financial, a Pennsylvania-based bank, received “outstanding” Community Reinvestment Act ratings in four of its five subsidiary banks. Keystone offers market rate loans of as little as $250 to help first-time borrowers establish a credit history.
These companies are publicly traded. Why aren’t they included in many SRI portfolios? Some may find them too small or too risky. Could these companies crash tomorrow? Yes. Could they be tomorrow’s Microsoft? Maybe. But, a well diversified, prudently invested portfolio can address the risks of including these social innovators and offer the diversification potential of smaller company investing.
Identifying Themes for a Portfolio of Innovators
The world faces a host of problems as it commences the new millennium: In America alone, 40 percent of us breathe unhealthy levels of air pollution, women represent only slightly more than 10 percent of corporate officers and board directors, and lower-income and minority communities lack sufficient financial capital for development. While solutions to many of these problems will require the participation of many people, innovative companies can play a major role. Whether the problem is lack of credit and banking services to poor, inner-city neighborhoods, or finding a way to utilize natural resources more efficiently, some companies are making a difference.
It is appropriate to consider several themes in order to build a diversified portfolio of innovators. Some thematic options include building community, promoting diversity, education, a clean environment, good employers, healthy living, decent and affordable housing, medical care, and resource conservation (see Figure 1). There is no right or wrong list of social issues. However, there are possible investment ideas associated with each theme. For example:
Resource Conservation, Fossil fuels are burned to move vehicles, generate electricity, and to run industrial boilers. The pollutants produced during their combustion contribute to climate change, acid rain, and urban smog. Energy conservation and renewable energy sources lessen the environmental damage of power production. But collectively, solar and wind power represent only a fraction of one percent of the electric generating capacity and production of U.S. electric utilities. Deregulation of the electric power industry, and increasing oil prices may increase the amount of “green” power consumed in the U.S.
There are a few publicly traded companies that focus on alternative energy. For example, Delaware-based Astropower is the world’s seventh largest photovoltaic (PV) manufacturer. The company makes PV solar cells, modules, and panels for generating solar electric power. AstroPower uses a proprietary, continuous sheet manufacturing process to make silicon wafers, and has technology to recycle discarded wafers from the semiconductor industry.
Diversity. According to the nonprofit research group Catalyst, there are only two female CEOs in the Fortune 500. While women were 46 percent of labor force participants in 1997, only 11.9 percent of corporate officers (and board directors) at Fortune 500 companies in 1999 were women. In fact, 25 percent of Fortune 500 companies have no women corporate officers.
A different model exists at California-based Autodesk, which supplies AutoCAD and other software and multimedia tools for design, geographic information systems, and other applications. Led by Chair and CEO Carol Bartz, half of Autodesk’s senior executives and VPs are women.
Constructing a Portfolio of Innovators
Here’s what we have done at Walden to build a portfolio that maximizes social objectives while providing a high quality investment option.
Many of the social themes lead to the selection of smaller companies, usually suggesting a riskier portfolio. But by targeting a range of innovative companies, the portfolio manager increases the opportunity to develop a portfolio diversified by economic sector (see Figure 2). In order to optimize the portfolio’s social quality, while retaining broad sector representation, Walden has followed these guidelines for its Innovations portfolios:
· Hold a large number of companies in order to reduce stock specific risk.
· Closely align economic sectors with the sector breakdown of an established small-capitalization benchmark that represents the range of small companies in the economy.
· Select a core set of innovators from an established index or with characteristics similar to such companies.
· Set an acceptable band of market capitalization with an eye toward maximizing social performance and sector diversification.
· Use financial optimization techniques to help guide stock selections that reduce portfolio risk.
· Manage the portfolio with a long-term time horizon and keep portfolio turnover relatively low.
A Competitive Portfolio of Innovators
Over long-term investment horizons, small-cap stock universes have generally outperformed large-cap stock universes. Although investors should expect additional return for the extra risk associated with owning smaller size companies, the bull market of the past few years has been driven by a relatively narrow segment of the large-cap market. However, this market trend may be shifting. In the year ending September 30, 2000, the S&P SmallCap 600 outperformed the S&P 500, 24.2 percent to 13.3 percent. While past results are no guarantee of future performance, Walden’s Innovations portfolios have significantly outperformed their small-cap benchmark over 1, 3 and 5 year periods.
The results are in. Indeed, an Innovations portfolio can complement a client’s existing portfolio both socially and financially. A prudent asset allocation strategy for socially responsive investors can include a portfolio of true innovators—companies that are not only responding to society’s greatest challenges, but are actively working to solve them.
The information contained herein has been prepared from sources and data we believe to be reliable, but we make no guarantee as to its adequacy, accuracy, timeliness or completeness. We cannot and do not guarantee the suitability or profitability of any particular investment. No information herein is intended as an offer or solicitation of an offer to sell or buy, or as a sponsorship of any company, security, or fund. Neither Walden nor any of its contributors make any representations about the suitability of the information contained herein. Opinions expressed herein are subject to change without notice. The writings of authors do not necessarily represent the views of Walden Asset Management, its parent, or affiliated entities. There are certain risks involved with investing, including various risks depending on the type of investment vehicle being used.
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