A Social Investment Scorecard
by William H. ApfelFrom the Fall/Winter 2008 issue of Values
Investment consultants, who help institutional investors select money managers, devote considerable energy to figuring out the underlying reasons for an investment manager’s performance. Complex algorithms have been devised to answer simple questions. Did good results stem from a discipline of buying undervalued stocks? Was the manager’s style to buy the stocks of companies with recent success, and did this prove rewarding in a rising market but costly in a falling one? Has the manager changed her approach so often as to make an assessment of her skill impossible?
With all due respect to our friends in the consulting industry, we have often been skeptical about the value of these “performance attribution” analyses. Too often the emphasis is on the short term. The math is backward looking. Novel investment approaches are difficult to evaluate. Still, trying to explain investment performance has merit and shouldn’t be avoided.
In recent years, many social investors (or sustainable, or ESG investors) have claimed that their approaches will not only advance their social agenda, but will also enhance investment performance. Of course, it is far too soon to reach definitive answers, and clearly, there will be a balance of positives and negatives in any reasonable assessment. But that said, what does the early scorecard say for Walden clients during this past year of market turmoil?
We claim no large victories based on our social investment discipline, but we do think some advantage has been gained. The early tally appears to be that our clients have fared a bit better than those of most professional managers over the past year, especially with respect to the fixed income market. We believe a long term perspective and a focus on sustainable business models rather than on quarterly earnings reports were important contributors. It should also be said that the modest performance advantages we achieved were similarly earned by the conventional, unscreened portfolios we manage. But perhaps that simply supports a view we have long held: Social investors share many of the perspectives of successful conventional investors who focus on the sustainability of the businesses in which they invest.
Our investment approach helped steer us away from such fragile businesses as aggressive lending or bond insurance, and kept us leery of investments in companies that depended upon increasingly unsustainable consumer appetites. Our long-term perspective also led us to limit our exposure to the most leveraged beneficiaries of the commodity price bubble, like producers of agricultural chemicals or steel companies.
On the other hand, it is now obvious that we retained too large a position in energy company stocks despite our view that oil prices had long passed sustainable levels by last summer. In this sector we preferred the domestic natural gas producers and their suppliers (and we still do) partly because we believed that natural gas would be a key part of the long-term solution to the country’s energy and environmental needs. We underestimated, however, the extent to which a sharp fall in oil prices would be accompanied by similar cuts in the price of gas, leading to large shortfalls in the profits of natural gas production and capital equipment companies.
Finally, we have been outspoken advocates of transparency with respect to a wide range of company reporting. In making investment decisions, we have taken to heart our contention that transparency is good for investors and businesses alike. Avoiding investments in companies with inscrutable financial reports, or bonds with mind-numbingly complex covenants, has surely helped us avoid the most disastrous investments of the past year. Highly rated sub-prime mortgage bonds are the most obvious example.
A Wider Context
What about the bigger goals that motivate social investors (beyond earning a higher investment return)? Here our view is unequivocal. The one-year-old financial crisis reinforces our belief that changes sought by social investors would be healthy for our economy, markets, and environment. Does anyone now doubt that the light of day needs to shine on the world of executive compensation? Our concern for social justice made us recoil at gargantuan pay packages in an economy with stagnating wages. But the fact that a business problem was often created by compensation programs that entailed perverse incentives is now plain for all former skeptics to see. The Nobel laureate Edmund Phelps (2006, economics) colorfully blames the collapse of banks on financial incentives that allowed “fortunes to be made for each additional day that the bank could operate.”
The need for long-range thinking in compensation practices extends well beyond the executive suite. Analysts now widely agree that a leading cause of the sub-prime mortgage debacle was the way mortgage brokers were paid: up-front commissions for transactions; no penalty for unsustainable loans. A more nefarious encouragement for unethical behavior is hard to imagine. But the implications go further.
Economist Paul Samuelson recently noted that some of his colleagues have claimed that the widening income gap between rich and poor in the United States is a “necessary price to encourage dynamic progress…and innovation” in the economy. But Samuelson, a Nobel laureate (1970, economics) and self-described centrist, recently argued against that view, saying extreme economic inequality in fact “breeds dysfunctional shortfalls in … total factor productivity.” Put simply, when income inequality is too great, workers get discouraged and entrepreneurial motivation is diminished.
Socially Responsive to Mainstream
One more item that has long been on the social agenda is now suddenly at the top of everyone’s list of requirements for a healthier economy: more disclosure. We at Walden have been ardent advocates for better disclosure of all sorts of information by corporations, from more complete and meaningful financial reporting to more information about environmental risks and vendor practices. This conviction influences our day-to-day investment decision making.
Our belief in the efficacy of disclosure has been challenged by many so-called free market advocates, most notably Alan Greenspan, who argued that systemic risks would be reduced (more efficiently dispersed, in his language) if a freer hand were given to financial companies in pursuing new strategies without requiring greater disclosure or regulation. We now know (and even Mr. Greenspan concedes) what this approach has wrought. Allowed to pursue perceived self-interest in secrecy, banks, brokers and insurers employed strategies that today threaten the health of the entire financial system. Books will be written about the arcane securities that the largest banks and brokers invented but that most investors could hardly understand. Just the names help tell the story: credit default swaps, conduits, SIVs, CDOs, CDOs squared, even synthetic CDOs.
Picking up the mantle of social investors, regulators are now rushing to improve disclosure and initiate sensible regulatory regimes. A soon-to-be-inaugurated administration should provide the much needed political will to see this through. Sometimes progress only follows a great deal of pain.
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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