Does it pay to be “ethical” when investing? Browse the investment bookshelves and you will end up none the wiser. That’s because for every sober-looking volume promoting ethical investing, you’ll find another more interesting-looking book extolling the virtues of vice.
The reality is somewhere in between, according to three professors at the London Business School who have crunched the numbers on vice and social responsibility. They conclude that the best returns may well come from seeking out the stock market’s black sheep and bringing them back into the fold.
First, the facts. Vice does pay for two reasons. First, companies operating in the market’s murkier corners – booze, tobacco, guns and gambling – have a steady demand for their products regardless of economic conditions, they tend to be high-margin businesses and they enjoy high barriers to entry. They are profitable and defensive.
Below intrinsic value
Second, the tendency for some investors to shun these businesses on ethical grounds can result in them trading below their intrinsic value. An unpopular investment will tend to offer investors a higher yield – and because income is the principal component of total return over time this can lead to investment success. Even if the stocks remain at a valuation discount, they will benefit from the compounding of their high dividends.
A fund that played to this theme, the Vice Fund, turned US$1 into US$3.37 between 2002 and 2015, according to the LBS report. That compared with the Vanguard FTSE Social Index Fund, an ethical fund, which turned US$1 into US$2.68 over the same period. Despite this, the ethical fund manages five times as much money as the Vice Fund, which perhaps not coincidentally now calls itself the Barrier Fund.
Tobacco illustrates the potential of investing in vices. Prior to the mid-1960s, before smoking became a vice, tobacco stocks underperformed the market. Once the health issues became well-known cigarette companies started to outperform and they have been key components in the portfolios of some of the most successful investors such as Neil Woodford.
Most corrupt
Something similar seems to happen at the country level, where investors have also from time to time filtered their portfolios using ethical criteria. A study by the LBS professors, Elroy Dimson, Paul Marsh and Mike Staunton, for this year’s Credit Suisse Global Investment Returns Yearbook, shows that the most corrupt countries enjoyed annualised returns between 2000 and 2014 of 11% while other countries averaged between 5.3% and 7.7%.
Again, it seems that a low standard of governance is a risk factor that investors price into their investments, resulting in better returns from a lower starting point. That was the painful experience of the California Public Employees’ Retirement System (Calpers), which had a policy of country-level exclusions between 2002 and 2006 that backfired. Steering clear of “bad” countries cost its investors US$400m and it switched to a principles-based approach to picking stocks in the developing world.
By shunning corrupt countries, Calpers was exercising one approach to ethical investing: negative screening. Another approach is the inverse of this, positive screening, or buying companies because they exhibit good social or environmental behaviours. The logic for this is that better-run companies are more highly rated by the stock market, have lower perceived risk and so are required to offer a lower return in the future to attract investors.
Premium faded
That, of course, is the problem with buying “good” companies. They are already expensive and can therefore end up delivering disappointing returns to investors. During the 1990s, when the benefits of good corporate governance began to be better understood, the share prices of better-managed companies did well. But once the good news was in the price the governance premium faded away.
The strong implication from this is that the best course of action for investors might be to buy companies that have a patchy record of governance and then to work with management to improve their performance on these social, ethical or environmental issues. By engaging in this way, investors stand to benefit from a double whammy: they lock in the high yields of out of favour shares and then gain from a re-rating as other investors recognise the companies’ improving behaviour.
A continuous strategy of buying so-called dirty companies and cleaning them up is unsurprisingly known as the “washing machine” model. For investors who are prepared to accept the time and cost involved in implementing this approach, it offers the nice combination of social responsibility and profits.
The Yearbook is available at www.tinyurl.com/DMSyb2015.
