SRI and performance: Don’t throw the baby out with the bath water

In the US approximately 10% or US$2.29trillion (€1.7trillion) of all assets are now managed with specific regard to corporate social responsibility (CSR) principles. Europe boasts more than €1trillion in similarly managed assets. The importance of incorporating CSR issues into stock and company valuation is gaining momentum. In a recent survey by Mercer Investment Consulting, 89% of the 195 investment managers surveyed predicted CSR would form a part of their mainstream investment criteria within 10 years. Clearly, corporations, governments, accounting firms and capital providers are making significant investments in the area. It is not surprising that many seek to better understand the association expected between CSR performance and corporate financial performance (CFP).
A review of the research suggests the evidence remains mixed; different studies find a positive, neutral or negative linkage between the two. The success of the CSR movement going forward will largely depend on our understanding of this relationship.
I believe there is a harmful obsession by researchers, investors and financial markets in general, in expecting corporations who exhibit best practice with regard to CSR to provide better returns.These better returns are expected with regard to the growth in a firm’s share price. As we know, share prices increase as a result of two main factors. The first is its internal revenue generating abilities. The second is a reduction in the yield (i.e. return) that people require given the risk profile of the company in question. With regard to the first, we expect the best CSR firms to provide comparatively higher market returns due to increases in productivity and other virtues bestowed upon them. Consequently, if we observe our best CSR firms providing a lower market ‘return’ relative to poorer performing CSR firms, we are tempted to argue that investing in CSR destroys shareholder value. A 2006 study by Brammer et al. found evidence of a negative relation and said investment in CSR was: “largely destructive of shareholder value”. I believe some researchers remain confused as to what the relationship should be. Often their results do not indicate a destruction of shareholder value, but rather, demonstrate a price premium (i.e. returns discount) afforded to firms with the best CSR performances. This negative association occurs not because firms perform badly, but rather, reflects the way in which the research has been undertaken.

I have strong empirical evidence that no significant difference in accounting measures of performance (i.e. return on assets/equity) exist between the best and worst performing CSR firms. I believe this is not unexpected. This is because the worst CSR firms should be able to cut costs and profit because they may choose to bully their suppliers, take unfair advantage of their work force, employ sweatshops and exploit third world countries, all whilst having little or no regard for environmental, social and governance related issues. This is especially so if these firms are poorly regulated and/or able to balance the economic costs of being a lagging CSR firm against the short-term economic costs of being socially irresponsible. On the other hand, leading CSR firms are equally likely to be rewarded for their commitment to social, environmental, and economic factors because they can better manage their reputation and brand, attract and retain the best managers and employees, and engage more effectively with stakeholders whilst improving the nexus of contracts through greater communication and trust. However, a rational and efficient capital market would not systematically allow or reward one activity over the other.The simplest argument as to why poor CSR firms cannot continue to exhibit weaker accounting performances relative to their industry peers over time is because these poorly performing firms would very quickly be taken over, become insolvent, or become a top performing CSR firm if it was clearly more ‘profitable’ to do so. As a result, I believe that studies employing accounting data and investigating the historical link between CSR and accounting returns should not find a systematic relationship.
Why and how should the value of CSR be reflected in a firm’s share price and future returns profile if there is little ‘historical’ difference in internal revenue generating abilities? The answer is simple, although often overlooked. If we recognise that an investors ‘expected’ return is also a function of the risk associated with an investment, then lower risk equates to lower expected return, much in the same way that we require lower yields/returns for quality versus ‘junk’ corporate bonds. I, like others, find very strong empirical evidence that the best CSR firms have significantly lower levels of business risk, with firms exhibiting a poor CSR profile being as much as 49% more risky.
Therefore, if we are willing to pay comparatively more for firms with lower risk, due to their better CSR performance, then the future income derived from these assets is logically expected to be lower than their riskier counterparts. If CSR has significant economic value, then this ‘value’ will already be reflected in the share prices of leading CSR firms. Consequently, the ‘expected’ returns of these less risky leading CSR firms are expected to be lower than their riskier lagging counterparts.
The best performing CSR companies, as identified by analysts, will form part of the many CSR indexes and ratings databases available globally. Positive CSR/CSP returns can only be generated if a firm changes from a lagging to a leading CSR firm and the share price reflects the value of this change. Only then would you observe an increase in the price of the firm.
If we observe a positive CSR/CFP linkage we would need to buy lagging CSR firms knowing that they would become leading CSR firms and thus experience a positive change in price.

Prior studies that argue a positive CSR/CFP link shouldexist, when using ratings that already reflect the value of CSR, are factually inaccurate and do not take this simple relationship into account.

“If CSR has significant economic value, then this ‘value’ will already be reflected in the share prices of leading CSR firms.”

If you hear of research arguing that better performing CSR firms provide lower returns relative to their lagging counterparts, don’t throw the baby out with the bath water! You are getting what you pay for, a quality asset with lower risk, and thus a lower expected and realised return (for firms this is seen as providing them with a lower cost of equity capital). If your ‘expectation’ is of higher returns then invest in poorly performing CSR firms that are significantly riskier. The risk is, you end up with a dog and lose your money.

Darren Lee (PhD) is a lecturer in finance at University of Queensland, Australia