I just came across this story on CBS Money Watch segment: The issues with Socially Responsible Investing”. My comments appear in parenthesis.
“MoneyWatch) Socially responsible investing (SRI) has been referred to as “double-bottom-line” investing. The implication is that you’re seeking not only profitable investments, but also investments that meet your personal standards. For instance, some investors don’t want to support companies that sell tobacco products or rely on animal testing. Of course, not everyone has the same set of beliefs, so SRI can mean different things to different people.
According to the Social Investment Forum, total SRI assets in the United States rose from $639 billion in 1995 to $3.07 trillion at the start of 2010. Clearly investors believe in SRI. One question for investors in SRI funds is: Is there a price to pay for avoiding “sin stocks”?
Expenses To answer the question, we begin by considering that SRI funds are typically more expensive than index funds and passive funds in general. One reason is that they incur the extra costs of screening out the undesirables. Those extra costs hurt returns.
(How and why is screening an extra expense, it isn’t with RMHI.)
Diversification SRI investors also typically sacrifice diversification. SRI funds typically are domestic and large cap. Thus, investors sacrifice exposure to small-cap and value stocks, and perhaps international and emerging market stocks as well. They also then lose exposure to the higher expected returns provided by small-cap, value and emerging market stocks.
SRI investors also may be accepting other risks. Because they avoid investing is “sin” stocks, they’re not fully diversified across industries.
(He has a major point here, but I feel like the kid in the back of his class with his hand raised and not being called upon by the teacher: He is spot on regarding Small Cap and Value stocks, which is why we focus on them. Several academic studies have proven small cap value to be an ideal combination.)
Cost of Capital There’s one other important point to consider. Economic theory tells us that because there are $3 trillion of SRI investments that avoid “sin” stocks, the cost of capital of sin stocks is driven higher than it would otherwise be, and the cost of capital of the non-sin stocks is driven lower. In other words, by avoiding investing in sin stocks, investors make those stocks cheaper (smaller and more value-oriented). And since the flip side of the cost of capital is the expected return to investors, SRI investors are missing out on the higher expected returns of “sin” stocks.
The authors of the study, “The Price of Sin: The Effects of Social Norms on Markets,” provide evidence that the hypothesis that there’s a societal norm against investing in “sin” stocks is correct, and that it does impact the cost of capital. The following is a summary of the findings:
- When compared to stocks of otherwise comparable characteristics, sin stocks have less institutional ownership — approximately 18 percent lower institutional ownership than comparable stocks (23 percent versus 28 percent).
- Sin stocks receive 21 percent less analyst coverage.
- Sin stocks are less held by norm-constrained institutions such as pension plans as compared to mutual or hedge funds that are natural arbitrageurs.
- The prices of sin stocks are relatively depressed, and, therefore, have higher expected returns than otherwise comparable stocks — consistent with them being neglected by norm-constrained investors and facing greater litigation risk (e.g., tobacco stocks) heightened by social norms.
- For the period 1965-2006, a portfolio long sin stocks and short their comparables has a return of 29 basis points per month after adjusting for a four-factor model comprising of the three Fama-French factors and the momentum factor. The statistics are economically significant. And just looking at a portfolio long sin stocks would yield even more significant out-performance of sin stocks relative to these benchmarks.
- The market-to-book ratios of sin stocks are on average about 15 percent lower than those of other comparable companies. These valuation ratios, using a Gordon growth model calibration, imply excess returns of about 2 percent a year.
- As out of sample support, sin stocks in seven large European markets and Canada outperform similar stocks by about 2.5 percent a year.
(Sin stocks, by and large and slow but consistent growers and have a tendency to do relatively well in recessions. However, an alternative to owning sin stocks is to merely cut stock exposure when earnings estimates on the S&P 500 begin to show material weakness. However, the author is using a simplistic “buy and hold” approach that is great in a secular bull market but is frustrating in a secular bear which we have today.)
The conclusion we can draw from this study is that social norms have important consequences in for the cost of capital of sin companies. They also have consequences for investors who pay a price in the form of lower expected returns and less effective diversification.
(He would largely be correct but he’s assuming there aren’t other methods of circumventing sin stocks as I’ve mentioned previously. I’m starting to think that he’s “talking his own book”)
While many investors will vote “conscious” over “pocketbook,” there’s an alternative to socially responsible investing that’s at least worth considering: Avoid socially responsible funds and donate the higher expected returns to the charities that you are most passionate about. In that way, you can directly impact the causes you care most about and get a tax deduction at the same time!
(Or! Why not find a manager who uses Small Cap Value and can still post very good and competitive returns while still avoiding Sin stocks…..yes, now I’m talking my own book 🙂
Its been no secret that 2011 has been a difficult year. A year that can make you doubt everything you’ve ever learned, tested and retested our models countless times even on vacation. (I refuse to allow the glare of the sun on the beach disable my ability to read our strategy test results on my Ipad. I know, that’s pretty pathetic.)
It should be a given to any investor that no strategy works wonderfully all the time, 2011 is enough to prove that. Long term investing has more to do with perseverance and discipline to your strategy regardless of your emotions and the market environment. With persistence, in the long run you should do quite well.
I’ve never made it a secret that I’ve been a fan of James O’Shaughnessy and his book: “What works on Wall Street”. The RMHI investment model is based on Shaughnessy’s “Trending Value” model but interpreted for Socially Responsible Investors.
But more importantly what strategy has worked the best for the past 50 years?
Well, Shaughnessy has released a new paper on “Trending Value” and it has trounced every other model that I’m aware of for the past 50 years.
“Its annualized return of 20.58% through Sept. 30 crushes the All Stocks benchmark (an equally weighted benchmark of stocks with an inflation adjusted market cap great than $200 million), which has a return of 10.71%. Plus, the Trending Value approach achieves its return with a volatility of 17.69%, lower than the benchmark’s 18.26%.
“The strategy makes use of one of the main innovations from the book: the use of a composite value factor. In the original publication, we identified price-to-sales as the most effective value factor. In this latest edition of the book, we have learned that a composite that combines several different value factors delivers stronger returns and more consistency than any individual factor.
By spreading our bets and ensuring that a stock is cheap in a variety of ways, we believe we can identify better stocks. One version of the composite value factor combines the following measures of value:
• Price-to-Sales
• Price-to-Earnings
• Price-to-Book
• Price-to-Cash Flow
• EBITDA/Enterprise Value
• Shareholder yield (dividend yield + rate of share repurchases)”
Now this gets interesting since RMHI has been using a composite model since the beginning of our model based strategy. It would be fair to say that we were one step ahead of Mr. O’Shaughnessy but now the gap is closing and I find that confirmation of research affirming our strategy a major confidence boost in a difficult environment.
Significant differences remain between O’Shaughnessy’s model and our own. Its impossible to know what the weighting of each criteria are since they have not been provided. In addition, the O’Shaughnessy model focuses on only holding stocks ranked in the top 10% of their ranking system while we have found that holding the top 1% versus the top 10% over time sharply improves returns.
Chart courtesy of American Association of Individual Investors
It should be noted at this time that O’Shaughnessy does not have a public fund that exclusively advertises itself as “Trend Value” but many of the stocks highlighted on AAII as acceptable to the TV and included in his “Tiny Titans” screen are also stocks found in our portfolios in the recent past:
Material Sciences
Core Molding Technology
Datalink
Town Sports International – current RMHI long position
While its obvious to see that the volatility of the portfolio is greater than that of the S&P 500 the returns more than make up for it in the long run.
All the best,
Brad
Long CLUB
This may be premature but I’ve noticed that our portfolios have been outperforming for the past three days. That may not sound like much but I believe its an indication that the breadth of the market is improving and that the major indices are masking underlying strength.
When underlying market strength is weak, the major indexes that you can own via ETF’s or Index mutual funds tend to do relatively well. However, when underlying strength is weak there is a strong tendency for individual equities and small caps to outperform. This could be the case now, time will tell. It has been 10 months since we last outperformed so the tide may be turning.
We continue to hold Appliance Recycling Centers of America ARCI Green Plains Renewable Energy GPRE and have a small position in Perma Fix Environmental Solutions PESI.
Severe sell off in solar play First Solar FSLR a former high flying darling of the solar energy industry. FSLR came out with a statement that 2012 earnings will be roughly half of analysts expectations. We have no position in FSLR but I must say the price is getting interesting.
FSLR share price is $33.90
The balance sheet is solid: Book value is $46 which includes $8 in cash and the equivalent of approximately $7 in debt.
But the market cap is now below revenues, which indicates very good value.
Its probably too early to buy as the stock needs to stabilize and the source of the earnings weakness must be determined. Stating again for the umpteenth time: Europe is the primary source of Alt Energy revenues and Europe is cutting back severely through austerity programs to curb their debt. Alt Energy will be sacrificed in the meantime as for most countries its a discretionary expense.
Long ARCI, PESI and GPRE
The one thing you can always be sure of in investing is that waiting for the all-clear signal that the economy and the world is fine is to invest when its too late. Several times Warren Buffet has stated that his best buys were during times of fiscal or monetary stress.
If you consider the present market valuations with the SPX at 1233 and 2012 earnings estimates presently at $108 this translates into a market selling at 11.5 times 2012 earnings. 11.5 is very good considering we’re not going into recession anytime soon and the historical average is a market selling at 15 times earnings.
Does this mean there is significant upside? Yes there is but it also means you have to have the stomach and nervous system to close your eyes and ears to the Cassandra’s and their calls for worldwide crisis. Keep in mind the crisis is primarily in Europe and calls for investment calamity rarely work. Its my guess that the Europeans will eventually isolate and put their crisis to bed but it will be a slow and gradual process, not a swift stroke that defines a solution.
There is another market factor that I maintain a closely kept eye on……..my own state of nervousness and apprehension. Rarely have I ever been this nervous and in previous cases my state of uneasiness is usually associated with market bottoms. I can’t even go on a vacation to a beautiful island with my incredible wife without keeping an eye on my stomach churning along with the markets. Needless to say, its pretty pathetic.
What causes me the greatest stress is the lack of traction by our value oriented small cap holdings. At present large stocks are making more net progress with little progress if any by small caps. While I’m sure this is a temporary situation it still causes me a great deal of angst.
My interpretation of this action is that investors have deleveraged away from investments that provide Alpha. In English, this means investors have sold and continue to avoid investments that normally do much better than the S&P 500 over time in an effort to avoid almost all kinds of risk. While the popular theme to buy a Treasury bond yielding just under 2%, they avoid a steady 10% grower paying a 4% or more dividend as in Cedar Fair LP FUN or Tessco Technology TESS.
One nagging question that plagues any investor using quantitative strategies is: Has your model simply lost its effectiveness? I’ve given this serious thought but our models are relatively simple in construction so “curve fitting” (creating the model to have capitalized on the near term past) is very unlikely. But I also monitor close to 50 models on a daily basis and there is a trend. The trend is away from small to mid size companies. I actually take a small degree of comfort in this since it means this phenomena is very likely to be a short term cyclical issue and not a long term signal. In addition, since small companies tend to focus primarily on the US they avoid what may be a severe recession in Europe that large cap companies with overseas revenues will be exposed to.
All the best,
Brad
Long FUN and TESS
The U.S economy continues to perform reasonably well and is certainly not getting the credit it deserves as we’re still held captive by the European drama. The massive market response yesterday was was a surprise since S&P lowered their ratings on US banks. But the news of coordinated worldwide action of the world’s central banks caught many investors leaning in the wrong direction which caused significant short covering and natural buying.
None of the gloom should be major news to anyone but the US economy remains a relative bright spot: ISM Manufacturing Index for November came in at 52.7, which is a nice bounce from 50.8 last month, economists were expecting a smaller bounce to 52. Indicators are highlighting an improving employment environment with the Rasmussen Employment Index rising to a high last seen in April.
The Fed’s Beige book shows slow to moderate growth.
US corporate earnings for 2012 remain in the $108 range. No decline apparent as of today. Thus the S&P 500 remains at 11x 2012 earnings, cheap by any measure in the past 50 years.
Our investment posture remains unchanged despite the turbulence. Timing is always tricky and we were a bit premature in our buying for a seasonal end of the year rally but should investors take their eye off of Europe and focus on the renewed economic momentum in the US, the rally could finally materialize.
Shortly I’ll be posting a new Green position: Perma-Fix Enviromental
Be careful out there.
Brad
Long PESI
Top of the list for a Green company – ARCI
Micro Cap stock with all the ingredients we love to see:
Price/Sales: .27
Price/Earnings: 7
Quarterly Earnings Growth: 30%
12 mos. Trailing EPS Growth: 87%
Earnings Yield: 10.7%
With better than average trading momentum
We are long ARCI for client accounts
