As an investment manager with Rocky Mountain Humane Investing (www.greeninvestment.com) the most common question we hear from potential clients is “and advisor told me that socially responsible investing isn’t profitable” versus unscreened portfolio management. In general the advisor providing the dogmatic opinion does not offer any foundation for their opinion but this is their chance to influence the potential client especially if they cannot offer an SRI option for the investor. Unless you have a few arrows of your own in your quiver you may be quite likely shrug your shoulders and resign yourself to an unscreened portfolio versus a clean portfolio.
Probably due to the fact that I’m over 50 now with a repellent view of hyperbole and unsubstantiated opinions I have been uncomfortable with opposite view as well: socially responsible investing improves rate of return. It has been my view based upon empirical experience of managing SRI portfolios for 20 years that SRI is not a significant determinant of investment performance. SRI is a highly subjective practice where investors can have divergent opinions on industries and companies. There is not unified screening standard amongst the SRI industry, each firm or fund makes their own decisions on screening criteria. While some funds screen for only 3 or 4 issues there are other funds that screen over a dozen.
Practitioners of SRI may draw attention that investors always assume a given level of risk with any equity investment but that the risk premium associated with SRI is less. Case in point the risks associated with Tobacco, Asbestos or BP and the Gulf oil disaster. However in my 20 years involved with socially responsible investing, screening stringency is often a matter of interpretation as BP was considered Best of the Lot for many years for funds that desired petrochemical exposure.
Let’s take a look at some of the academic studies that have touched upon the issue of the factors of SRI performance:
- Moskowitz Award winner, John Guerard, Jr., director of quantitative research at Vantage Global Advisors, examined the returns of Vantage’s 1,300 stock unscreened stock universe and a 950 screened universe (The screens eliminated companies that failed to pass alcohol, gambling, tobacco, environmental, military, and nuclear power). He found “that there is no significant difference between the average monthly returns of the screened and unscreened universes during the 1987-1994 period. The “unscreened 1,300 stock universe produced a 1.068 percent average monthly return during the January 1987-December 1994 period, such that a $1.00 investment grew to $2.77. A corresponding investment in the socially-screened universe would have grown to $2.74, representing a 1.057 percent average monthly return. There is no statistically significant difference in the respective returns series, and more important, there is no economically meaningful difference in the return differential.”
Guerard’s conclusions are reinforced by other works:
- “Socially Responsible Investment: Is it profitable” Dhrymes, Columbia University July 1997 June 1998.Dyrymes concluded that: “that by and large the Concerns and Strengths of the KLD index of social responsibility are not consistently significant in determining annual rates of return.”
- Socially Responsible Investment Screening Strong Empirical Evidence For Actively Managed Value Portfolios. June 2001, revised December 2001 Stone, Guerard, Gultekin, Adams.“No Significant Cost” means no statistically significant difference in risk adjusted return”. In addition, they surmise that “the conclusion of no significant cost/benefit is not just a long term average. It has remarkable short term consistency!”
In my opinion this report presents a balanced view in that they concluded that the during the time of the study 1984-1997 the stock market rewarded the growth oriented style and that the performance of SRI investments could become “brittle” if markets were to become risk averse and adopt a more Value oriented style……….a remarkably accurate presumption!
Could the performance of SRI funds which have exceeded or lagged their respective benchmarks be in part due to size (average capitalization from micro cap to large cap) and style (Value or Growth)?
Fama and French of Dartmouth University examined the annual rate of return and beta (volatility) of an unscreened universe of Growth vs. Value from 1928 to 2009 by dividing stocks into ten deciles (groups) based on book-to-market value, rebalanced annually and found that Value had the lower risk while Growth had the higher risk. In addition, they found that the highest book –to-market stocks exceeded the return of the lowest book-to-market by 21% to 8% on average. Stock valuation was as significant factor in the Fama and French study where the cheaper the equity valuation the better the return.
Market Cap size was important in the Fama and French study as well (1992). Market cap size showed a significant edge to small and micro cap equities on a monthly basis. *Monthly returns for the smallest 10% of equities were 1.47% versus 0.89% for the largest decile.
It is our contention that there are attributes that could account for performance to equities other than social profiles and that concurrently a portfolio of socially screened equities with the highest book-to-value ratios could exceed comparative benchmarks largely due to valuation metrics and capitalization size. In a case of pure cherry picking the monthly rate of return smallest market cap and lowest book value to market price was 1.63% versus .93% monthly for largest market cap and highest book value to market price.
I tested this theory using data supplied by the Social Investment Forum and Russell Index regarding the 10 year average rate of return for socially responsible mutual funds versus their respective benchmarks trends do emerge.
Data as of June 30, 2010
Benchmarks
- Russell Mid Cap Value Index was the top 10 year performer +7.55%.
- Russell Mid Cap Growth Index returned -1.99%.
- Russell 2000 Value returned +7.48%
- Russell 2000 Growth Index returned -.92%
Equity Large Cap performance (information provided by SIF)
- 4 mutual funds show positive 10-year average annual rates of return:
Calvert Social Investment Equity +0.14% (Growth)
Neuberger Berman Socially Responsive +3.18% (Value)
Walden Social Equity +1.46% (Value)
Parnassus Equity Income +4.65% (Value)
Equity Small Cap performance
- 2 mutual funds from one mutual fund company showed a positive 10-year rate of return.
Ariel Appreciation +6.16% (Value)
Ariel Fund +5.62% (Value)
Disclaimer: While the sample size of SRI fund performance is very small. I gleaned data from only the profitable SRI funds for the last 10 years. The SIF forum does not show fund performance information for funds that have closed, merged or liquidated. It would be a safe presumption IMO that funds that no longer exist were weak performers since money will flock to where it’s treated best. Plus, hedge fund performance data was not available on the SIF site.
The results do fall in line with substantial academic works (Fama and French, Lakonishok) and it is possible that SRI performance should be viewed thru the lens of Value/Growth and Market Cap size.
A logical question that must be asked upon reading this might be: “If small market cap and low valuations are the sweet spot for investing, then why are there so few funds or managers focusing on this strategy?” Not to be obvious…………ok, well lets be obvious: The small cap / low price to BV tends to be the focus of many private portfolio managers since our small size allows us the dexterity to invest in companies that are simply too small for billion dollar mutual funds. Successful funds tend to outgrow the size/valuation strategy espoused by Graham as assets become larger and the investment selection becomes narrower. But this topic should best be explored at a later date.
No holdings mentioned
Brad Pappas
President of Rocky Mountain Humane Investing
Allenspark, Colorado
970-222-2592
www.greeninvestment.com
While we may be unabashed in our enthusiasm for Socially Responsible Investing (SRI) that does not mean we look at Green stocks with rose colored glasses. In truth we devote more time and attention, plus number crunching to make sure the holding is justified and meets our financial criteria.
Case in point is Gaiam Corp. (GAIA)
Company description: “Gaiam, Inc., a lifestyle media company, provides a selection of information, media, products, and services to customers focusing on personal development, wellness, ecological lifestyles, and responsible media. The company engages in content creation, product development and sourcing, customer service, and distribution. It operates in three segments: Direct to Consumer, Business, and Solar segment. The Direct to Consumer segment provides an opportunity to launch and support new media releases; a sounding board for new product testing; promotional opportunities; a growing subscription base; and customer feedback and the lifestyles of health and sustainability industry?s focus and future. This segment offers content through direct response television, catalogs, e-commerce, and subscription community services. The Business segment provides content to businesses, retailers, international licenses, corporate accounts, and media outlets. The Solar segment offers turnkey services, including the design, procurement, installation, grid connection, monitoring, maintenance, and referrals for third-party financing of solar energy systems. This segment also sells renewable energy products and sustainable living resources; and offers residential and small commercial solar energy integration services. Gaiam, Inc. sells its products in the United States, Canada, Mexico, Japan, and the United Kingdom. The company was founded in 1988 and is headquartered in Louisville, Colorado.”
Current Price $6.61
NCAV $2.88
Intrinsic/Discounted Cash Flow Value $10.67
Price to Book: 1.0
Book Value $6.45
Cash per share : $2.07
LT Debt $0
Market Cap $156 million
Piotroski score: 7 out of 9 (which is good)
Altman score 5.7 (little chance of bankruptcy)
GAIA is a small cap retail stock focused on the lifestyle/yoga market/alternative energy in Colorado. The stock has pulled back along with the market albeit at a faster pace for the past two months and in our opinion is nearing a very attractive valuation as it begins to touch Book Value along with minimal expectations.
The company has met or exceeded analyst expectations for the past year and current and 2011 estimates have been firm. However this stock is thinly traded and there is only one analyst following the stock.
Back in late 2007 and 2008 when the consumer was empowered the stock traded in the high $20’s and topped at $30. The company posted a loss of (.08) for 2008 The stock does seem to be volatile long term and has a bust / boom personality as it trades in sympathy with the economy. We don’t envision that the US consumer is completely on its back:
“socially acceptable deleveraging needn’t entail the pesky inconvienence of forgoing consumption.”
Revenue growth does appear to be making an improvement with sales improving 14.8% year to year.
A comparison to competitor Lululemon Athletica (LULU) shows the contrast between the much loved LULU and the loathed GAIA. Eco-cache has a cost in terms of potential return:
Current Price $38
NCAV $2.38
Intrinsic/Discounted Cash Flow Value $12.5
Price to Book: 10.4
Book Value $3.79
Cash per share : $2.45
LT Debt $0
Market Cap $2.7 billion
Piotroski score 7
Altman Z 44 (excellent)
To be a successful investor frequently means to cut against the grain of popularity and think in terms of buying a business cheaply. LULU is an excellent example of the price you pay for “Glamour” to own what is currently in fashion and popular. No doubt there are many unhappy GAIA shareholders at present but we believe there will be a Reversion to Mean Valuation which in our definition would be appreciation above DCF valuation ($10+), a level GAIA sustained during the economic expansion of 2003 to 2007. In addition, GAIA is a candidate for tax loss selling within the next 3 to 5 months which could be the catalyst to drive the price lower.
In sum, GAIA represents good value at present however the company’s volatility requires an even greater discount to intrinsic value/DCF than the current price offers, but we’re near those values. A move in price below $6 might just be the opportunity for longer term investors comfortable with the risk of a consumer cyclical company with a very Green edge.
No positions
Brad Pappas
A company we spoke of last week, Hawk Corporation HWK is surging on news that it has hired advisors to investigate possibilitity of increasing shareholder value which would include the potential sale of the company. Hawk is a diversified industrial goods company that also makes alternative energy fuel cells. It should be noted that Mario Gabelli of GAMCO Investors owns 13% of the shares.
Hawk becomes the second holding of ours that is “in play” in the past month. RCM Technologies RCMT is the target of a hostile takeover from CDI corp. This does take some of the bitter taste away from a miserable market.
Hawk Corp.
Market Cap $212 million
Book Value $9.68
Cash per share $10.13
Debt to Equity 1.0
Price to Sales 1.1
ROA 6%
ROE 11%
IBES est: 2010 $1.57
2011 $2.11
I’ve run a quick DCF calculation to get a feel for the value of HWK in a sale: Using 2010 eps of $1.50 with a 3% growth rate and a discount rate of 5% the value could approach $40 per share. The problem with Hawk is that its eps are very volatile but there is the fact of having a great deal of cash on hand. To be continued………………
Regarding the economy: The ISM manufacturing composite index feel to 56.2 (a number above 50 is pretty good) indicating a slower rate of expansion. ISM characterized the current expansion as “solidly entrenched”. While many including myself expected a slowing of the expansion in the second half of the year, the rate of the deceleration has been surprising. While the herd is screaming “double dip recession” the data does not support the mob.
From morning commentary of MKM Partners Mike Darda:
“To recess or not to recess, that is the question. Either way, we believe the stock market has essentially discounted a double-dip scenario, with our NIPA-based model showing a gap between equity earnings yields and corporate bond rates that rivals anything seen in nearly six decades. Even using a 10-year moving average for earnings (which implies a 12.4% decline in corporate profits from current levels), the S&P 500 has fallen to valuation levels below those seen at the market lows in October 2002, October 1990 and December 1987.
We would be more concerned if the credit markets were in worse shape. Yes, corporate spreads have widened, but all of the action has been in (declining) Treasury rates; corporate bond yields have been flat, unlike the situation in 2007-08. Three-month dollar-LIBOR has been in a flat to down trajectory since late May. Two-year swap spreads at 37 basis points suggest that both the VIX and corporate spreads have overshot significantly to the upside (implying that equities are overshooting to the downside).
The catalyst for today’s slide appears to be the upward move in first-time jobless claims and the miss on the June ISM Manufacturing Index, although both were consistent with a continuing, albeit slower, expansion.”
BP
Long HWK, RCMT
Both the US stock market and Treasury market are seeing non-confirmations in the most recent moves lower.
US stock market:
Advance / Decline line is not confirming the move lower as the average stock is not falling with the market indices.
New Lows: The number of new lows continues to shrink when compared to the two other times we’ve been this low in the past month.
VIX: The VIX which is a measure of volatility which peaked in this cycle at 45 in May closed yesterday at 34.
Sentimentrader.com’s Intermediate Term model has moved to excessive pessimism once again. Generally a good time to increase long exposure.
In the Treasury market:
Investor Sentiment is at the highest since December 2008, not one of the better times to be buying bonds. Plus we have to be concerned with the thought of worldwide investment managers buying US Treasuries to look good for their clients in light of the decline in Euro bonds, otherwise known as “Window Dressing”.
Lastly, the decline in US Treasury yields is not confirmed by the bonds of other G-7 nations.
The Tesla IPO has gained a great deal of attention but it has to be time to ring the register. There will be other times to buy this if it can deliver something other than losses. I just read the battery for the car costs $30,000 and does not work in cold weather. Well, that pretty much kills the potential for a Tesla at 8000 feet in Colorado.
No positions
Stock futures are signaling weakness in US markets this morning with the catalyst being China. The Conference Board revised its leading indicators lower for the month of April to the lowest rate of growth in 5 months. The Shanghai Composite is down 4.3%. We keep in mind that the China GDP grew at an annualized 11.9% in the 1q which is a risk to overheating, a more moderate GDP growth in the 7-8% range would be welcome longer term.
In addition the highly anticipated offering of the Agricultural Bank of China has been pared back which has not helped investor sentiment.
One note we’d like to express in our view of socially responsible investing and China. In our view investing in China is split between state owned businesses like the Agricultural Bank of China and those owned independent entrepreneurs and businessmen free of state ownership. We have no interest in owning state owned companies where the proximity to the Chinese government is too close for comfort. We only consider companies free of state control.
Market Commentary: Pessimism in US markets is quite high now and cycle projections indicate a rally in US shares could commence very soon. However, I believe this is a rally that should be used to lighten equity holdings as September is generally the worst performing month of the year. Market action in the September/October time frame will be very important going forward. Should the market stage a significant sell off in September/October it may create the combination of very attractive valuations and high degree of pessimism (a market positive) that could propel stocks higher into 2011. Should the September/October weakness be shallow or non existent it will likely be borrowing from 2011 upside potential which will increase the odds of a bear market in 2011.
The 10-year Treasury bond is gaining a great deal of attention this week as it approaches the prices of early 2009 when our economic outlook was in question. There are other possible reasons for this move which include the US being a haven of security from European sovereign bonds. Regardless this move higher bears watching:
