Owners, Managers, and Social Investors

Lloyd KurtzHaas PresentationFebruary 21, 2007

Outline

1) The Rationale for Social Investing

2) Stakeholder Theory

3) A Controversy in Modern Finance

4) The CalPERS Effect

1) The Rationale for Social Investing John Wesley – Christian Ethics Adam Smith – ‘Das Adam Smith Problem’ Albert Hirschman – Exit, Voice, and Loyalty

Christian Ethics

Christian Premises

The world is corrupt. “Enemy-occupied territory – that’s what the world

is.” - C.S. Lewis, Mere Christianity

We act of our own free will. “By their deeds you shall know them.” – Matthew

7:16

Money is important.

Money is Important

“In the New Testament, Jesus had more to say about money matters than any other single subject, be it worship, sexual behavior, violence and peace, or even eternal life. From his parables (the rich fool, the rich man and Lazarus) and his encounters with people (Zacchaeus, the rich ruler), a basic assumption emerges: for those who would follow Jesus, economic questions are really spiritual questions.”

- Burkholder (2002)

John Wesley

For, let the world be as corrupt as it will, is gold or silver to blame? "The love of money," we know, "is the root of all evil;" but not the thing itself. The fault does not lie in the money, but in them that use it. It may be used ill: and what may not? But it may likewise be used well…

‘The Use of Money’

1. We ought to gain all we can gain but ... Don’t hurt yourself, physically or mentally. Don’t hurt your neighbor. Compete fairly.

2. Do not throw the precious talent into the sea (i.e., save).

3. Having, First, gained all you can, and, Secondly saved all you can, Then "give all you can."

Specific Prohibitions

Physically harmful occupations. Smuggling. Tax evasion. Businesses that require cheating or lying. Unethical medical professionals. Purveyors of alcohol.

“They murder His Majesty's subjects by wholesale, neither does their eye pity or spare. They drive them to hell like sheep.”

Pax World controversy

Most Common Social Screens Tobacco Alcohol Gambling Defense/Weapons

Source: Social Investment Forum

Adam Smith – ‘Das Adam Smith Problem’

‘Das Adam Smith Problem’

“At the age of fourteen, Smith was sent to the University of Glasgow [where he] first confronted the great issues which were to drive Scottish moral philosophy in the eighteenth century.

“The first of those issues was how to reconcile classical and Christian demands for altruism and benevolence in human relations with recent arguments by Thomas Hobbes and Bernard Mandeville that egoism and self-interest were the driving force in society, and how to do so without resorting to the disputed authority of revelation.”

- Muller (1993)

Adam Smith #1 – Empirical Ethics“[In Smith’s ethical system] our desire for the sympathy of others leads by steps to the restraint of our self-love…

“Our natural egoism is partially restrained by our awareness of an external standard, the standard we would use to judge our actions if we were a spectator who was biased neither toward ourselves nor toward those affected by our actions.”

- Muller (1993)

Adam Smith #2 – The Invisible Hand“[E]very individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it…he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

Lydenberg’s Modest Proposal

The goal: Harness market forces to encourage better corporate behavior.

“How do you direct corporations to the public interest? We need new vocabulary to do that, new data. And I think [socially responsible investment] can bring great value to that. We can bring fresh perspectives to risk, intangible assets, and wealth creation.”

Steven Lydenberg’s To-Do List Build consensus that better corporate

behavior is desirable. Create data sources so people can be better-

informed about corporate social responsibility.

Build institutions that will make society more sophisticated about corporate social responsibility.

Engage market forces to encourage better corporate behavior.

Albert Hirschman – The Playbook

The Problem is Easy to StateBut Hard to Answer

An organization is engaged in behavior we don’t like. What should we do?

Economic strategies

Moral and ethical strategies.

Option #1 - Exit

This is the classical economic response Only option when voice is impossible Abandons opportunity for change

Biggest risk: reinvestment

Option #2 - Voice

‘Political’ response Only option when exit is impossible. Requires investment of time, energy, money

Biggest risk: entrapment

Loyalty

A rational judgment to try voice instead of exit.

Loyalty is based on… The likelihood of positive change The quality of the alternatives

Social Investment Strategies

‘Negative Screening’ Excludes companies violating social screens

‘Shareholder Activism’ Promotes change through negotiation and shareholder

resolutions

‘Positive Screening’ Seeks to proactively include exemplary companies.

2) A Version of Stakeholder Theory

At the Center…

CONTROLGROUP(MGMT)

Stakeholder theory can be viewed as a constellation of ‘Hirschman relationships’ between a Control Group and a variety of groups...

Commercial Relationships

CUSTOMERS

CONTROLGROUP(MGMT)"There is only one boss. The customer.

And he can fire everybody in the company from the chairman on down, simply by spending his money somewhere else."

- Sam Walton

Commercial Relationships

CUSTOMERS

SHAREHOLDERS

EMPLOYEES

SUPPLIERS

CONTROLGROUP(MGMT)

In the 80s and early 90s it was popular to say that if you took care of these groups, you didn’t need to worry about much else.

You Mean There Are Others?

A McKinsey & Co. study leaked to the press by walmartwatch.com found that up to 8% of shoppers had stopped patronizing the chain because of its reputation.

[CEO Lee] Scott wondered,

“If we had known ten years ago what we know now, what would we have done differently that might have kept us out of some of these issues or would have enhanced our reputation?”

Source: Fortune magazine, 7/31/2006

Community: Hercules Chooses Exit

The Hercules [California] City Council voted unanimously Tuesday night to take the unprecedented step of using eminent domain to prevent Wal-Mart from building a big-box store on a 17-acre lot near the city's waterfront. The vote caused most of the 300 people who had packed Hercules City Hall for the meeting to break out in cheers and applause...

During a 90-minute public comment period that preceded the vote, nearly everyone who spoke urged the council to fight Wal-Mart. "Throw the bums out," Hercules resident Steve Kirby said at the podium of Wal-Mart. "Wal-Mart will never understand what we want."

Another resident, Anita Roger-Fields, expressed concern for small businesses in the city, saying they could be driven out of business by the discount store. “(Wal-Mart is) the worst thing that could happen to our community.”

Source: San Francisco Chronicle, 5/24/2006

Government Clears Its Throat“Now, Wal-Mart finds itself under attack for what critics see as its miserly approach to employee health care, which they say is forcing too many of its workers and their families into state insurance programs or making them rely on charity care by hospitals.

“A survey by Georgia officials found that more than 10,000 children of Wal-Mart employees were in the state's health program for children at an annual cost of nearly $10 million to taxpayers. A North Carolina hospital found that 31 percent of 1,900 patients who described themselves as Wal-Mart employees were on Medicaid, while an additional 16 percent had no insurance at all.”

Source: New York Times, 11/1/2004

Social/Environmental Relationships

ENVIRONMENT

LOCALCOMMUNITY

GOVERNMENT CUSTOMERS

SHAREHOLDERS

EMPLOYEES

SUPPLIERS

CONTROLGROUP(MGMT)

The Environment: Silent No More

“As we look at our responsibility as one of the world's largest companies, it just became obvious that sustainability was an issue that was going to be more important than it was, let's say, last year, and the years before. I had embraced this idea that the world's climate is changing and that man played a part in that, and that Wal-Mart can play a part in reducing man's impact. We recognized that Wal-Mart had such a footprint in this world, and that we had a corresponding part to play in sustainability.

“On a personal level, as you become a grandparent -- I have a granddaughter -- you just also become more thoughtful about what will the world look like that she inherits. So I think it was a confluence of both the personal side and the business imperatives that at least drew me to be interested in it.”

Source: Grist Interview with Lee Scott, 4/12/2006

Financial Claims/Hirschman Relationships

ENVIRONMENT

LOCALCOMMUNITY

GOVERNMENT CUSTOMERS

SHAREHOLDERS

EMPLOYEES

SUPPLIERS

CONTROLGROUP(MGMT)

With the notable exception of the environment, these are voluntary relationships mediated by loyalty.

Which Leaves a Question…

Who gets what’s left?

There’s a Lot Left:Stakeholders Are Not Killing Profitability

3) A Controversy in Finance

Who gets undistributed earnings?

After Everyone Else is Paid, There are Two Claimants

Shareholders Dividends Earnings Reinvested in the Business

Management Executive Pay

Dividends Are Down

0%

10%

20%

30%

40%

50%

60%

1986 1990 1995 2000 2005

DP

S /

EP

S (

Fir

stC

all)

S&P 500 Payout Ratio

Arnott

Arnott’s Observations and Predictions Observations

Dividends are an important component of historical total returns.

Dividend payouts and yields have fallen. Companies with low payout ratios grow slower than

companies with high payout ratios.

Predictions The return on retained earnings is likely to be disappointing

going forward. Expected total returns should be lower going forward.

Arnott on Retained Earnings

"[R]etained earnings are often not reinvested at a return that rivals externally available investments; earnings and dividend growth are faster when payout ratios are high than when they are low, perhaps because corporate managers are then forced to be more selective about reinvestment alternatives."

Premise #1

The percentage of firm earnings paid directly to shareholders is falling. Stakeholder theory predicts this. Arnott’s empirical work confirms it.

Premise #2

Executive Pay is High by Historical Standards Senior Management is Winning the Tug-of-War

4) The CalPERS Effect

Constructing the CalPERS Focus List Quantitative Screen

Stock Performance Capital Efficiency Corporate Governance

Qualitative Review Overall financial performance Valuation Strategic plans Management and board member relations Compensation Practices Other miscellaneous shareowner issues (including takeover defense)

Engagement Process – Since Exit is Impossible, Try Voice “CalPERS considers the engagement process to be a crucial component of

the overall Focus List Process. CalPERS makes a persistent effort to meet with the management and directors to discuss performance and governance issues. CalPERS will focus on reforming the company's governance practices with an emphasis on accountability, transparency, independence, and discipline.”

Source: CalPERS

Short-Term Impact

Barber finds a “small, but reliably positive” +0.25% effect on announcement date.

“My best estimate, based on conservative short-term market reactions, indicates CalPERS activism has resulted in total wealth creation of $3.1 billion between 1992 and 2005.”

Long-Term Impact

0

10

20

30

40

50

60

70

80

90

100

1 Day 2 Weeks 1 Month 6 Months 1 Year 2 Years 3 Years 4 Years 5 Years

$ B

illio

ns

Source: Barber (2006)

NotesArnott, Robert, and Peter Bernstein. “What Risk Premium is ‘Normal’?“ Financial Analysts Journal. March/April 2002.

Barber, Brad. “Monitoring the Monitor: Evaluating CalPERS’ Shareholder Activism.” Working Paper, University of California, Davis, March 2006.

Burkholder, J.R. “Biblical Faith and Investment: Toward a Theology for ‘Making Money.’” Mennonite Mutual Aid, 2002.Accessed at: http://www.mmapraxis.com/features/columns/feature_burkholder.html

Dixon, Frank. “CSR, Wal-Mart, and System Change.” Presentation to American Enterprise Institute, March 3, 2006.

Hirschman, Albert O. Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States. Cambridge, Massachusetts: Harvard University Press, 1970.

Lydenberg, Steven. Corporations and the Public Interest: Guiding the Invisible Hand. San Francisco: Berrett-Koehler, 2005.

Muller, Jerry Z. Adam Smith in His Time and Ours. Princeton, NJ: Princeton University Press, 1993.

Orlitzky, Marc, Frank L. Schmidt, and Sara L. Rynes. "Corporate social and financial performance: A meta-analysis." Organization Studies, 24, 2003.

Smith, Adam. The Wealth of Nations. Modern Library edition. New York: Random House, 1994.

Wesley, John. “The Uses of Money.” Edited by Jennette Descalzo, student at Northwest Nazarene College (Nampa, ID), with corrections by George Lyons for the Wesley Center for Applied Theology. General Board of Global Ministries, The United Methodist Church, 2000. Accessed at: http://gbgm-umc.org/umhistory/wesley/sermons/serm-050.stm