Articles

Doing Well While Doing Good: Socially Responsible Investors Dodge Scandal-Prone Companies

Tuesday, July 2, 2002
by Marc J. Lane

Reprint permission from the July 2, 2002, www.ABC7Chicago.com


Corrupt CEO's and CFO's, crooked accountants and untrustworthy Wall Street analysts have punished investors mercilessly. Add to that lackluster corporate earnings, the probability of a hike in interest rates, the plunging U.S. dollar, and the fear of another domestic terrorist attack, and no one should be surprised that investors are sitting on their hands.

Sooner or later, the market will regain its footing. And, in the meantime, ironically, the most compassionate of investors may stay the safest and prosper the most, even as further corporate deceit comes to light.

The stock market's performance has been abysmal. From January 1 through June 30, Nasdaq fell nearly 25 per cent, turning in its worst first-half performance since it dropped more than 45 per cent in 1974. The S&P's and the Dow's six-month performance is not much better; they're off 13.8 per cent and 7.8 per cent, respectively.

Cause for Hope

Despite the fact that greed-driven scandals continue to wreck havoc on investor confidence, there is reason for optimism. Corporate miscreants are already feeling the unbridled wrath of regulators, legislators and prosecutors. The nation's Gross Domestic Product grew 5.6 per cent in the first quarter. Consumer spending is up. Unemployment is under 6 per cent. And corporate profits are expected to improve markedly in the year's final two quarters.

Human behavior figures into the mix, too. Even those who are most cynical about the drip, drip, drip of corporate ethics breaches haven't sold their stocks to buy bonds or money market funds because interest rates are unappealingly low. And most people remain optimistic that, over the long haul, stocks offer the greatest hope that they will achieve their retirement goals.

Gaining the Upper Hand

Yet, millions of people are waiting for a signal that the market is "safe" again and the billions they're holding in cash can be invested without more risk than they're prepared to assume. The sad truth is that they're almost certain to miss the market's move. To put it bluntly, nobody knows enough to predict reliably exactly when stocks will have bottomed out, and trying to time the market is a prescription for disappointment, if not disaster.

So, what is an investor to do?

The rules are simple to recite, but tough to apply. That's why, more than ever, investors are relying on professional asset managers to design and monitor their portfolios.

But a few principles are worth highlighting.

  • "Asset allocation," now as always, is the key to prudent investment planning. How much an investor should have in stocks, in fixed income securities with "laddered" maturities, and in other investment classes depends on one's time horizon, risk tolerance, cash flow needs, liquidity requirements, and other factors.
  • Diversification hedges risk. A carefully constructed stock portfolio should be diversified among industries and sectors. Some advisers are inviting long-term investors to overweight industries that have been pummeled, such as telecommunications and financial services; others, fearing further negative surprises, continue to steer clear of industries where the manipulation of financial statements has been widespread.
  • Investors should probably zero in on stodgy companies with value characteristics and superior earnings growth.
  • Some financial advisers have trashed companies whose financial statements hype EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). World-class investor Warren Buffet, for one, has argued that as EBITDA rises, real problems, such as excessive borrowing, can be camouflaged. Other advisers counter that EBITDA is an excellent metric to plot a company's growth, especially if the company is debt-free and boasts a net positive interest number on it profit-and-loss statement.

    Where Mr. Buffet and his challengers agree is that all of them urgently call for "transparency" in big business. And it's that rallying cry which suggests that socially responsible investors are likely to do well in spite of the gathering scandals in major U.S. companies.

Enlightened Management Is Good Business

Socially responsible investors consider their investments' impact on society. They favor companies whose boards are diverse, which support human rights, which treat their employees with dignity, and which respect the environment.

And, they believe that, when a company routinely considers the social and environmental consequences of its policies, it's less prone to greed, fraud and arrogance. It follows naturally that such a company will also be less susceptible to scandal and, for that reason, its stock is less likely to be hammered by a revelation du jour.

The socially-responsible investing public insists on corporate responsibility. It pushes for more disclosure of off-balance sheet debt and secret off-shore tax havens. It calls for the unconditional integrity and independence of auditors. It demands that boards be diverse and that they advocate the interests of all a company's stakeholders.

One shouldn't overstate the case, but it makes perfect sense that companies which pay close attention to social and environmental risks and opportunities will be more competitive in the long run. And studies have shown that, as a company improves its environmental management, for instance, its financing risk declines. So, expenditures for pollution prevention can be financially justified because, by reducing risk, they lower the company's cost of capital.

Value-based Investing

Those who promote the social investment philosophy want their investments to reflect their core values, and their goals are ethical as well as financial. They include nonprofits whose endowments should certainly be invested in a way that's consistent with—and, ideally, in furtherance of—their charitable missions. And, increasingly, they include families who take a stand on the social issues they care most about and involve their children and grandchildren in their good work.

Socially responsible investors back companies which show leadership in employee policies, human rights, environmental protection or other practices, but shun those which manufacture or distribute products they deem objectionable, such as tobacco products or weapons.

According to the Social Investment Forum's "2001 Report on Responsible Investing Trends in the United States," assets in socially screened investment portfolios under professional management grew 36 per cent in the last two years versus 22 per cent for all professionally managed assets. Socially screened assets now represent about one in ten dollars in professionally managed accounts.

Some socially responsible investors also become shareholder advocates, promoting corporate decisions that might have beneficial long-term effects on social change. Others put investment capital to work in their communities, seeking high-impact social returns.

Socially responsible investors are likely to do well, even as the current crisis in confidence deepens. They are vigilant in tracking a company's performance on socially important issues that, if mismanaged, might hurt corporate earnings. And they see a company's positive record on socially important issues as an indicator of good management, unquestionably the most reliable predictor of stock performance.

The Calculus of Conscience

But many financial advisers reject socially responsible investing, arguing that it compromises investment performance. They contend that limiting asset classes subjects a portfolio to greater volatility and downside risk.

Such critics postulate that socially responsible investors may give up one or two per cent in total returns each year. And they may be right.

Even so, the trade-off may prove worthwhile. Further research may find that there is a demonstrable longer-term correlation between a company's positive social and environmental performance and its quality as an investment. Beyond that, there is certainly an issue of conscience: one's investment dollars and beliefs should pull in the same direction. For now, it's clear that corporate treachery has energized socially responsible investors and, for that, all investors are in their debt.

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Marc J. Lane is the President of The Law Offices of Marc J. Lane, a Professional Corporation, and Marc J. Lane Investment Management, Inc. Marc is a business and tax attorney who develops and implements wealth management strategies, a Master Registered Financial Planner, an Adjunct Professor of Law at Northwestern University School of Law, and an Adjunct Professor of Business at the University of Illinois. He is the author of 30 books, including Advising Entrepreneurs: Dynamic Strategies for Financial Growth (Wiley, 2001).

 


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