Corporate social responsibility can make good business sense, but the investment options can be a little pricey.
By Alex Bryan, CFA | 01-07-15 | 06:00 AM | Email Article

In 1970, Milton Friedman famously wrote, "There is one and only one social responsibility of business--to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud." While that may seem like an extreme view, Friedman does have a point. As the owners of a firm, shareholders hire managers to act as their agents. When managers focus on profit maximization, they also tend to maximize shareholder wealth. If they choose, shareholders can then donate part of that wealth to social causes that are important to them.

Alex Bryan, CFA, is director of passive strategies for North America at Morningstar.

To the extent that managers pursue objectives other than profit maximization, they may reduce shareholders' wealth and effectively substitute shareholders' priorities with their own. Profit maximization also tends to promote efficiency and accountability. In the pursuit of their self-interest, firms usually allocate scarce resources to their most productive uses.

The trouble is that firms do not always bear the full social costs of their actions. Economists call these phenomena negative externalities. For example, a coal power plant that expels its waste into the atmosphere could increase the prevalence of acid rain and make the surrounding area less desirable to live in, potentially hurting property values. Because the power generating firm does not directly bear these costs (in the absence of regulation), it may produce more electricity from coal than is socially optimal. So a narrow focus on profit maximization does not always lead to the most efficient social outcome.

There is also an argument that this focus can result in an unfair distribution of resources. Perceptions about fairness are very subjective, but they can have a big impact on a firm's image, and ultimately its profitability. For example,  Nike faced consumer boycotts in the 1990s for its suppliers' use of sweatshop labor. Even though the suppliers paid market wages in the developing countries where they operated, the conditions those workers toiled in and the compensation they received seemed unfair to many Western consumers, who used their purchasing power to express their discontent.

In order to mitigate these potential problems, many corporations have defined their corporate social responsibility more broadly than Friedman to include taking responsibility for their impact on the environment and social welfare even when there is no legal requirement to do so. While that is certainly laudable from a social perspective, an expansive view of corporate social responsibility may also be consistent with long-term profit maximization.

In getting out ahead of environmental and social problems that their operations may create, companies may be able to stave off potentially onerous regulations and reduce political risk. A proactive approach can also reduce the risk of conflicts with nongovernment organizations and other advocacy groups that can hurt sales and damage the value of a brand. Mindful of this risk,  Starbucks developed standards for ethically sourced coffee in partnership with Conservation International in the early 2000s. In accordance with these standards, it now sources most of its coffee from producers with independently verified environmentally friendly practices.

Many companies have actually built strong brands and competitive advantages with their corporate social responsibility programs. For example,  Whole Foods Market caters to environmentally and health-conscious consumers and commands premium prices for its organic products. Whole Foods' environmental stewardship is an integral part of its brand identity and contributes to its pricing power. Similarly, Ben & Jerry's (part of Unilever ) environmentally conscious production processes and image as a socially responsible firm help it differentiate its products. To a large extent, the firm uses ingredients that have been Fairtrade certified, which offers farmers in developing countries above-market prices for their goods in order to promote better standards of living. Many consumers are willing to pay more for these products because they feel better about the way they were made. Because corporate social responsibility can influence how consumers perceive a brand and their purchasing decisions, the pursuit of social and environmental goals can serve a similar role to advertising.

In some cases, pursing these goals may also help reduce costs. For instance, by improving the energy efficiency of its manufacturing processes,  Dow Chemical has saved about $400 million from 2005 through 2013. It doesn't always work out that way. Firms must balance the costs of implementing these programs against their benefits.

A strong reputation for social responsibility may help firms attract and retain better talent, which could further sharpen their edge. It's attractive to many people to be part of an organization they can be proud of and to feel that their work is making a difference.  Merck's program to end river blindness may have allowed it to attract scientists who would not have otherwise been available, according to a paper by Geoffrey Heal. This disease affected millions in Africa who could not afford the drug Merck developed to treat it. So Merck gave it away to those who needed it, which enhanced its reputation.

Because a firm's impact on the environment and social welfare can affect its brand, risks, and ability to attract and retain talent, pursing social and environmental goals can promote sustainable and attractive profits over the long term. Companies that take a more holistic view toward corporate social responsibility may be less likely to take shortcuts to boost short-term profits at the expense of long-term opportunities than their less socially conscious counterparts.

However, there is a risk that firms with an expansive view of corporate social responsibility might also have less accountability for their results. It is easy for a firm to claim it has a long-term view, but because the results do not materialize for several years, it's difficult to hold managers accountable for their immediate actions. Firms might also justify actions that are socially suboptimal in favor of a preferred stakeholder. For instance, a firm may avoid necessary layoffs that would improve efficiency in order to support the community. But that firm may ultimately become less competitive and contribute less to society than it would have if it were more efficiently run. Good corporate governance is vital to prevent this type of waste and promote accountability. Fortunately, a few sustainable, responsible, and impact investing, or SRI, funds incorporate governance into their stock-selection criteria.

Investment Options
Investors looking for a core holding that targets stocks with socially responsible characteristics might consider iShares MSCI KLD 400 Social Index and iShares MSCI USA ESG Index . Both screen for stocks with strong environmental, social, and governance, or ESG, records in areas that are relevant to their industries, such as carbon emissions, labor management, and corporate governance. They exclude tobacco companies, anchor their sector weightings to the MSCI USA Investable Market Index, and charge a 0.50% expense ratio. However, the MSCI KLD 400 Social Index also excludes companies operating in the weapons, alcohol, gambling, nuclear power, adult entertainment, and genetically modified organisms industries, while the MSCI USA ESG Index could include these companies. The MSCI USA ESG Index uses an optimization approach to manage tracking error relative to the MSCI USA Investable Market Index while maximizing exposure to companies with strong ESG characteristics. In contrast, the MSCI KLD 400 Social Index applies market-cap weighting and does not explicitly manage tracking error.

From its inception in 1990 through 2014, the MSCI KLD 400 Social Index outpaced the S&P 500 by 0.5% annualized with slightly greater volatility, due in part to its smaller average market cap. A returns-based regression analysis also reveals that the MSCI KLD 400 Social Index exhibited a modest tilt toward more-profitable companies. This is not enough to infer causation between social consciousness and profitability or stock market performance. It could go the other direction. More-profitable companies may be more likely to implement strong social responsibility programs because they may face greater risk for failing to do so. Highly profitable firms have also historically had better stock market performance.

Ultimately, what matters is performance relative to expectations. Even if investors expect a company to have higher costs as a result of its social responsibility program and that it will not reap any benefits, they should price it accordingly so that it offers a competitive return. Aggregate shareholder wealth may be lower than it otherwise would have been, but the stock's return could be comparable to the market's.

However, SRI index funds tend to charge higher fees than traditional index funds, which can put investors at a disadvantage.  Vanguard FTSE Social Index helps reduce this cost hurdle: It is the lowest-cost SRI fund available, with a 0.27% expense ratio. This fund tracks the FTSE4Good US Select Index, which targets stocks with strong ESG characteristics, similar to the two iShares funds. It applies similar industry exclusions to the MSCI KLD 400 Social Index, though it does not necessarily exclude companies that produce genetically modified organisms.

Where SRI index funds passively screen for companies with strong ESG characteristics, their actively managed counterparts, such as  Parnassus Core Equity and  Domini Social Equity , can use their relationships with portfolio companies to advocate for positive social change. Both funds vote proxies to advance ethical business practices, such as diversity, fair pay, and environmentally friendly policies.

Reference
Heal, G. 2004. "Corporate Social Responsibility--An Economic and Financial Framework." Columbia Business School, Working Paper: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=642762

 


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