Investing — Then Do Better

“Active Ownership” by Elroy Dimson , Oğuzhan Karakaş and Xi Li - this paper, in my view, suggests that successful active engagement in a collaborative and constructive manner on material ESG concerns improves the fundamentals of a company and also increases stock returns.

I differentiate this type of engagement with what one typical sees from “hedge-fund activists” or where board proxy fights occur; and where media engagements and open letters are used (although that type of activism has also seen positive returns see Klein and Zur, 2009).

Starting with the conclusions: “How does the market react to ESG activism? We find that ESG engagements generate a cumulative size-adjusted abnormal return of +2.3% over the year following the initial engagement. Cumulative abnormal returns are much higher for successful engagements (+7.1%) and gradually flatten out after a year, when the objective is accomplished for the median firm in our sample. We do not find any market reaction to unsuccessful engagements. The abnormal return patterns and magnitudes are similar for the subsamples of CG and ES engagements.4 This suggests the existence of a threshold for success to be pursued and achieved for both types of engagements. We then examine the cross-section of abnormal returns (controlling for industry and year fixed effects) and find that the positive market reaction to successful engagements is most pronounced for the themes of corporate governance and climate change. For these themes, the cumulative abnormal return of an additional successful engagement over a year after the initial engagement averages +8.6% and +10.3%, respectively.”

Then:

“To investigate the sources of the positive market reaction to successful engagements, we take a difference-in-differences approach and examine the subsequent changes in target firms’ operating performance, profitability, efficiency, institutional ownership, stock volatility, and governance after successful engagements relative to after unsuccessful engagements. We observe significant improvements in all these measures (i.e., an increase in firm performance, investor base, and governance, and a decrease in stock return volatility) following successful engagements, as compared to the unsuccessful ones.

Particularly focusing on the ES and CG subsamples, we first find that the return on assets and the ratio of sales to the number of employees improve significantly one year after successful ES engagements, as compared to the unsuccessful ones; but such improvements are less pronounced for successful CG engagements. These findings support the view that successful ES initiatives enhance customer and employee loyalty. Second, we observe an increase in shareholdings by the asset manager, pension activists, and SRI funds one year after successful ES engagements; but such an increase is not apparent for successful CG engagements. These results support the view that ES initiatives generate a clientele effect among shareholders. Third, we find improvements in the corporate governance structure of targeted firms, as measured by the Bebchuk, Cohen, and Ferrell (2009) entrenchment index, two years after successful engagements on all ESG issues. This suggests that good ESG practices signal improving governance quality.

And to conclude:

“We conclude that environmental, social, and governance activism of the type that we study

improves social welfare to the extent that it increases stakeholder value when engagements are successful and does not destroy firm value even when engagements are unsuccessful. We note that, after successful engagements (particularly on ES issues), firms with inferior governance subsequently improve their governance and performance. Our interpretation is that active ownership attenuates managerial myopia and hence helps to minimize intertemporal losses of profits and negative externalities (see Benabou and Tirole 2010). This approach is differentiated from other styles of shareholder action, particularly hedge fund activism. Responsible investment initiatives are less confrontational, more collaborative, and more sensitive to public perceptions; yet they achieve success.”

The full methodology and discussion is in the link SSRN here (further bibliography in that paper to studies on the full range of stewardship to activism) .

An overview of several Active Ownership studies is given by Share Action here.

Summary slides given by Dimson on this paper are here.

If one puts this work together with the work on the outperformance of Global Equity managers described here, one can start to build a defense of Active Management; where John Kay would argue Active Managers should compete on style and philosophy in any case.

If you'd like to feel inspired by commencement addresses and life lessons try: Ursula K Le Guin on literature as an operating manual for life; Neil Gaiman on making wonderful, fabulous, brilliant mistakes; or Nassim Taleb's commencement address; or JK Rowling on the benefits of failure. Or Charlie Munger on always inverting.

The chart above figure plots the cumulative monthly abnormal returns (CARs) around the initial engagements from one month prior to the engagement month to 18 months afterward. The chart examines the entire sample Each CAR is decomposed into the CAR for successful engagements (i.e., those that achieved milestones) and the CAR for unsuccessful engagements. For each event month, authors calculate the average abnormal return from holding an equally weighted portfolio of all target firms that initiated engagements in month 0. The stock returns are adjusted for Fama-French decile size-matched returns. The stock returns are winsorized at the 1st and 99th percentile levels before calculating the average CARs.

Richard Thaler has won a Nobel prize. Perhaps most famous for his book Nudge and the behavioural policy units spawned in the UK and US. This has led to the default on option on UK pensions as being enrolled, with an opt-out option given. This has “nudged” participation in UK private-sector pension schemes from 42 per cent to 73 per cent between 2012 and 2016. That’s quite an impact from “libertarian paternalism”. Video of Thaler at Google Talk below.

His observations on the “irrational” behaviour of man can be neatly seen in this New York Times column.

“This illustrates an important problem with traditional economic theory. Economists discount any factors that would not influence the thinking of a rational person. These things are supposedly irrelevant. But unfortunately for the theory, many supposedly irrelevant factors do matter.

Economists create this problem with their insistence on studying mythical creatures often known as Homo economicus. I prefer to call them “Econs”— highly intelligent beings that are capable of making the most complex of calculations but are totally lacking in emotions. Think of Mr. Spock in “Star Trek.” In a world of Econs, many things would in fact be irrelevant.”

Later in the article he mentioned how cash is the perfect econ gift.

I once gave one of my best friends cash for his birthday. He was in debt, and I was much better paid. I had thought about it long and hard, and decided cash was the most optimal solution.

It wasn’t particularly well received. In fact, I recall he tried to return it almost immediately, something the most ugly jumper from a grand-aunt would not trigger.

I now tend to make a card and sometimes a drawing or poem. Perhaps, much more valuable a higher return on investment for sure.

Still, my friend is now out of debt. Perhaps not wanting to be embarrassed by his friend giving him money ever again.

(In my defence, it’s fairly traditional in Chinese culture to give money on various occasions perhaps that rooted me in this one rational strategy)

(Today, I’d suggest as a gift i. Some shared experience (there’s evidence that experiences → postivity/happiness over objects) ii. Hand made some thing and then iii. Cash only leaving a physical retail object as a distant iv. Sadly, this would likely lead to a global recession if people stopped buying things, so perhaps good that not everyone thinks like this.)

Cross fertilise. Read about the autistic mind here. On investing try a thought on stock valuations.

Richard Thaler, in conversation with Hal Varian, Google's Chief Economist Richard Thaler, co-author of Nudge, will discuss his new book, Misbehaving: The Making of Behavioral Economics. In this book, he couples recent discoveries in psychology with a practical understanding of incentives and market behavior to tell us how to make smarter decisions in an increasingly mystifying world.