How “Sustainable” are Publicly Traded Firms?

Dan diBartolomeoNorthfield Information ServicesApril 2010

Review published research on the “sustainable” and more generally SRI related investing practices

Review research studies conducted by Northfield on sustainable investing strategies for our clients

Present an entirely quantitative approach to measuring the expected life of firms based on the contingent claims approach of Merton (1973)

Illustrate the method with an “expected life” analysis for the constituents of the KLD 400 SRI index, as compared to S&P 500 at two moments in time

Goals for this Presentation

The Body of Information on Sustainable Investing is Growing Fast The Moscowitz Prize has been awarded by University of

California at Berkeley for best research paper in SRI and Sustainable Investing since 1996 Hundreds of papers have been submitted, mostly academics Winners posted on the UC Berkeley website I think I’m the only person to be a judge all 13 years A Favorite paper: The “Eco-Efficiency Premium Puzzle”, by

Guenster, Derwall, Bauer and Koedijk (2004) Lots of “soft” books have been written

“Sustainable Investing: by Krosinsky and Robbins But few really quantitative studies by practitioners

“More Gain than Pain: Sustainability Pays Off” by Garz, Volk and Gilles (West LB Panmure, 2002) showing positive risk-adjusted payoffs to sustainability and SRI in general

Northfield Internal Studies

diBartolomeo, Dan and Lloyd Kurtz, “Socially Screened Portfolios: An Attribution Analysis of Relative Performance, Journal of Investing, 1996. Comparison of the KLD 400 SRI index against the S&P 500 with

monthly detailed attribution using Northfield models over five years, and updated in 1999 with no differences in outcomes

diBartolomeo, Dan and Lloyd Kurtz, “DSI Catholic Values 400”, Jouirnal of Investing, 2005. Comparison of KLD DSI Catholic Values 400 agains the S&P

500 over ten years

Conclusion in Both Cases Differences in performance were fully explained by traditional

risk model factors. No evidence of a “social factor” returns positive or negative

Conservest Study

Conservest is a small HNW manager in Woodstock, Vermont Founder Joseph Bragdon wrote “Profit for Life: How Capitalism

Excels” on sustainable investing concepts and strategies Uses an “almost passive” portfolio known as the LAMP 60

In 2007, we did an attribution study of LAMP 60 Outperformance from 2002 to 2006 showed about 250 basis

points annually that could not be attributed to conventional factor bets, but not statistically significant

Extended study back to 1997 (subject to selection and survivor bias) and showed about 400 basis points annual outperformance, of which we attribute about 150 basis points to survivorship bias

Updated information through 2007 shows marginal statistical significance

A Quant Approach to Sustainability Let’s actually estimate how long companies are going to

survive using contingent claims analysis Merton (1974) Leland and Toft (1996) KMV http://www.haas.berkeley.edu/groups/finance/WP/LECTURE1.pdf

The idea is simple A corporate bond holder is long a riskless bond and short a put on

the assets of the firm Alternatively, a stockholder has a call option on the assets of the

firm with a strike price equal to paying off the firm’s debt If you know the volatility of the firm’s assets set up your favorite

option pricing model and solve for the unknown expiration date Assume asset volatility is the stock volatility adjusted for leverage

Filling in with “Distance to Run” For firm’s with no debt, we simply note that default will be

coincident with stock price to zero, since a firm with a positive stock price should be able to sell shares to raise cash to pay debt If you have a stock with 40% a year volatility you need a 2.5 standard

deviation event to get a -100 return Convert to probability under your distributional assumption

We convert both measures to the median of the distribution of future survival in years What is the number of years such that the probability of firm survival to

this point in time is 50/50 Highly skewed distribution so we upper bound at 300 years

Z-score the “median of life” for both measures and map the distance to run Z-scores into the “option method” distribution for firms with no debt

Empirical Results over Time

Estimate “median of life” for all firms in Northfield US equity universe from 1992 to date, updated monthly

Calculate the cross-sectional mean, median each month Average of the monthly medians, 21.63 years Average of the monthly means, 24. 42 Lowest expectations, January 1992 median 10, average 13.20 Highest expectations, January 2005, median 30, average 41.09

Current expectations Median 23, average 22.18 AIG 7, Citicorp 6, GS 6, IBM 30, MSFT 32, RD 30/39, XOM 54

Sources of Time series variation Stock prices, debt levels, Northfield risk forecasts Mix of large and small firms, 4660 <= N <= 8309

Empirical Results, KLD 400 versus S&P 500 July 31, 1995

DSI 400, Median 17, Average 17.91, Standard Deviation 9.93 S&P 500, Median 14, Average 15.40, Standard Deviation 9.28 Difference in Means is statistically significant at 95% level

March 31, 2010 DSI 400, Median 30, Average 26.39, Standard Deviation 11.45 S&P 500, Median 30, Average 24.93, Standard Deviation, 10.92 Difference in Means is statistically significant at 90% but not 95%

Ignoring the stocks in common yield very strong statistical significance between the disjoint sets

Conclusions

Published literature provides inconclusive, but mostly positive evidence on the economic benefits of “sustainable” investing strategies

Studies done at Northfield find no evidence of “social factor” returns, but do find some support for sustainable investing as a strategic approach

Contingent claims models are a direct and informative approach to assessing real sustainability

Limited comparison of SRI and convention US stock indices reveals a positive and significant difference in investor perception of expected firm lives, but causality is unclear