How “Sustainable” are Publicly Traded Firms? Dan diBartolomeo Northfield Information Services April 2010

Goals for this Presentation

 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

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