Prof. Rob Bauer held the second lecture of the Sustainability Series on 26 September on the topic of Responsible Investing.
Bauer, a professor of Finance at Maastricht University, also conducts research on pension funds, social responsible investments (SRI), corporate governance and other related fields. Bauer is also the founder and Managing Director of Rob Bauer Consultants BV and the Director of the European Centre for Corporate Engagement (ECCE).
Bauer gave the attentive audience an insightful and constructive overview on the topic of sustainable investment, providing extensive background theory and empirical evidence.
His main message was that it is possible to practise responsible investment.
Responsible investing: how?
Many investors want to have the option to invest in socially and environmentally responsible companies. Several approaches already exist but there is no unambiguous answer to the question as to whether such an investment makes sense financially.
Evidence shows that ESG (Environmental, Social and Governance) factors can add long-term advantages when integrated in investment analysis and decision-making.
It has become a trend among institutional investors to take such factors into consideration in a response to pressure from the public (people demand more transparency), the press (ESG is covered extensively in the media) and peers (there is a disadvantage in being the last one to implement such a policy).
Bauer classified the different ways in which an investor can practise responsible investment.
An investor can choose to exclude stocks based on non-financial preferences, for example, by leaving out “sin stocks*” such as alcohol or tobacco producers.
Investment companies also adopt ESG policies and can choose to exclude unwanted stocks. For example, a Norwegian pension fund decided to exclude Wallmart from its investing portfolio because of the company’s poor labor practices.
Alternatively, investors can also choose to include a company based on their sustainable practices or other non-financial reasons.
The last, more laborious, approach consists in direct engagement with companies with the intent to impact their strategy on sustainability.
The role of corporate governance
From within the company, corporate governance plays a big role in determining the approach on sustainability. Empirical evidence shows that in the long term, sustainable approaches do pay off, but since most CEOs usually stay with a company for a period of two to five years, they tend to pursue shorter-term strategies.
Such strategies can potentially impact the company’s return. A study conducted by Paul Gompers at Harvard University in 1990 showed that companies with good governance had the highest return when compared to similar companies with poorer governance (8,52 percent compared to 7 percent or less). Nevertheless, the same study conducted 10 years later by Harvard Professor Lucian Bebchuk revealed no significant differences.
“A good company is not necessarily a good investment,” Bauer pointed out. If everyone is already integrating ESG into stock markets, the simple fact of buying ESG stocks does not give an investor any advantage.
Furthermore, ceasing to invest in less sustainable companies does not mean that their returns will decrease. Ironically, the opposite can actually happen. Such stocks can be influenced by the “neglect effect” that requires holders to ask for a risk premium, which allows them to gain higher returns. For example, an index made of sin stocks called the Vice Fund was able to provide a 8,88 percent return since inception compared to a 6,22 percent return for the S&P 500.
What can bondholders and shareholders influence do?
Bauer continued the lecture by analyzing the corporate bond market.
Bondholders have a very different approach on investment from shareholders. Besides benefiting from monitoring advantages and increased transparency, bondholders prefer adopting tactics that don’t necessarily impact only the value of the stock.
For example, banks charge higher interest rates if the company is easily taken over, so bondholders prefer takeover defenses. Shareholders, on the other hand, would prefer for the company not to have takeover defenses. This dichotomy is created by the separation of ownership and control or otherwise called “agency cost of debt.”
If shareholders are driven by mechanisms that promote shareholder wealth, bondholders are also concerned with the cost of debt. A company’s rating has a big influence on the interest that a company pays on its loans. If a company has a good record and high ratings, the risk of default is much smaller, so that banks can afford charging a smaller fee. If the company has poor ratings, banks have to safeguard themselves from the possibility of default and charge a higher rate. Even though rating agencies have neglected corporate governance and generally don’t look at ESG, credit risk is influenced by corporate governance. Bauer pointed out that credit risk rises with increased CEO power whereas strong takeover defenses and family ownership decrease it.
Furthermore, interest rates are related to environmental performance. Investors ask for a risk premium to guard against potential fines, damages and additional costs. As a consequence, bondholders take a closer look at the company’s performance and demand more responsibility both at the governance level and from an environmental perspective.
Finally Bauer explained the engagement tactic. Shareholders can engage with companies through informal or private engagement: they can vote by proxy, file lawsuits or run media campaigns. Both managers and shareholders can file proposals. Companies have to review the proposals and decide to decline or accept them.
Watch the lecture on Responsible Investing by Prof. R. Bauer
The value of engagement
Thus, investors play a big role in a company’s sustainability practices. This influence is essential in pressuring companies to adopt more sustainable approaches and helps instill better corporate governance practices as well. Nevertheless ESG factors have to be considered carefully when investing. Investors are able to choose stocks based on their preferences but should also be careful when projecting returns. Some ESG related information might already be partially priced in so the returns might not be influenced by the company’s sustainable practices alone.
In conclusion, engagement seemed to be the most influential method. Even though it is the most laborious, it also promises better long-term results.
By Ana Mihail
Ana Mihail is a student in International Business Economics at Maastricht University.
* term used in the US to describe stocks of tobacco, alcohol, gaming or weaponry companies
- The Price of Sin: The Effects of Social Norms on Markets, Hong &Kacperczyk (2008)
- Stocks of Admired Companies and Despised Ones, Anginer et al (2008)
- Neglect effect of social tastes in Europe, Salaber (2007)
- Just say no? Implications of tobacco divestiture, Kahn et al (1997)