Eth­i­cal in­vest­ing: Gra­ham Wit­comb Why it doesn’t pay

It may be more con­struc­tive to buy a stake in a “bad” com­pany than to avoid it al­to­gether

Money Magazine Australia - - CON­TENTS - STORY GRA­HAM WIT­COMB Gra­ham Wit­comb is an an­a­lyst at In­tel­li­gent In­vestor, owned by In­vestS­mart Group. To un­lock In­tel­li­gent In­vestor stock research and buy rec­om­men­da­tions, take out a 15-day free mem­ber­ship at in­vests­

Don’t get me wrong: I’m a huge fan of so­cially re­spon­si­ble com­pa­nies, but I think eth­i­cal in­vest­ing gets it wrong. If eth­i­cal in­vestors ac­tu­ally em­braced the “bad” and the "ugly"cor­po­rate cit­i­zens, in­stead of favour­ing only the "good", they would achieve more, so­cially and fi­nan­cially.

Of course, there are in­dus­tries do­ing harm in the world: oil com­pa­nies, gun mak­ers, to­bacco pro­duc­ers, gam­bling stocks and the rest.

Many in­vestors refuse to own stocks or funds op­er­at­ing in these in­dus­tries, pre­fer­ring to put their money in com­pa­nies con­sid­ered so­cially re­spon­si­ble. Eth­i­cal in­vest­ing has boomed over the past decade as a re­sult.

Maybe you sleep bet­ter at night know­ing that your div­i­dends are paid by so­lar panel man­u­fac­tur­ers rather than cig­a­rette mak­ers. Fair enough.

How­ever, if you’re avoid­ing the bad eggs of the cor­po­rate world be­cause you’re try­ing to make the world a bet­ter place, there are more ef­fec­tive ways to do good – and make more money at the same time.

For one thing, eth­i­cal in­vest­ing doesn’t pay well. Mu­tual funds that tar­get spe­cific stocks have higher fees than broadly di­ver­si­fied in­dex funds and, his­tor­i­cally, have been slower grow­ers.

The big mama of all so­cially re­spon­si­ble funds is Van­guard’s FTSE So­cial In­dex Fund. It’s also the low­est cost, with an ex­pense ra­tio of just 0.22%. Still, that’s more than four times the 0.05% fee of the Van­guard 500 In­dex Fund, which is much larger.

In the­ory, the so­cial fund could have made up for the ex­tra fees by earn­ing higher re­turns, but that wasn’t the case: the so­cial fund earned 5.6% a year over the past 15 years, com­pared with 6.7% for the S&P 500 fund.

The dif­fer­ences seem small but they add up. If, say, you put away $5000 a year over 30 years to­wards your re­tire­ment, your nest egg would be around $394,000 un­der the so­cial in­vest­ing strat­egy, com­pared with $480,000 us­ing the gen­eral in­dex fund.

The ques­tion, then, is whether the ben­e­fits of eth­i­cal in­vest­ing out­weigh the costs of hav­ing to save more for re­tire­ment and hav­ing less money to give to wor­thy causes.

The most com­mon ar­gu­ment I hear for eth­i­cal in­vest­ing is that the in­vestor doesn’t want to help bad com­pa­nies do bad things.

Let’s ad­dress that by talk­ing about what a stock re­ally is: a claim on a cur­rent set of as­sets and a fu­ture stream of cash flows. If Bad Corp has 100 shares out­stand­ing and you own one share, then you own 1% of ev­ery fac­tory, fur­nace and of­fice chair and have a claim on 1% of ev­ery dol­lar of profit.

To build a new fac­tory, Bad Corp can ei­ther use re­tained earn­ings, bor­row money or raise cap­i­tal by

is­su­ing new shares. Most com­pa­nies favour the first two op­tions and rarely the lat­ter (new shares are typ­i­cally is­sued for large ac­qui­si­tions).

But here’s the thing. When you buy shares on the ASX, you’re buy­ing from an­other in­vestor – not hand­ing money to the com­pany it­self. These are sec­ondary trans­ac­tions. If your friend owns shares in Bad Corp and sells them to you, the cash that changes hands is be­tween you and your friend – Bad Corp doesn’t see a penny of it.

In the case of ini­tial pub­lic of­fer­ings (IPOs), en­ti­tle­ment of­fers and share pur­chase plans, you are hand­ing money to the com­pany for po­ten­tially so­cially ir­re­spon­si­ble uses, so not par­tic­i­pat­ing makes sense. But if you’re buy­ing ex­ist­ing shares, the com­pany isn’t fi­nan­cially in­volved.

“But wait!” I hear you say. If enough in­vestors refuse to buy the stock, the com­pany’s share price will fall, which sends a sig­nal to man­age­ment and share­hold­ers that the world isn’t best pleased with their ac­tions. Money grub­bers that they are, man­age­ment will then make more so­cially re­spon­si­ble de­ci­sions to ap­pease the do-good­ers and boost the share price.

Not so fast. Be­cause a share in a com­pany is a claim on fu­ture cash flows, as the share price goes down the re­turns per share ac­tu­ally go up.

By boy­cotting the stock, you’re giv­ing those in­vestors who are will­ing to buy and hold the com­pany a big­ger re­turn. You are, in fact, en­rich­ing the “evil” in­vestors and neu­tral in­dex funds at your own ex­pense.

If the bad guys are get­ting richer than you, faster than you, then their in­flu­ence in the world is grow­ing. That doesn’t seem like a good plan to me.

So what’s an eth­i­cal guy or gal to do?

If you dis­agree with a com­pany’s poli­cies, you can still vote with your wal­let by boy­cotting its prod­uct or ser­vice. This re­duces the com­pany’s rev­enue, which means less cash flow for it to in­vest in build­ing its busi­ness.

You can also lobby for reg­u­la­tory in­ter­ven­tions and more scru­tiny of the com­pany’s ac­tiv­i­ties. Get­ting your elec­tric­ity from “green” providers is one thing but con­vinc­ing pol­icy mak­ers to ban coal power en­tirely is far bet­ter.

But there’s an even more pow­er­ful ar­gu­ment: to ac­tively in­vest in un­eth­i­cal com­pa­nies.

Re­fus­ing to own bad com­pa­nies is like re­fus­ing to vote in elec­tions be­cause you don’t like cur­rent poli­cies. You’re giv­ing up your voice.

If Exxon Mo­bil and Philip Mor­ris will be with us for decades to come, I’d rather their own­ers were a group of en­vi­ron­men­tal and so­cial ac­tivists who could then vote on board ap­point­ments and man­age­ment de­ci­sions, as well as di­rect the com­pany’s div­i­dends to­wards wor­thy causes.

This is a dif­fer­ent, more ac­tive way of think­ing about in­vest­ing in sin­ful in­dus­tries. In­stead of steer­ing clear al­to­gether, get in­volved. Read the proxy state­ments, vote for eth­i­cal board mem­bers and lobby ma­jor share­hold­ers to change per­son­nel.

By all means boy­cott a bad com­pany’s prod­ucts – but hap­pily take its div­i­dends, then in­vest them in the IPOs and ser­vices of re­spon­si­ble com­pa­nies, or do­nate them to char­i­ties and lobby groups. This, I sug­gest, will ac­com­plish a great deal more and leave you a lit­tle richer.

In­stead of steer­ing clear, get in­volved and lobby for changes

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