A Responsible CAPM. Michelle Sisto, PhD EDHEC Risk Institute Research Associate. Abraham Lioui, PhD EDHEC Business School

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2 A Responsible CAPM Michelle Sisto, PhD EDHEC Risk Institute Research Associate Abraham Lioui, PhD EDHEC Business School

3 Motivation Growth of Corporate Social Responsibility (CSR) Movement Early research: Does CSR impact financial performance/firm value? How does CSR impact financial performance/firm value? Our Focus: Impact of CSR on firms discount rate

4 Main Questions Main questions: 1. Is responsibility a priced risk factor? 2. If so, what is the impact on expected returns? 3. Does a responsibility factor significantly contribute to a linear pricing model?

5 Plan for answering questions What we do: Create responsibility factors based on measures of CSR strengths and concerns Test these factors in a multifactor asset pricing model Examine model performance with and without responsibility factors

6 Main Findings We find: Responsibility factors are priced Findings are robust Impact of responsibility on expected returns is economically significant Responsibility contributes above and beyond classic Fama French factors

7 Responsibility CAPM 1. Introduction to CSR 2. Data and Methodology 3. Results 4. Conclusion 5. Further Questions

8 Defining CSR Impacts that a company s strategies and operating practices have on its stakeholders and the natural environment (Waddock, 2006) The responsibility of enterprises for their impacts on society which includes integrating social, environmental, ethical, human rights and consumer concerns into business operations and core strategy in close collaboration with their stakeholders with aims of maximizing the creation of shared value for their owners/shareholders and for their other stakeholders and society at large and of identifying, preventing and mitigating their possible adverse impacts. Commission of the European Communities 8

9 Interest in CSR Industry Investors Regulators Academics 9

10 Interest in CSR: Industry Incorporation of ESG and CSR considerations in corporate strategies Proactive and positive measures employee training, community engagement Reduction of negative externalities reduce waste, emission Recent examples of CSR related events Bangladesh Rana Factory Collapse => > 1100 dead Bangladesh Fire and Safety Accord Walmart launches environmentally friendly cleaning products line

11 Interest in CSR: Industry

12 Interest in CSR Industry Investors

13 Interest in CSR: Investors Socially responsible investment industry: 147 equity funds on US (Social Investment Forum, 2013); Over 170 funds in France in 2009 (Amenc & LeSourd); Size of market: US over $3 trillion in assets under management ( Europe 5 trillion as of Dec (Eurosif European SRI Study 2010) France - over 149 million in SRI equity funds (Novethic)

14 Interest in CSR: Investors

15 Interest in CSR: Investors Large institutional investors consider ESG concerns in investment decisions: Calpers Dutch fund PGGM divestment from Walmart due to poor labour relations in domestic market and board s lack of meaningful dialogue with shareholders Norwegian SWF Ethics Council

16 Interest in CSR Industry Investors Regulators

17 Interest in CSR: Regulators Mandatory and Voluntary Corporate Reporting Guidelines: 10 Principles of UN Global Compact UN Guiding Principles on Business and Human Rights OECD Guidelines for Multinational Enterprises ISO Guidance Standard on Social Responsibility Principles for Responsible Investment Global Reporting Initiative

18 Interest in CSR: Regulators

19 Interest in CSR Industry Investors Regulators Academics

20 Interest in CSR: Academics 1. Corporate social performance and financial performance Theoretical: Slack resource vs. Instrumental Management Empirical: Positive relation (Waddock & Graves 1997, Surroca et al. 2010, Servaes & Tamayo 2013) Negative relation (Bird et al 2007, Fisher- Vanden, Thorburn 2011) Direction of relation (Hong, Kubik, Scheinkman 2012) 20

21 Interest in CSR: Academics 2. Socially responsible investing Underperformance of SRI funds (Renneborg, ter Horst, Zhang 2007) Outperformance of SRI funds in crises (Nofsinger, Varma 2012) 21

22 Interest in CSR: Academics 3. Mechanism by which CSR impacts financial performance Theoretical: Demand differences due to investor preferences (Merton 1987, Heinkel, Kraus, Zechner 2001) CSR enhances customer loyalty and thereby reduces systematic risk (Albuquerque, Durev, Koskinen 2013) Empirical: Sin stocks have higher expected returns (Hong, Kacperczyk 2009) Higher CSR ratings associated with lower market beta (Albuquerque et al 2013) CSR and cost of capital Higher responsibility associated with lower cost of capital (El Ghoul et al 2011, for US; Cheng et al 2012, international) Intangibles: Advertising and R&D (Servaes and Tamayo, 2013) 22

23 Interest in CSR: Academics 3. Mechanism by which CSR impacts financial performance Theoretical: Demand differences due to investor preferences (Merton 1987, Heinkel, Kraus, Zechner 2001) CSR enhances customer loyalty and thereby reduces systematic risk (Albuquerque, Durev, Koskinen 2013) Empirical: Sin stocks have higher expected returns (Hong, Kacperczyk 2009) Higher CSR ratings associated with lower market beta (Albuquerque et al 2013) CSR and cost of capital Higher responsibility associated with lower cost of capital (El Ghoul et al 2011, for US; Cheng et al 2012, international) Intangibles: Advertising and R&D (Servaes and Tamayo, 2013) 23

24 Our Expectations from Literature Firms (portfolios) expected returns will be related to their sensitivities to responsibility factors - Higher exposure to responsibility associated with lower expected returns - Higher exposure to irresponsibility will have higher expected returns to compensate for risk exposure 24

25 Responsibility CAPM 1. Introduction to CSR 2. Data and Methodology 3. Results 4. Conclusion 5. Further Questions 25

26 Data Sources CSR measurement: MSCI ESG metrics, formerly KLD Analytics (annual, ) Return and market cap data: CRSP (WRDS) Factor data for market, size, value, momentum: Kenneth French s data library 26

27 CSR Data Coverage universe of MSCI ESG Stats Coverage Universe Present 500 Largest US companies X X X MSCI KLD 400 Social Index X X X 1000 Largest US Companies X X 3000 Largest US Companies X Approximate Total Number of Companies Rated

28 CSR Data Measuring CSR with MSCI ESG STATS: Time period Annual snapshot of US companies social and environmental performance Seven areas Community, Diversity, Employee Relations, Human Rights, Products and Core Business Environment Corporate Governance plus Controversial Business Issues Strengths and Concerns in each area: rated as 0, 1, or NR. 28

29 CSR Data 29

30 Mean Sums of Strength and Concern Ratios Means of Single CSR measures: Strengths - Concerns CSR Measures Strengths Cons Strengths Broad Concern Cons Concern Broad Single Conservative Single Broad Year Year 30

31 Top and Bottom Ranked Firms along CSR Dimensions Panel A: Top Responsible and Top Irresponsible Firms based on Strengths/Concerns Separately HIGH STR IBM PRD IBM IBM PRD WMT NOBE IBM CUM IBM IBM LU GE GE IBM IBM IBM IBM IBM PG PG FDX LOTS LOTS BAX BJICA HD HD HWP IBM MOT MOT PCG FNM FNM MOT HPQ INTC HPQ HPQ F MRK HIGH CON GM TX UIS GM GM GM GM RD DD RD RD XOM XOM XOM XOM WMT XOM XOM XOM F WMT DD F MD UIS RD RD UCL DD CHV XOM XOM DD DD KO CVX XOM WMT WMT WMT WMT GE Panel B: Top Responsible and Top Irresponsible Firms based on Aggregate Measure of Sums - Concerns HIGH BAX LOTS CSFN BJICA PRD NOBE NOBE HWP CUM XRX HWP FNM FNM FNM MOT HPQ A MOT MOT PG PG STR-CON PRD PRD AIT LOTS BJICA HD HWP XRX IBM MOT CUM PG JNC INTC GIS MOT INTC HPQ HPQ AVP INTC LOW GM TX UIS UIS RD CAG GM RD CHV OXY GMH EP OXY SSCC TIE WMT WMT KBR KBR HAL MDR STR-CON X MRO MD AR GM RD AR CHV UCL RD SPOT OXY FE XOM WMT XOM KBR WMT WMT CWST HAL

32 Creation of Responsibility Factors (1) Double sort stocks on strengths and concerns Strength dimension - 30 th, 70 th percentile breakpoints Concern dimension - median breakpoint Str = mean (high str) mean (low str) Con = mean (high con) mean (low con) Low Concern L c High Concern H c Low Strength L s Medium Strength M s High Strength H s 32

33 Creation of Responsibility Factors (1) 33

34 Creation of Responsibility Factors (2) Sort stocks on single aggregate dimension (strengths concerns) Agg Factor = low quintile minus high quintile 34

35 Asset Pricing: Multifactor Models Methodology: two pass cross-sectional full period regressions R k,t r f, t k k, mkt f mkt, t r f, t k, smb f smb, t k, hml f hml, t k, resp f resp, t k, t E[R k - r f ] = g 0 + n å j=1 g j b k, j 35

36 Factor summary statistics rf mkt smb hml mom liq con str agg Mean % Std % Skew Kurt Min % Max %

37 Asset Pricing: Factor Correlations mkt smb hml mom liq con str agg mkt 1 smb hml mom liq con str agg

38 Cumulative Return Cumulative Behavior of Factors: Market SMB HML Aggregate CSR Concern Strength

39 Cumulative Behavior of Factors: Market SMB HML Aggregate CSR Concern Strength

40 Test Assets: 9 Responsibility Portfolios LL LM LH ML MM MH HL HM HH Mean % Median % Std % Min % Max % Mean log ME Mean strength Mean concern Mean % stocks in portfolio

41 Test Assets: 10 Industry Portfolios NoDur Durbl Manuf Enrgy HiTec Telcm Shops Hlth Utils Other Mean Std Skew Kurt Min Max

42 Responsibility CAPM 1. Introduction to CSR 2. Data and Methodology 3. Results 4. Conclusion 5. Further Questions 42

43 Is Responsibility Priced? g 0 g mkt g smb g hml g con g str Estimate t FM t Shanken t JW t PM Estimate t FM t Shanken t JW t PM Estimate t FM t Shanken t JW t PM Estimate t FM t Shanken t JW t PM

44 How do loadings on factors behave, i.e. what is sensitivity of assets to factors? mkt smb hml mkt smb hml con mkt smb hml str LL LM LH ML MM MH HL HM HH NoDur Durbl Manuf Enrgy HiTec Telcm Shops Hlth Utils Other

45 What is the impact of responsibility on expected returns? mpr mkt mpr smb mpr hml mpr mkt mpr smb mpr hml mpr con mpr mkt mpr smb mpr hml mpr str LL LM LH ML MM MH HL HM HH NoDur Durbl Manuf Enrgy HiTec Telcm Shops Hlth Utils Other

46 Is the model well-specified? Tests of R 2 FF3 FF3 con FF3 str FF3 all Sample R p (r 2 =1) p (r 2 =0) se(r 2 ) p (model is correctly spec)

47 Does the responsibility factor contribute beyond other factors to explaining crosssectional returns? Testing equality of R 2 of nested models (Kan, Robotti, Shanken, 2013) FF3 vs FF3+con FF3 vs FF3+str FF3 vs FF3+con+str Difference in R Correctly specified models Misspecified model

48 How robust are these results? Assets to price? (Responsibility portfolios, Industry portfolios) Factors included (CAPM, FF3, Responsibility) Methodology (rolling windows or one shot full period regressions) Time period (holds in full period and post 2003 period)

49 Responsibility CAPM 1. Introduction to CSR 2. Data and Methodology 3. Results 4. Conclusion 5. Further Questions 49

50 Main Questions 1. Is responsibility a priced risk factor? Yes robust to various methods of factor construction, economic significance varies with construction and dimension of CSR

51 Main Questions 2. What is the impact of responsibility on expected returns? Higher expected returns for less responsible stocks along strength dimension require a premium to hold them

52 Main Questions 3. Does a responsibility factor significantly contribute to a linear pricing model? Yes the difference in explained variation of cross sectional returns is significant.

53 Responsibility CAPM 1. Introduction to CSR 2. Data and Methodology 3. Results 4. Conclusion 5. Further Questions 53

54 Further Questions Does responsibility contain information different from market, size, or value? Yes - regressions against each of these variables available and all together What underlying risk does responsibility proxy for? - regressions against business cycle variables and FACTIVA data on CSR in news

55 Correlation between Responsibility Factors and Mentions of CSR in News Factiva Environmental con str Factiva Social engagement con str Factiva CSR - general con str ENV: global warming, climate change, environmental issues, environmental degradation, pollution, renewable energy Social: Employee engagement or community engagement or diversity or employee relations or human rights in companies or sustainable supply chain General: Corporate social responsibility or corporate citizenship or corporate sustainability or social imperatives

56 Thank you for coming Questions?