Studies that show ESG works (2)

The second in my series examining papers evidencing ESG works.

First part can be read here.

I’m going to explain these next two studies in my non-technical understanding. However, Professor Alex Edmans had to explain the regression discontinuity method to me twice, before I even half understood it. I then needed a whole afternoon to read up and understand it, and my maths and statistics are strong enough for a Cambridge University Natural Science degree.

Partly, because of their somewhat technical nature, I don’t think they have been discussed in the investment practitioner community much. In fact, no investment manager or ESG practitioner on the asset owner or asset manager side has ever mentioned them to me.

The papers are:

Does Corporate Social Responsibility Lead to Superior Financial Performance? A Regression Discontinuity Approach by Caroline Flammer

Link here

And

DOES A LONG-TERM ORIENTATION CREATE VALUE? EVIDENCE FROM A REGRESSION DISCONTINUITY by Caroline Flammer and Tima Bansal

Link here

The abstracts are:

“This study examines the effect of corporate social responsibility (CSR) on financial performance. ...Consistent with the view that CSR is a valuable resource, I find that the adoption of CSR proposals leads to positive announcement returns and superior accounting performance. .... This evidence suggests that CSR improves employee satisfaction and helps companies cater to customers that are responsive to sustainable practices.”

And

“In this paper, we theorize and empirically investigate how a long-term orientation impacts firm value. To study this relationship, we exploit exogenous changes in executives' long-term incentives. Specifically, we examine shareholder proposals on long-term executive compensation that pass or fail by a small margin of votes. The passage of such "close call" proposals is akin to a random assignment of long-term incentives and hence provides a clean causal estimate. We find that the adoption of such proposals leads to i) an increase in firm value and operating performance ― suggesting that a long-term orientation is beneficial to companies ― and ii) an increase in firms' investments in long-term strategies such as innovation and stakeholder relationships….”

On the first paper – Flammer finds evidence of this:

“…CSR improves employee satisfaction…”

Put together with the Edmans paper (referred to in part 1) that employee satisfaction leads to improved corporate performance, and long term stock return outperformance

This is already a substantive link to these type of CSR proposals and stock returns.

Now, I’d like to theorise about the nature of these “close- call CSR proposals”. I’ve not viewed them.

But, my experience of reading proxy votes over the last 20 years suggests to me that these are proposals that a significant number of shareholders give value to. There may also be some degree of “signaling” from shareholders here. (As issue they don’t expect to pass but want to bring more forcefully to management’s attention)

Furthermore, given the non-votes and the inertia in a default vote for management, it is likely that these close calls actually have majority support on those thinking about such matters.

You could theoretical argue that this study is silent on non-close call proposals, so those that gain limited or no support. But that also makes sense to me because certain proposals may be non-material for those thinking about such matters, and those gain little support.

For instance, a proposal for transparency surrounding a reduce refine replace policy and animal testing maybe material for some life science companies, but is unlikely to be material for financial services company – and I would suspect if proposed at a bank AGM would garner little support.

“CSR” from a company perspective overlaps with “ESG” (that language problem again) and investors such as myself would likely add “materiality” to this (I think this does apply to the close call nature of these proposals, my guess would be these are material, but that’s a judgment) – the Harvard BS study I referred to in part 1 also lends weight to this.

I find this study compelling, even more so when you pair with the next study

The results on stock price can be summarised here:

“…the evidence …suggests that long-term …compensation proposals that are marginally approved lead to a significant increase in shareholder value compared to proposals that are marginally rejected…. the results…are consistent with the hypothesis… stating that an exogenous increase in long-term incentives leads to a positive stock market reaction. In Appendix A… we show that this finding is robust to a large battery of robustness checks….”

Perhaps of even deeper interest to me are the operating metrics results:

“…We consider three measures of operating performance: ROA, NPM, and sales growth….all three measures increase significantly…ROA increases by 0.9 percentage points (p = 0.046), NPM by 1.9 percentage points (p = 0.049), and sales growth by 3.9 percentage points (p = 0.059), suggesting that long-term incentives improve operating performance in the long run… Interestingly, all three measures of operating performance actually decrease in the short run (albeit the decrease is not significant). This indicates that, following an increase in long-term incentives, firms engage in long-term investments that are costly in the short run, but pay off significantly in the long run…" [My emphasis]

Again, this aligns with what business managers have to decide on – an investment that has a short term cost but leads to longer term stronger performance

They also “....examine whether the passage of long-term compensation proposals leads to higher engagement in long-term strategies. Specifically, we examine two types of investments that are commonly considered long-term: innovation (R&D expenditures) and stakeholder relationships…As can be seen, both increase significantly following the vote…..”

And then the auxiliary work on patents is even more intriguing to me – in summary:

“…we find that both the share of hits and flops and the share of explorative patents increase significantly following the adoption of long-term compensation proposals…Overall, the results in suggest that adopting a longer-term horizon is conducive to innovation, and especially the pursuit of risky and explorative R&D projects…”

This is a long detailed and robust set of papers, which conclude on what seems to be a common sense theory to me.

If you incentivize (which is a G or an S or certainly something that is ESG) the long term, you shift behavior to items that cause investment in projects that might impact short term metrics but lead to stronger longer term outcomes.

Do reach out to me, if you are interested in chatting more on this.

Disclaimer: These views are my personal views. They are not the views of my employer or any institution I may be affiliated with. They may change with the facts. They may change with experience. They might even change with the phase of the moon. I am not promising anything going up, down or sideways. I'm not even promising the sun will come up tomorrow. I'm certainly not promising these views will be updated. OK. You get the point. It's only my view. You can't rely on this for anything.