One of the most asked questions in business today is whether there is a link between a company’s social responsibility and its profitability. Ioannis Ioannou’s research sheds new light on the subject.
In recent years, the issues of ethics and morality in business have received a great deal of attention. This has often been of a negative sort — from Enron to Lehman Brothers and beyond. I have always been interested in the positive aspects of the intersection between the business world and society. Today, many companies are pursuing environmental and social initiatives, often popularly called sustainability initiatives. My colleague, George Serafeim of Harvard Business School, and I wondered if any or all such initiatives have a direct impact on the financial performance of firms. In other words, do such corporate social responsibility (CSR) initiatives create real economic value?
It has been difficult, in the past, to find any empirical evidence of a causal relationship. We thought that, if there is a link between CSR and profitability, we should be able to trace it by examining the way information is transferred to the capital markets. We thought of the influence that sell-side analysts’ recommendations and long-term growth forecasts have on expectations of value creation at the firm level.
Evidence suggests that they are an important information intermediary, and there’s a vast literature examining their role and impact on capital markets — stock prices and trading volumes in particular. They essentially reflect equity holders’ expectations about the future of the company.
We obtained data from KLD, the major company producing CSR ratings and rankings in the US, and then took a step back to better understand analysts and the potential reaction they could have to such ratings. Work in finance, for example, shows that analysts, on average, tend to have accurate forecasts. However, work from economic sociology found that when companies deviate from what they’ve traditionally done in their choice of strategy, in such a way that they seem to be moving away from their traditional industry categorisation, analysts tend to drop coverage and appear to have a lag in amending their evaluation models to reflect these changing firm behaviours. In the short run, this is reflected in relatively negative stock recommendations.
Thinking more positively
So, often there is some delay before analysts recognise that a change in a company’s strategy might be a beneficial move. If a company is improving safety standards or moving into a different industry, for example, it is likely to take analysts a while to understand and incorporate such actions in their valuation models and therefore reflect the potential long-term benefits for the firm and the perceived level of value creation in their recommendations.
In our research, we found that until 1997/1998, if a company engaged in CSR initiatives, analysts tended to penalise it with more negative (‘sell’ or ‘strong sell’) recommendations. After 1998, we find that the trend reverses and becomes positive: it seems that analysts began to understand and think more positively about the implementation of CSR strategies. In order to understand why that was the case, we searched for articles that mentioned the phrase ‘corporate social responsibility’ in the Factiva database, from 1990 to 2001 or later. If you graph the number of mentions over the years, you can see that during the 1990s they are flat; then, around 1998 and 1999, there is the beginning of exponential growth in CSR mentions in the popular press. This told us that a process of external legitimatisation of these strategies could be taking place, as well as some learning at the analyst level about what impact CSR strategies actually have on a firm’s real value creation potential. According to our econometric analysis, this happened around the same time that the analysts’ attitudes towards CSR seem to have changed.
All of this matters for leaders of companies committed to CSR. It is clear that firms must work closely with the investor community to enhance the interface between the firm, analysts and investors — letting them know exactly what they’re trying to achieve through their CSR strategy. In this way, analysts are fully informed and understand where the firm is headed strategically. In other words, managers are well advised to educate and inform analysts about what the target is and why CSR stakeholder value maximisation is beneficial for the firm in the long run. And managers should definitely not hide their dedication to CSR. We found that the positive link between CSR and recommendations is stronger for more visible firms, suggesting that the CSR benefits are perceived as being greater for more visible firms.
We also looked at analysts themselves. We examined the number of years an analyst has been following a specific firm, the idea being that if someone follows a firm for many years and reads all their reports, he or she is more likely to be able to understand the strategic implications of CSR. The other measure we noted was the size of the analyst’s employer — larger brokerage houses may provide analysts with superior research resources or administrative support and are thus better positioned to understand CSR initiatives. Another thing we looked at was the broader exposure the analyst had to CSR initiatives. We constructed a composite measure of what we call ‘CSR awareness’ based on the total number of firms the analyst was following and how CSR-strong they were. We found that analysts with a higher ability to understand CSR were more likely to positively incorporate CSR strategies in their recommendations.
To sum up, managers should particularly focus on communicating the value of CSR strategies to the investment community. Highlighting not only short-term costs but also long-term benefits could mitigate difficulties that investors may face in understanding the value generated through such activities and might expedite the adjustment of their valuation models to these new CSR-augmented business models. In other words, managers should be aware that not only what is communicated matters but also to whom it is communicated.
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