Social Screening: Still Controversial; Still Misunderstood

         Social screening remains controversial 35 years after Pax launched the first SRI mutual fund and generations after Quakers and evangelicals began the practice. “How can sophisticated financial professionals not get it? It’s obvious, intuitive,” I’ve heard social investors say.

         Well, it’s neither obvious nor intuitive to a broad segment of our industry. I’ve had two conversations just today that reinforced that point.

         When I get this kind of feedback, my instinct is to return to the basics, then try to explain the concept better. This month’s column is a stab at an explanation SRI advocates could use.

The Screening Process

         “Screening” is the application of a criterion to differentiate companies in the investment process. As a verb, “screen” means to select securities based on a pre-determined set of factors. As a noun, “screen” refers to a criterion used to winnow a universe of investable securities.

          All investors apply screens to their investments. They are many and varied, and they can relate to the stock’s price-earnings ratio or to the issuer’s line of business. A social screen is a non-financial criterion that relates to business activities or products.

        Objectives. Screening divides an investable universe between those companies suitable for the investor and those that are not – whether for social or financial reasons or a combination of the two.

         The social screening process does not yield a list of “socially responsible” or “sustainable” companies nor, conversely, a list of “socially irresponsible” or “unsustainable” companies. No set of investment screens, however comprehensive, can identify “socially responsible companies”, if such exist.¹

         What social screens can do, are designed to do, is to identify characteristics and behaviors the investor finds useful, relevant, tolerable. Screening is not about companies. It is about investors and the values they want their portfolios to meet.

         Alignment. Values-based investors began applying social screens to stocks in the early 20th century. They sought consistency, alignment of their holdings with their values.²

         Screening is simple. As that pool hall philosopher, Rudolf “Minnesota Fats” Wonderone, replied when asked why he – unlike most pool pros – neither smoked nor drank, “I learned everything I know not from intelligent people, but from imbeciles. It’s automatic. You don’t do what they do.”³ And in the view of values-based investors, it is immoral to profit from imbeciles doing it.

         Using what are now termed “exclusionary screens”, the earliest investors to apply screens barred classes of businesses based on the nature of the goods or services they offered. Because they believed drinking and smoking to be sinful, like Minnesota Fats, they eliminated alcohol and tobacco companies from their portfolios.

         For years many critics have mocked social investors for this “negativity” with a kind of “real investors own tobacco stocks” attitude. But none has explained why, if sound investors avoid investments in companies whose businesses they do not understand, social investors should invest in businesses they do understand all too well.

        Screening’s Evolution. Over the past 35 years, screening’s potential subjects have grown far beyond simple product exclusions. Still, for values-based investors, consistency remains the key objective.

        Today social investors also screen stocks on qualitative social criteria such as employee relations and corporate governance. These screens usually require nuanced appraisals of corporate behavior.

        Whether a company has a “good employment record” seldom yields a quick answer, much less a yes or no. Reaching an answer for a large, complex company, such as DuPont, can take hours of analysis. In contrast, whether a company is in the gambling industry always produces a yes or a no, sometimes in a matter of seconds.

SRI Research & Corporate Culture

        All screens rely on research for implementation. SRI investors use – to varying degrees – non-financial research of a type that has come to be called “social research”: information about how corporations perform on issues social investors consider in the investment decision-making process.⁴

        As values-based investors use it, social investment research, in its analysis of the past performance of a corporation against the screening standards, can hint at how the company will perform in similar situations in the future.

         This approach is neither new nor novel nor unique to SRI. In 1933, for instance, Parker Follett wrote:

         The Nature of Corporate Culture. A corporation’s history is formed by a mosaic of management decisions in which one can discern patterns revealing its culture.

         Marvin Bower, McKinsey & Company’s long-time managing director, described corporate culture as “the way we do things around here.” Two McKinsey alumni who did much to popularize the concept described “a robust culture” as:

         Because its purpose is to support screening judgments, SRI research does not typically evaluate corporate culture. But the decisions it reports and rates are critical pieces of the mosaic.

         The importance of corporate culture in assessing a company’s prospects – social and financial – is not to be underestimated. As an Australian human resources consultant commented in 2004, “We are on the cusp of companies recognizing that all of their failures are failures of culture, not of systems. Companies are beginning to reward the behaviour that produces good results, rather than the results themselves.”⁸

         In their investment decision-making, SRI investors emphasize corporate culture far more than other investors. It is also an essential element in shareholder activism amongst all types of investors. For “corporate culture” is to the company what “character” is to the individual.

         So, screening is about character: primarily the investor’s, which is reflected in the criteria applied to investments, but also a company’s, which reveals itself in the actions its managers have taken over the years.

Endnotes

         The author would like to acknowledge the vital assistance of Conor Savoy in the writing and editing of this piece and the helpful reviews of Elizabeth Edgerly and Elizabeth Umlas. Of course, the responsibility for any errors or omissions in this article and for the opinions it sets forth are the author’s alone.

¹ Adam Smith was probably the first to argue that corporations by their nature cannot be “responsible”. He based his argument primarily on the corporation’s limited liability and secondarily on the dynamics of boards and management. Adam Smith, The Wealth of Nations [1789] [ Glasgow ed.] (Indianapolis, Ind.: Liberty Press, 1981), p. 741 [V.i.e.18]. Later insulating devices, such as the “business judgment rule”, have further removed responsibility from the corporation. The identification of the corporation’s purposes solely with its shareholders’ financial interests by Milton Friedman and others makes arguing for the existence of “socially responsible corporations” very difficult. See Milton Friedman, “A Friedman Doctrine – The Social Responsibility of Business is to Increase its Profits”, New York Times Magazine, September 13, 1970, p. 126

² For a more detailed discussion of screening’s history, see Peter D. Kinder “Values and Money: A Research Practitioner’s Perspective on Values for Money”, pp. 4-7. http://www.kld.com/resources/papers/values_and_money.pdf.

³ “Ask the Globe”, Boston Globe, Oct. 2, 1991, p. 36.

⁴ For an extensive discussion of the differences between values-based and value-seeking applications, see generally “Values and Money”, op. cit. The definition of “social research” here is drawn from it. The next section deals with the research modifications value-seeking investors have brought about.

⁵ John Micklethwait & Adrian Wooldridge, The Company: The Short History of a Revolutionary Idea (London: Weidenfeld & Nicolson, 2003), p. 109.

⁶ Terrence E. Deal & Allan A. Kennedy, Corporate Cultures [1982] (Cambridge, Mass.: Perseus Books, 2000), p. 4.

⁷ Terrence Deal & Allan Kennedy, The New Corporate Cultures [1999] (London: TEXERE, 2000), p. 3.

⁸ Alan Kohler, "Get a Conscience – Mindless Capitalism Fails The Test" Sydney Morning Herald (AU), August 3, 2004.