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Chapter 2: Literature Review
Stock valuation influenced by social index entry/exit
Stock market prices should reflect the fundamental expected value of the stock, i.e.
the discounted sum of the expected dividends accruing to the owners of shares. When investors are rational and fully informed, expected values are instantaneously revised upon news’ arrivals if the announcement refers to an event affecting one or more factors determining the fundamental value of the stock (expected future cash flows, interest rates, risk premium, stock betas, etc.). In this perspective the impact of events such as entries or exits from Dow Jones Sustainability Index should be predicted based on a theoretical framework which evaluates the impact of the event itself on the different components of the formula of the fundamental value of the stock.
A crucial issue to consider when formulating our hypothesis on the effects of the announcement of an event related to the CSR choice is therefore the investigation of the nexus between corporate social responsibility and corporate performance and, more specifically, in our case, the specific criterion of corporate performance represented by shareholder’s value.
Social impact hypothesis supporting positive effects of CSR
Two prominent conflicting theories academically dominate the topic regarding the financial impacts of CSR. The social impact hypothesis, which is proposed by Preston and O’Bannon, claims positive association between CSR and financial performance (Preston & O’Bannon, 1997). Several reasons could explain this positive effects, such as the public acknowledgement of the firm’s CSR enhances its overall reputation and
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image (Dutton & Dukerich, 1991) and brand image and product competitiveness (C. J.
Fombrun & Gardberg, 2000). The CSR choice may also have positive effects on market value by enhancing workers productivity. The importance of intrinsic
motivations of workers in productivity, and the availability of workers to accept lower wages or even voluntary work when intrinsic motivations are strong, suggests that the latter are partial substitutes for pecuniary transfers. Intrinsic motivations are therefore a channel through which corporate social responsibility, by fostering alignment between corporate goals and workers’ motivations, may reduce costs and increase productivity. On the relationship between workers’ intrinsic motivation and productivity (Frey & Oberholzer-Gee, 1997).
As several scholars have shown, empirical attempts to capture this relationship have produced complicated and inconclusive results as well. Supporters of social impact hypothesis, such as Waddock and Graves (1997) employ reputation ratings developed by Kinder, Lydenberg and Domini (KLD)3
Shift of focus hypothesis viewing the opposite of CSR
as the proxy of CSR and found that past and current KLD ratings are positively related to subsequent firm performance. Ruf et al. (2001) claims that change in CSR is positively associated with growth in sales and returns on sales are positively associated with CSR for three financial periods.
Consider that many of these papers find evidence of a positive effect on economic and not on financial performance (with the exception of Preston & O’Bannon, 1997).
Hence, the corporate CSR choice may be beneficial in terms of net sales or value added per worker, but not necessarily in terms of shareholder’s value.
On the negative side, the shift of focus hypothesis, suggested by Becchetti, Ciciretti
3 Kinder, Lydenberg and Domini Research & Analytics, Inc. (KLD), is a leading research group in providing ratings of corporate social performance to investors.
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and Hasan (2007), argue that most of the CSR activities such as building employee and community relationship, providing environmental protection and improving corporate governance causes a shift of focus from the maximization of stockholders’
value to the interests of a wider set of stakeholders and thereby increasing the firm’s costs. Jensen and Meckling (1976), Bertrand and Mullainathan (2003) argued that managers might prefer to submit to employee demands for higher pay because higher pay fosters a more pleasant working environment for the managers, even though the money comes from the pockets of shareholders, who gain nothing from the pay increase. Barnea and Rubin (2006) suggested that company insiders, such as
managers, are willing to engage in socially responsible actions whose costs exceed the benefits to shareholders because they reap private benefits, such as awards and other expressions of appreciation, from those promoting social responsibility. The excess of costs over benefits is reflected in low returns to shareholders. The empirical support for their argument in evidence is that insiders in companies that rank high on social responsibility hold relatively small portions of their company’s shares and thus bear relatively little of the cost of the accolades they receive for their socially responsible actions. Particularly noteworthy is the lack of public responsiveness to philanthropic behavior as well as the insignificant feedback effect on financial performance (Walley
& Whitehead, 1994). Hence, firms having higher social awareness result in worse financial performance.
The shift of focus hypothesis also receives substantial supports. Newgren et al. (1985) find that those firms with environmental assessment have inferior stock market
returns. Brammer et al. (2005) examine the relationship between stock returns and CSR score, proxied by the composite indicator constructed from environment protection, community relationship and financial transparency. They find that CSR scores on composite indicator are significantly negatively related to stock returns.
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Literature on social index deletion or addition
To date there has been little research that addresses whether inclusion on such indices serves as a credible signal to shareholders regarding a company’s sustainability.
Curran and Moran (2007) test whether inclusion in, or deletion from, the FTSE4Good Index results in a positive (negative) impact on share price. Their results show only minor evidence of any significant effect due to being added to or deleted from the index. This may be explained by the fact that the FTSE4Good Index also uses market capitalization as a screen, and hence changes to the index do not necessarily indicate a change to a company’s social responsibility practices. The other paper closely related to my thesis is Karlsson and Chakarova (2008), whose research uses inclusions and exclusions from nine countries including the US. However, Karlsson and Chakarova (2008) show that both index exclusions and inclusions do not generate significant abnormal returns in the overall sample, even though they observe differences in market reactions when decomposing the sample across different markets.
My thesis takes a different approach comparing to others. First, as a means of overcoming firm heterogeneity a propensity score matching (PSM) pairs design is employed to ensure greater homogeneity between adding-in firms, delete-out firms and S&P500 portfolios. Propensity score matching (PSM) not only resolves the traditional matching method problems as it reduces multi-dimension matching to only one dimension matching (Rosenbaum & Rubin, 1985), but also overcome the
selection bias problem (Rubin & Thomas, 1992). Secondly, by looking into how stock markets respond to these index inclusion (or index exclusion) events it can provide direct answer to the question of whether or not investors care about corporate sustainability.
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Proposed Hypothesis
I build on the literature cited above by testing whether there are significant impacts on the value of American firms associated with the shareholder effects of being added to, or deleted from the Dow Jones Sustainability Index. By considering the above
mentioned theoretical and empirical considerations I expect different, and potentially conflicting, effects of addition and deletion from the DJSI. If the shift of focus
hypothesis holds (and the cost increasing dominate over the cost decreasing effects), I should expect a negative (positive) abnormal return in case of an addition (deletion) announcement. If, on the other hand, the social impact hypothesis holds, then the expected returns of socially responsible stocks should be higher than those of conventional stocks. I also consider the growing volume of financial assets
intermediated by socially responsible funds and I take into account that a relevant part of them follows the passive strategy of tracking a social index, then I would expect the opposite effect of a negative (positive) abnormal return in case of a deletion (addition) announcement.
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