How Markets Learn to Value the Financial Performance of Socially Responsible Firms

Market reactions to a company’s performance on environmental and other social issues are ambiguous, because it is difficult to measure social and financial performance and how they affect each other. We, however, create a virtual value-weighted portfolio based on the list of “100 Best CSR companies in the world” published by Reputation Institute and show that investing in this portfolio could provide investors annual abnormal returns of between 1.98 percent and 2.74 percent.

Corporate social responsibility (CSR) facilitates the integration of business operations with values so that the interests of all stakeholders—including customers, suppliers, employees, communities, governments, society, and the environment—are reflected in the company’s policies and actions. Some argue that CSR is costly to shareholders, especially when their interests conflict with those of other stakeholders. In addition, CSR may be misused to provide additional job security to inefficient managers by pleasing stakeholders, compensating for the negative consequences of earnings management, and enhancing the individual reputations of managers. From this point of view, the stock market should respond negatively to superior CSR performance. However, more and more people believe that CSR increases firm value by raising customer awareness, improving transparency, and reducing risk. For example, CSR can reduce firm risk by generating “moral capital” that protects a firm’s relation-based intangible assets, such as customer loyalty. This may contribute to superior financial performance during periods of stress, suggesting that the market should respond positively to superior corporate social performance.

To test the value of social performance, we used the Reputation Institute’s “100 Most Socially Reputable Companies,” which was first published in 2013 on the website of Forbes magazine. The Reputation Institute studies over 7,000 public and private companies in 20 industries and 55 countries. The stocks of most of the companies are traded on U.S markets. A reputation measure is based on seven dimensions, including products and services, innovation, workplace, governance, citizenship, leadership, and performance. Greater performance in the seven dimensions implies that a firm pays more attention to its social performance when it makes decisions about purchasing, recommending, accepting, defending, working, and investing. Based on these measures, the Reputation Institute lists the 100 global firms with the highest CSR scores annually. A total of 137 private and public firms have been listed over the past five years, and 75 are publicly traded: 46 of the 75 are traded in United States, 12 on the Tokyo Stock Exchange, six on Euronext Paris, and four on the London Stock Exchange. Due to availability of trading data, we focus on the 40 public companies that are actively traded on NYSE or Nasdaq and appear on the CSR list each year from 2013 through 2017.

Our study highlights the benefits of CSR by providing evidence that the value-weighted CSR portfolio of 40 companies with the best CSR performance earns from 1.98 percent to 2.47 percent annual abnormal returns (applying Fama French five factor model and Carhart four factor model, respectively) in the sample period from November 2007 to October 2017. To explain the superior return, we find that  companies with strong social performance are more likely to have positive earnings surprises.

Our study also finds that the abnormal returns of these CSR firms were highest before Forbes first published the list in 2013, and then decreased after 2013, implying that the abnormal returns fell gradually as the market learned more about the importance of firms’ social performance. Today, investing in the companies on the list provides no financial advantage.

The simple explanation for the disappearing abnormal returns is that the CSR firms were undervalued but are now fairly valued. In addition, more CSR-related information is now disclosed, either by firms themselves or by institutions like analysts, regulators, rating agencies, and the media, and markets process the information more efficiently. Though the financial advantages of investing in socially responsible companies may have largely vanished, the benefits to society—and of doing the right thing—remain.

This post comes to us from professors Zhichuan Frank Li and Jun Wang at the University of Western Ontario and Chong Yu, a graduate student at the university. It is based on their recent paper, “A Learning Curve of the Market: Financial Performance of Socially Responsible Firms,” available here.