In this episode of All Else Equal: Making Better Decisions, a podcast produced by Stanford Graduate School of Business, hosts Jules van Binsbergen and Jonathan Berk explore what strategies are available to social-minded investors who want to do what’s good for business and what’s good for society. But as van Binsbergen and Berk explain, optimizing both is far from a clear-cut decision. The discussion is based on their research paper titled, “The Impact of Impact Investing.”
An edited transcript of the conversation follows.
Jonathan Berk: Today we’re going to do something a little different. We’re going to talk about our own work. We’re going to talk about a research paper that Jules and I recently wrote on social change.
Jules van Binsbergen: And particularly, we want to ask the question, what is the most effective way to accomplish social change, if that is your objective? And we’re going to do that in the context of what’s called impact investing or ESG investing, where E stands for environmental, S stands for social, and G stands for governance.
Berk: Investing for the social good. So a common approach is what we call a divestiture strategy. You decide that the companies you don’t like you’re going to not invest in, and the companies you do like you are going to invest in. For example, the university I work for, Stanford, has a policy of not investing in the coal industry. And the U.S. Conference of Catholic Bishops restricts Catholic organizations from investing in [pharmaceutical] companies like Teva that make money from family planning.
van Binsbergen: And another approach is to do exactly the opposite. The other approach is an engagement strategy as opposed to a divestment strategy. An engagement strategy implies that you intentionally will invest in companies to further the goal by changing policy at existing companies or by investing in companies that further the goal that you have in mind, particularly if you think that otherwise they wouldn’t have received financing.
Berk: And so let’s talk about the ‘All Else Equal’ mistakes in this space.
van Binsbergen: One thing I think that you see in this space is that people really would like to have it both ways. And what we mean with that is what is good for business, is that also good for the social good? And so the question is, if it was so obviously the right thing to do and good for business, why wouldn’t managers already be doing that? So in the end, I think we have two choices, right? Either managers were not optimizing before and, through ESG investing, we are going to fix this mistake. Or the alternative is, well, maybe they were already doing the profit-maximizing, the value-maximizing strategy for the firm as it was and, therefore, if we would engage in ESG strategies, that would mean that we’re giving up something else.
Berk: Now Jules, I think it’s obvious that managers make mistakes. Nobody’s suggesting they don’t. We all make mistakes. But I think it’s equally obvious that it’s hard to believe that investors would have a better idea of how to run a company than the managers who are managing the company themselves. Now obviously, there are cases when we see it. For example, when the company’s underperforming, often you will find a corporate raider who will go in and attempt to buy the company and replace the managers. But usually, those are companies that are not performing well.
If the company is performing well, it’s hard to believe that investors could be smart enough to second-guess the managers. So it seems really implausible for me to believe that what’s really going on is that managers don’t know how to run their companies, and a much more plausible explanation is managers do know how to run their companies, and the value-maximizing strategy is not the same thing as the socially maximizing strategy.
“One of the perhaps surprising results of [our] research is that it is quite difficult to have a large effect on the stock price by divesting.” – Jules van Binsbergen
van Binsbergen: No, exactly. Let’s just be clear. There’s nothing wrong with not maximizing the value of the company per se. It is just that we need to realize that we cannot have it both ways, right? The only interesting case is one where there is a tradeoff, meaning if it was so obvious what the right thing was and it was already good for both the company and the social good, it would already be happening. And so it’s not interesting to talk about those cases. It’s more interesting about the cases where there is a tradeoff.
Berk: Yeah, so you think about a sports team, and you think about when we watch sports, it’s greatly entertaining to second-guess the coach. But realistically, we could not possibly know more than the coach knows. It’s like going back to the agreeing to disagree discussion. The coach has a huge informational advantage over us, and if he’s made the decision to make a substitution, it’s almost certainly the best decision. … Nobody’s suggesting that one of us should take over the coaching job.
van Binsbergen: Indeed. So now let’s go back to the various ways in which we could try to effect social change and particularly tie it back to the work that we have recently done. One way in which people think they could effect change is by divesting from the stocks in a particular company. So what you would say is there’s a company that does something I don’t like and, for that reason, I will not invest my money in it. Now by not investing my money in it, what people are trying to do is to put downward pressure on the stock price so that the stock price of the company is going to be lower than it otherwise would have been, and people hope that, through that strategy, the company will change its investment.
Berk: Well, Jules, I mean, I think we should take a step back here. I think it’s very seldom people enunciate why not investing in the company will actually effect social change. I think the first question is, how would it effect social change? And as you point out, there’s only one way I can think of, right? You know, taking a step back here, if I sell my stock, I have to sell it to somebody. So the total holding of stock has not changed. All that’s changed is who owns the stock. And why would the people that own the stock have any effect on the strategy of the company? In fact, you might think it goes the other way.
If I want social change and I sell my stock, I sell it to somebody else. They’re indifferent to social change, so I’ve reduced the number of owners who care about social change. So the question is, why would my selling my share of stock effect social change? And as you point out, the only logical way we could think that through is if I choose to sell, if the market was [inequitable] before, if supply equals demand, and I suddenly choose to sell, somebody has to buy, and I’m going to induce that person to buy. And the only way to induce him to buy is to lower the price.
van Binsbergen: And so the main thing that we explore in our article is how much do we see an effect on the stock price, and how much do I need to induce the buyer [to] buy? And the lower price is a way to induce them, but how much lower of a price do I need?
Berk: Well, Jules, before we go there, there’s one more thing we need to point out. A lower price still doesn’t necessarily affect how the company operates. There still has to be a connection between the lower price and how the company operates.
van Binsbergen: Yeah, because, for example, if you think about a company like Apple, they have so much cash from profits that they actually don’t have to go to the capital market and tap the capital market to get new capital.
van Binsbergen: And so the only way in which it affects the company is if the company does need to go to the capital markets and actually needs to raise more financing from that capital market. And indeed, if the price is lower, then for the same number of new shares that they issue, they will get less money, which will then have a downward effect on the real investment that they will do.
“To really affect the investment strategy of companies, you would need 85% of investors to divest.” – Jonathan Berk
Berk: Right. They can’t do as much with the investment. And let’s take the opposite of that: When I sell one company and buy the other company, the company I buy, the stock price is higher. And so if that company needs to make an investment and they need to go to the capital markets, they have to sell their shares. And so they are [at an] advantage in the investment space, and the other company is at a disadvantage, meaning the company with the advantage does more investment and grows faster, and the company at the disadvantage does less investment and grows more slowly. And so the good companies expand in the economy, and the bad companies contract on a relative basis.
The end result is the good companies form a bigger share of the economy, and we get more social good. That’s the mechanism [by which] a divestment strategy achieves social good.
van Binsbergen: So now the key question then is, how many effects do we see in the market when people divest their stock? And what are the driving forces for the effect that we’re seeing there? And one of the perhaps surprising results of the research is that it is quite difficult to have a large effect on the stock price by divesting.
Berk: Yes. So given current levels of divestiture in the market today, the levels are so small, the effect on the stock price is so small it can’t possibly have any real effects on investment strategy, and that to give a large enough effect to really affect the investment strategy of companies, you would need 85% of investors to divest. And we are so far away from that high number that we don’t think a divestiture strategy is at all effective in achieving social change.
van Binsbergen: So now let’s try to understand why that is. And maybe the easiest way to understand it is through an example with apples and oranges. So suppose that the two of us both want to consume apples and oranges, and we have the same price for apples and oranges, and we are both consuming apples and oranges in equal amounts. Now suddenly, I decide that I no longer want to consume apples and, therefore, I only want to consume oranges. Now how are we going to make that happen? Well, clearly, my demand for apples is now much lower, so that could potentially put downward pressure on the price for apples.
Now given the fact that I now want to consume more oranges, that could put an upward pressure on oranges.
Berk: So the question is, how big is that pressure? And that is determined by the substitutability of apples and oranges. So if Jules has a sudden desire to consume oranges, I have to decide to consume apples. And the way Jules induces me to consume apples is he offers me a much lower price for apples, and so I will change. Now if I don’t really care about the taste between apples and oranges, I won’t demand much of a price difference. I’m [indifferent].
van Binsbergen: And that difference between consuming the two is what we call the two goods [being] very substitutable.
Berk: Substitutable. And on the other hand, if I care a lot, you’re going to have to pay me a lot of money to change my preferences.
van Binsbergen: Yeah. So for example, if you really want to have in your fruit salad a 50-50 mix between apples and oranges, and now suddenly I’m telling you that you need to consume many more oranges because I’m eating all the apples, then there’s going to be a large price effect. Now what do we find in the data?
Berk: In the data, it turns out stocks are highly substitutable. And it’s obvious why. The obvious investment strategy for anybody who’s saving for retirement or investing in the stock market is to hold a very well-diversified portfolio, a portfolio of stocks that represents the economy as a whole. But the fact is there are lots and lots of stocks that will achieve that goal. So let’s say I wish to have an exposure to the energy sector, and you decide you don’t want to hold British Petroleum. Well, as long as I can hold Shell, I don’t care. I’ll sell British Petroleum. As far as my diversification strategy’s concerned, I just need to hold stocks in the energy sector.
And if you tell me I can’t hold either Shell or British Petroleum, I can hold wind power. And so I don’t really care. And so if you look at the data, what you find is that stocks are highly substitutable. And for that reason, you do not see much of a price change when a section of consumers decides not to hold some stocks. And in order to see a large price change, you have to have an enormous number of consumers so that the remaining consumers who hold them are such a small fraction of the economy that they then demand a big price change.
van Binsbergen: And there is another point there, though, that’s important to make, which is even if we had that very large fraction of consumers being involved in this, what would that really imply? And so one argument that I often have for my students is the following: They say if I could drive the stock price of a company down all the way to zero, wouldn’t I just make the company disappear? But unfortunately, it is still the case that somebody else will buy the stocks of this company. And if they can buy it at a very cheap price, you are giving them a very large gift. So if you drive the stock price of an oil company almost to, say, ten cents per share, that means that the CEO of that company can buy the stream of profits that the oil generates for almost nothing. So it’s a fantastic gift to the person who doesn’t care about the social impact.
“If you look in the data, what you find is that stocks are highly substitutable. And for that reason, you do not see much of a price change when a section of consumers decides not to hold some stocks.” – Jonathan Berk
Berk: Also, the fraction of the people that don’t care [is a factor of] their price because it’s not that I just don’t care at all, for the price I will care. And when the price gets very low so that the returns are enormously high, that attracts people into the space. And so there’s a limit to how much this price can be affected. And so I would say 85% is just too high a number.
van Binsbergen: Indeed. Now the 85% number comes from us applying the standard model in finance, right? But in the paper, we do something else, which is we simply look at the data, and we actually see what happens when stocks get included or excluded from leading ESG-type indices.
Berk: And what do we find? We find that it’s entirely consistent [with] what the theory predicts. When a stock is included or excluded, presumably because the company took different strategies, what you find is the price changes by a very small amount, exactly in line with the theory.
van Binsbergen: Very good. Now that we’ve established that while divestment in principle could have been a solution, it seems to be very difficult to make it work empirically. We can talk a bit about alternatives. So what about corporate managers themselves? What if they just simply care about social impact? How would that work?
Berk: Well, let’s first think about what it means for a corporate manager to engage in strategy for the social good. The first question I think you need to ask is, are the investors onboard? If they’re not on board, then I don’t think there’s a difference between that and any corporate perk. For example, if the corporate manager used corporate funds to give to his own personal charity that he liked. There’s a perk, and I don’t think people think that that is socially responsible behavior on the side of the corporate manager, okay?
van Binsbergen: Yeah, even if the charity’s a very noble cause, we would not really like corporate managers to just start giving money to their favorite charities.
Berk: Right. Of course, the alternative is that the shareholders are on board, right, in which case, if the shareholders are on board, then it’s okay for those corporate managers to effect social change. But I think the question that we need to think about is, what does it mean for the shareholders to be on board? I mean, let’s talk about a very current example. Let’s talk about Elon Musk and Twitter. Elon Musk is — I don’t know what he’s actually doing, but based on the news reports, it appears that he is interested in taking over Twitter because he’s not happy about the fact that Twitter has a particular kind of [censoring] policy on some of his users.
van Binsbergen: So there are two possibilities here: On the one hand, it could be that Elon Musk believes that the managers are currently making a mistake, meaning they’re not maximizing the value of Twitter by censoring and, therefore, by influencing the corporate decision-making, they would increase the value of Twitter. The other alternative is that the managers of Twitter are currently maximizing the firm value by doing some of this censorship, but Elon Musk believes that it’s better to sacrifice some value by removing these censorship policies.
Berk: And I mean, we could all — we could debate this, but it seems to me unlikely that the managers of Twitter are making a mistake and that, to me, it’s more likely that Elon Musk feels he wants to be an impact investor and he’d like to change how Twitter affects the social good in his opinion. And that, I think, makes it clear to us some of the problems of the strategy because let’s say Elon Musk were to take over some of — you don’t even need a majority stake sometimes to take over a company. A very large minority shareholder can dictate policy. What about the other shareholders?
van Binsbergen: The first thing that this makes explicit is that, in this case, there is a clear tradeoff. To achieve the social good, you need to sacrifice some value. And then the question is, is everybody on board and willing to make that sacrifice? And as you pointed out, if he’s a large minority shareholder, how do the other shareholders actually feel about this? Now one thing that’s interesting here, though, which is something we pointed out in the paper, is that to achieve the social change through the divestment strategy, we need 85% of the investors to be on board.
But in this case, when you just need to get a vote through, if the vote was going to be close already anyway, then if you have a couple of percent extra voting power, you could actually push a proposal through as a minority shareholder.
Berk: That’s interesting. You need far less than 85%. In the case of Elon Musk, it’s just one person. Okay, admittedly, a very wealthy person, but compare his wealth to the total wealth of the economy, it’s still minuscule, right? And yet he can achieve enormous social change. I think there’s also something else to consider. Imagine that Elon Musk bought the whole company, okay? So he’s the only shareholder, right? Then what he does is his business. But would he achieve the social change? So for example, let’s take another example. For example, let’s just think about the opiate epidemic and Purdue Pharma.
And let’s just say you were a shareholder of Purdue Pharma and you felt strongly that the work they were doing was immoral. And you took over — and all the shareholders agreed — and you took over Purdue Pharma and said you can no longer produce opiates. Would that solve the problem?
“I really wonder whether we should think more carefully about what are different institutions and corporations particularly for?” – Jules van Binsbergen
van Binsbergen: Well, also the question I would ask is, are there competitors that will produce the opioids in that case anyway? And so as long as there are others that are fulfilling that demand, we’re still not achieving the social change that we had in mind.
Berk: Exactly. So in that sense, in order to achieve that goal, it’s a pretty high standard. Not only does the company itself need to change, but it needs to be an industry where nobody else can do what the company’s doing. And it seems to me that is a reasonably rare case.
van Binsbergen: So that really raises the question of, who is the right institution or the right organization or the right body to address these very complicated issues where we want to achieve a larger social good? Now one group of people that we could think about too outside of the investment space is the consumers. What about the consumer market? What if we could simply organize a consumer boycott for particular products? Would that work?
Berk: And look, there are cases where consumer boycotts work. The problem with consumer boycotts is they vary in difficulty and force. The consumers themselves have to endure some cost for the boycott. So I like your example in this case, Jules, of whale oil. One hundred fifty years ago there was [much] overfishing of whales because we needed the whale oil to light lamps. Now how did the whale fishing end? Was it a consumer boycott or whale oil for lamps? No.
van Binsbergen: No. And it wasn’t a divestment strategy in whale-hunting companies either. In the end, what really solved the problem was a technological breakthrough. And so I really think here you see the power of technological advancement with that of economics. And that is, as soon as a cheaper alternative for the good is being provided, there’s no other coordination or enforcement mechanism necessary. The problem will automatically resolve itself because the consumers themselves will choose the cheaper alternative.
Berk: And perhaps that leads us back to the government. If you really don’t want oil producers, the best way is to find an alternative. And the way you find an alternative is you make the price of oil very high. So if you make the price of oil very high, that will induce people to find alternatives. Consumers don’t want to pay a lot for oil. And the way you do that is you tax oil.
van Binsbergen: Although obviously, if we would do that, there are a lot of short-term frictions that that would induce. I mean, there are large population groups that would suffer tremendously from very high energy prices in the short term. But definitely, as you said, in the long term that would provide an incentive to try to come up with better and cheaper alternatives for energy as the ones that we see now. I think if we wanted to have an example of where a coordinated consumer-government action did achieve what we want it to achieve, I would say it is tobacco, right?
Berk: Absolutely. That’s a very good example. Smoking in America would be at its old levels if the government didn’t get involved, both by education but, more importantly, with taxing and making the price of tobacco high. And the combination of the education in the labels and making the price of tobacco very high made it clear to consumers that they were doing something that wasn’t good for them. But again, you needed the role of government. And I think that effecting social change without a coordinated government role seems very difficult.
van Binsbergen: And so I think one key question that has come to my mind repeatedly in the last couple of years is I really wonder whether we should think more carefully about what are different institutions and corporations particularly for? Not everything can be there for everybody, meaning right now we’re having debates about, what are central banks for? We have debates about, what are pension funds for? What are corporations for? What are governments for? And not all of these institutions can solve all social problems for everybody at the same time.
Berk: And so I think that we need to really rethink the role of a corporation and what the role of the corporation is and, at the same time, rethink what the role of the government is.