Can Socially Responsible Investors Change Bad Companies from Within, or Should They Stay Away?

4 min read

Can Socially Responsible Investors Change Bad Companies from Within, or Should They Stay Away?  planes

There is a bad cliché from doomed romantic storylines where one person in the relationship believes they can change the other - even when the situation is hopeless. While it makes for depressing TV, it might hold the key to a raging debate in the world of ethical investing: Should a socially responsible investor invest in bad companies to try to change them from within, or should they stay away and instead exclusively invest in the good companies?

Proponents of the “invest in bad companies” approach - we can call them activists - claim that they can use the power of their ownership to try and put in place their preferred slate of board of directors and vote their preferred policies. Activists consider their ownership stake to be a way to get a seat at the table and engage with each company’s management team. Through these efforts activists hope to improve the companies’ socially responsible standing. On the other side of the debate, proponents of the “invest only in good companies” approach – we can call them withholders – prefer to leave bad companies in the dust. Withholders prefer to invest only in companies with good social responsibility characteristics. But how can they change bad companies if they don’t invest in them? Withholders’ theory of change is that bad companies will work to improve so that they can earn their investment, or fold if they cannot keep up with the times. Each of these two perspectives has its merits. Being an activist can be a powerful tool to influence a company’s direction. Similarly, withholding capital can be a strong financial incentive for companies to change. However, each approach, if employed on its own, falls short.

Being an activist without withholding investment 

Imagine this ethical investing debate occurring in the 17th century. At issue is a major slave trading company. Withholders prefer to simply stay away, given the tremendous human cost associated with the business. But activists believe that by investing they can shepherd the company’s transition from slave trading to its less objectionable counterpart – HR recruiting. It’s almost laughable, but the implications are quite serious. It seems obvious that there are some companies whose core business model is so rotten there isn’t much that a socially conscious investor can do to change them. Take this argument to its logical conclusion and activists risk trapping themselves in a relationship that they can’t fix – a doomed romance indeed. 

If the company cannot be fixed, activist investors that truly care about social responsibility have but one option: destroy the company. Destroying the company from within might not be such a bad idea, though from a pure financial performance perspective it would likely be disastrous. Imagine a major activist hedge fund with a single goal – end the tobacco industry. They could raise pharaonic sums of money to buy up majority stakes in every tobacco company and then vote their shares to make them stop selling tobacco products – instead they could immediately “transition” the companies to make Moroccan veggie cigars, or sugar-free bubblegum cigarettes. What would happen? First, it would be extremely expensive to buy up these majority shares. Then, those share prices would likely not be supported as these companies undertake essentially gut renovations of their businesses. If done seriously, there could, immediately, be zero tobacco revenue at these firms. Depending on how successful the company was at making the transition, maybe some investor value could creep back. But there is little doubt this would be disastrous for equity holders. I’m not saying I’m necessarily against this – there could be a net gain for humanity if this happened, as people are forced to quit smoking due to widespread tobacco product shortages, reducing smoking-related deaths and illnesses, even as investors lose their money. But I haven’t seen any activist investors out there successfully pursue this strategy yet – perhaps because investors are not yet prepared to take that hit. 

So, unless authentic socially responsible investors are prepared to lose a good chunk of their money, they may want to withhold their investment from bad companies. This gives investors the benefit of keeping their hands relatively clean, while also potentially benefiting from outperformance that may come if society moves in a more socially responsible direction and the bad companies’ rotten business models become untenable.  

Withholding investment without being an activist 

Not that it’s all roses for the withholders. One of the criticisms of a withholding approach is that by divesting from certain companies, withholders lose the ability to vote those companies’ shares and therefore lose their voice in company decisions. If all the withholder does is divest, then companies may indeed discount that withholder’s perspective, as the companies are not legally required to take it into account. Without understanding why the investment is being withheld, companies may not realize how they can improve to potentially earn the withholder’s investment, which diminishes their influence on the company. 

The best of withholding and activism 

What if hybrid activist withholders let bad companies know why they missed inclusion in their portfolio? Companies that want to make their shares more attractive as an investment may indeed listen to the changes withholders recommend, regardless of whether they happen to currently hold any shares at the moment or not. Additionally, activist withholders have the benefit of keeping their hands relatively clean, and can still vote the shares of the good companies to get them to improve further. Thus, activist withholders may benefit from the best of both worlds – they can withhold capital from bad companies while still engaging with them, and also vote the shares of the good companies that they hold to push both kinds of companies to improve, and hopefully make a positive impact on humanity. 

Published on May 19, 2022

About the Author

James Katz, founder and CEO of Humankind Investments, is an experienced quantitative equity analyst and data scientist with a passion for socially responsible investing. He got his start in the ETF industry as a quantitative equity analyst and data scientist at Vanguard, before founding Humankind. He holds a PhD in Business Administration from Stanford University's Graduate School of Business and a BA in Psychology and PPE (Philosophy, Politics and Economics) as well as a BAS in Computer Science from the University of Pennsylvania. James is a CFA charterholder.

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