Pendulum swings for SRI

Stock Selection:

LVMH (LVM)
United Technologies Corporation (UTC)
Fiat (FIA)
Yell (YELL)
Pearson (PSON)
Cranswick (CWK)
Whatman (WHM)
RPS Group (RPS)
Latchways (LTC)

"It used to be accepted that we cannot afford to be green. Now the opposite is true: we cannot afford not to be," said environment secretary, David Miliband in a recent speech to the City in Canary Wharf.

Politics notwithstanding, there is something in this. In the early days of ethical investing, a few specialist socially responsible investment (SRI) funds invested in a relatively narrow range of stocks and were prohibited from entire sectors and even countries. Their performance was often poor, not least because they were forced to omit robust sectors such as tobacco and arms manufacturers, and because ethical investment was a career dumping ground for lacklustre managers whose more glamorous brethren took the helm of the large mainstream funds.

Today, ethical investment is no longer a niche.

A much wider range of funds screen on ethical criteria, even if the hue is a lighter shade of green. Often, it is no longer a question of a manager's mandate excluding certain stocks as much as being asked to achieve a return whilst choosing companies that are socially, environmentally and ethically responsible. Many managers use a best of breed approach to select the companies that are most responsible in their field.

In the eyes of the investment industry SRI's credibility is increasing. UK SRI funds exceeded £6 billion at the end of 2006 - four times the level in 2000, and according to Fidelity are expected to double (yes, double) by the end of this year. Yet we still have a way to go to catch the US where 10% of all equity investment is currently managed under SRI guidelines according to the US Social Investment Forum. Many pension schemes have ethical mandates and shareholders of all types are much more aware than they used to be.

Investors checking stocks for their ethical credentials can drive certain stocks up and equally cause others to drop if they are seen to fall short. For example, a share will be lifted if it is accepted into the FTSE4Good index, which reflects the performance of companies that meet responsibility standards, such as reducing their carbon emissions. This works just like entry to any other stock index, because many fund managers are only permitted to buy stocks in the FTSE4Good indices. When in March for instance luxury goods company LVMH (LVM) was expelled for failing to meet supply chain labour standards, the shares dropped from 5700p to 5500p.

The Gospel according to…

 
Even more of a sea change in the City is the belief that companies with excellent corporate social performance are better run, with practices such as environmental awareness and fostering transparent, fruitful and fair relationships with staff and suppliers translating into enhanced profitability. Managements which are on top of SRI issues are more likely to be on top of other commercial issues. This is a gospel that many in the fund management community no longer question.

Enhanced social performance may lead to improved stock returns either directly through productivity improvements, cost reductions or improved sales, or indirectly through an improvement in the company's overall reputation making analysts and stockbrokers more willing to recommend the stock and investors more willing to hold it.

Often regulatory or legislative requirements on business are connected to social responsibility. Customer loyalty also depends on social responsibility as a major contributor to image and reputation.

Research into the link between social responsibility and corporate success is plentiful but not terribly clear-cut. In 2003, the University of Sydney analysed 52 studies produced over 30 years and found a statistically significant association between corporate social performance and financial performance. A 2004 meta-study commissioned by the UK Environment Agency examined 60 research studies over six years and found 85% showed a positive correlation between environmental management and financial performance.

The FTSE4Good Index series has moved fairly closely in line with comparable indices in the six years since its launch, but this is not surprising as there is huge overlap. Some 80% of the FTSE 100 is included in the UK index, for instance.

Deutsche Bank research reports that the top 10% of FTSE 350 companies scoring best on a range of governance and socially responsible criteria outperformed the bottom 10% by more than 7.5% a year - an argument for identifying the best of breed stocks. Best of breed stocks can even include companies you would not expect to see in a roll-call of SRI darlings, such as Heineken, which has strict policies on how its product is advertised and is big on initiatives educating consumers about responsible drinking and the dangers of alcohol abuse.

Eight green companies

Even aerospace and air conditioning manufacturer United Technologies Corporation (UTC) could be a contender with its commitment to cutting its total greenhouse gas emissions by 3% every year until 2010, on top of  a record of reducing its energy use by an average of 2% annually for the past decade.
 
Others might be Fiat (FIA), which makes some of the cleanest cars around, with an average performance of 139gCO2/km, compared with the industry average of 158gCO2/km, or Yell (YELL) the Yellow Pages and classified advertising business, renowned for its strong ethical and recycling policies.

Even publisher Pearson (PSON) appears in some SRI portfolios on the basis of its educational interests.

Other companies that may continue to be buoyed up on the enthusiasm for all things ethical include Cranswick (CWK), which supplies organic foods to brands such as Duchy Originals and Whatman (WHM), one of the best known brands in separations technology, which makes filters for research and quality control in the pharmaceutical, biotech and environmental testing industries.

RPS Group (RPS), an Oxfordshire consultancy that advises on the development of natural resources, land and property, as well as health and safety, has also experienced rapid growth, and has developed a strength in the UK water industry, advising on water shortages and legislation seeking to improve water quality.

Latchways (LTC), founded in 1974, is a market leader in engineered cable-based fall arrest systems and other safety gear, designed to improve worker safety at height.

Companies with genuine social responsibility concerns rather than those who are just seeking accreditation by box-ticking are the ones most likely to outperform. Companies with deep and genuine policies are likely to spell out very specific objectives in their Reports & Accounts, and will have communicated their commitment very clearly to their staff.