How “Sustainable” are Publicly Traded Firms? Dan diBartolomeo Northfield Information Services April 2010

 Review published research on the “sustainable” and more generally SRI related investing practices  Review research studies conducted by Northfield on sustainable investing strategies for our clients  Present an entirely quantitative approach to measuring the expected life of firms based on the contingent claims approach of Merton (1973)  Illustrate the method with an “expected life” analysis for the constituents of the KLD 400 SRI index, as compared to S&P 500 at two moments in time Goals for this Presentation

The Body of Information on Sustainable Investing is Growing Fast  The Moscowitz Prize has been awarded by University of California at Berkeley for best research paper in SRI and Sustainable Investing since 1996  Hundreds of papers have been submitted, mostly academics  Winners posted on the UC Berkeley website  I think I’m the only person to be a judge all 13 years  A Favorite paper: The “Eco-Efficiency Premium Puzzle”, by Guenster, Derwall, Bauer and Koedijk (2004)  Lots of “soft” books have been written  “Sustainable Investing: by Krosinsky and Robbins  But few really quantitative studies by practitioners  “More Gain than Pain: Sustainability Pays Off” by Garz, Volk and Gilles (West LB Panmure, 2002) showing positive risk-adjusted payoffs to sustainability and SRI in general

Northfield Internal Studies  diBartolomeo, Dan and Lloyd Kurtz, “Socially Screened Portfolios: An Attribution Analysis of Relative Performance, Journal of Investing,  Comparison of the KLD 400 SRI index against the S&P 500 with monthly detailed attribution using Northfield models over five years, and updated in 1999 with no differences in outcomes  diBartolomeo, Dan and Lloyd Kurtz, “DSI Catholic Values 400”, Jouirnal of Investing,  Comparison of KLD DSI Catholic Values 400 agains the S&P 500 over ten years  Conclusion in Both Cases  Differences in performance were fully explained by traditional risk model factors. No evidence of a “social factor” returns positive or negative

Conservest Study  Conservest is a small HNW manager in Woodstock, Vermont  Founder Joseph Bragdon wrote “Profit for Life: How Capitalism Excels” on sustainable investing concepts and strategies  Uses an “almost passive” portfolio known as the LAMP 60  In 2007, we did an attribution study of LAMP 60  Outperformance from 2002 to 2006 showed about 250 basis points annually that could not be attributed to conventional factor bets, but not statistically significant  Extended study back to 1997 (subject to selection and survivor bias) and showed about 400 basis points annual outperformance, of which we attribute about 150 basis points to survivorship bias  Updated information through 2007 shows marginal statistical significance

A Quant Approach to Sustainability  Let’s actually estimate how long companies are going to survive using contingent claims analysis  Merton (1974)  Leland and Toft (1996)  KMV   The idea is simple  A corporate bond holder is long a riskless bond and short a put on the assets of the firm  Alternatively, a stockholder has a call option on the assets of the firm with a strike price equal to paying off the firm’s debt  If you know the volatility of the firm’s assets set up your favorite option pricing model and solve for the unknown expiration date  Assume asset volatility is the stock volatility adjusted for leverage

Filling in with “Distance to Run”  For firm’s with no debt, we simply note that default will be coincident with stock price to zero, since a firm with a positive stock price should be able to sell shares to raise cash to pay debt  If you have a stock with 40% a year volatility you need a 2.5 standard deviation event to get a -100 return  Convert to probability under your distributional assumption  We convert both measures to the median of the distribution of future survival in years  What is the number of years such that the probability of firm survival to this point in time is 50/50  Highly skewed distribution so we upper bound at 300 years  Z-score the “median of life” for both measures and map the distance to run Z-scores into the “option method” distribution for firms with no debt

Empirical Results over Time  Estimate “median of life” for all firms in Northfield US equity universe from 1992 to date, updated monthly  Calculate the cross-sectional mean, median each month  Average of the monthly medians, years  Average of the monthly means,  Lowest expectations, January 1992 median 10, average  Highest expectations, January 2005, median 30, average  Current expectations  Median 23, average  AIG 7, Citicorp 6, GS 6, IBM 30, MSFT 32, RD 30/39, XOM 54  Sources of Time series variation  Stock prices, debt levels, Northfield risk forecasts  Mix of large and small firms, 4660 <= N <= 8309

Empirical Results, KLD 400 versus S&P 500  July 31, 1995  DSI 400, Median 17, Average 17.91, Standard Deviation 9.93  S&P 500, Median 14, Average 15.40, Standard Deviation 9.28  Difference in Means is statistically significant at 95% level  March 31, 2010  DSI 400, Median 30, Average 26.39, Standard Deviation  S&P 500, Median 30, Average 24.93, Standard Deviation,  Difference in Means is statistically significant at 90% but not 95%  Ignoring the stocks in common yield very strong statistical significance between the disjoint sets

Conclusions  Published literature provides inconclusive, but mostly positive evidence on the economic benefits of “sustainable” investing strategies  Studies done at Northfield find no evidence of “social factor” returns, but do find some support for sustainable investing as a strategic approach  Contingent claims models are a direct and informative approach to assessing real sustainability  Limited comparison of SRI and convention US stock indices reveals a positive and significant difference in investor perception of expected firm lives, but causality is unclear