Last week, the California Public Employees’ Retirement System, or “Calpers,” said it is considering investing in tobacco stocks again. If it decides to do so, it will be a noteworthy reversal. As the U.S.’ largest pension fund, Calpers’ actions carry weight.
Calpers divested from tobacco in 2000, but not for the social responsibility reasons some investors identify. Instead, Calpers cited financial concerns over the potentially enormous legal settlements then hanging over tobacco companies. At the time, it was a very legitimate worry: A major legal settlement in 1998 had required the four largest U.S. tobacco companies to pay a minimum of $206 billion over the next 25 years, and it wasn’t clear how much more would be coming beyond that.
As it turned out, subsequent litigation hasn’t been that bad, and tobacco stocks have soared -- significantly outperforming other stocks.
The Wall Street Journal reported that between 2005 and 2015, the MSCI World Tobacco index returned more than 309% versus just 72% for the MSCI World Index. According to an outside consultant, shunning tobacco may have cost Calpers up to $3 billion in investment return through the end of 2014.
Even though smoking has declined, tobacco companies have done a fine job pushing through higher prices, generating earnings, and paying out steady dividends. In fact, tobacco stocks have outperformed far longer than the decade and a half since Calpers divested. The London Business School found that tobacco has massively outperformed the broader market for the entire 20th century.
Other so-called “sin” stocks, like alcohol and gambling, also have outperformed, and the reason is fairly simple: When certain investors shun sin stocks out of ethical concern, they only make them cheaper for other investors all too willing to scoop them up at lower prices. Thus did Drew Faust, president of Harvard, justify that university’s recent decision not to divest from fossil fuels in this way: “If we and others were to sell our shares, those shares would no doubt find other willing buyers. And such a strategy would diminish the influence or voice we might have with this industry. ”
Limiting one’s investment universe in any way is likely to be a negative constraint over time. As a result, it has been difficult for socially responsible funds that exclude certain categories of “objectionable” stocks to perform well.
Still, that does not mean it’s hopeless for those who value environmental, social and governance or “ESG” sustainability. That is because there is growing evidence that screening positively for the companies with the very best ESG policies – rather than negatively screening out objectionable companies -- can lead to investment outperformance.
A study by Robert Eccles, Ioannis Ioannou, and George Serafeim of the Harvard and London Business Schools found that “high sustainability” companies yielded higher returns on equity and assets than the broader market over time.
These “high sustainability” companies shared certain characteristics in board structure, compensation policy, and a commitment to multiple stakeholders – including employees and the broader community. Beyond that, they all had a long-term orientation that made them willing to make short-term sacrifices for longer term benefit. That mindset created sustainable competitive advantage – or in other words, long-term orientation was very often a marker of investment quality.