Don't just buy good companies, sell bad ones

Investors can earn a decent return by buying companies that conform to their values. But they can do even better by selling – or shorting – companies that don't fit their values, research suggests. Is it ethical to short stocks, which drives down their value? For some answers, the Monitor's Laurent Belsie sat down with two Boston-based experts on the subject: Damon Barglow, a portfolio manager at Eastern Investment Advisors, and John DeSantis, founder of Civic Capital Group, a hedge fund. Here are edited excerpts of their conversation:

John DeSantis: You borrow it. You go to a broker, you borrow the stock, and then you sell it with the idea of profiting by having that stock price fall in value and being able to buy it back and return the stock at a lower price to the broker.

Damon Barglow: That really is up to individual investors to ask themselves: Am I comfortable [profiting from the losses of] a company that maybe has lax environmental guidelines or governance rules? For me, the answer's yes. For some investors, the answer might be no.

DeSantis: Look at this whole "Is it ethical?" question more globally.... There's so much attention placed on buying stocks. Wall Street is always out issuing "buy" recommendations. If you spend more time and you have more participants focusing on [short-selling] overpriced stocks, what you're doing in aggregate is increasing the liquidity of the market, which is good. And you're also getting a truer price for each individual security. So in essence the short-sellers are doing a good service for the average investor by preventing excess in speculation.

Barglow: The universe of hedge funds out there that are actually doing this is rather small at this point. So it's difficult to do a long-term study and make a determination of the overall effect. By my count, there are seven or eight hedge funds out there in total, including John's fund.

That said, there's been quite a bit of research done in this area. Two gentlemen – Derwall and Günster – did a study looking at environmental excess return from using a hedging strategy. What they found in a long-short context – where you [go] long the environmentally good companies and short those that are environmentally bad, so to speak – [is that] you generate about 600 basis points of outperformance....

On the governance side also, there was a study that came out of Harvard ... where they looked at good-governance versus bad-governance companies. [The] long-term study again suggested 850 basis points of outperformance.

I've done this as a model portfolio for a year now and have generated a reasonably good return from that as well.

Barglow: Yes. Again, these were academic studies and these were model portfolios that they constructed, so to some extent you have to be careful when looking at those numbers. But they were well-constructed studies and made a very persuasive argument.

Barglow: There was a great study done by a team – Orlitsky, Schmidt, and Rynes.... And it found a modest effect. But again, because of the heterogeneity of factors on the social side, it's a more difficult case to make.

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