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:

How can you short – or sell – a stock you don't own yet?

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.

That drives down the price of a stock. Is that ethical?

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.

What kind of results do you get when you combine buying good companies and selling bad ones?

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.

You mean these long-short portfolios generate an extra 6 to 8.5 percent return over average market gains?

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.

Does the strategy work in other areas, such as companies with good and bad labor relations or high and low charitable giving?

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.

What's your experience, John?

DeSantis: We look at a lot of factors. But I think the intellectually interesting thing ... is that a long-short equity hedge fund offers the opportunity to focus right in on that ethical component. In a long-only portfolio, a majority of the return is a function of whether the stock market is going up or it's going down. And there's a very small piece of that return that's driven by these factors that we've talked about.... If you do [long-short investing] in the real world, then what you've done is isolate the return. The returns of your portfolio are more driven by this ethical component. So I'd argue it's a much higher-octane approach to socially responsible investing.

Where has it worked, and where hasn't it worked?

DeSantis: I think it works best by paying attention to what's happening in society. And one very big trend is the issue of obesity. On the long side, this gets a lot of investment play by people investing in companies that produce natural and organic foods – a Whole Foods or a SunOpta, which provides a lot of healthy ingredients to food companies. And yet, on the short side, there [are] all sorts of other opportunities. You can short sugary, sweet, trans-fatty fattening products.

Like what?

DeSantis: We've shorted companies such as Tootsie Roll.

Tootsie Roll? An American icon?

DeSantis: It was painful. I like Tootsie Roll as well. But intellectually, a few years ago, we made the assumption that the square footage in selling space was going to expand in the areas of natural and organic foods and that it was going to contract in the checkout aisles for the sugary things.

Did the antisugar strategy work?

DeSantis: It was enormously successful.

Is it harder to short stocks when markets are rising?

Barglow: It is. For instance, in this model portfolio that I'm running, there was a short stock that I purchased that was a wholesaler of used cars. This was a poorly run company, and it met my screens for a short candidate. I shorted it and then, a month later, a group of private equity buyers came in and said: We can run this well. They bought it and the stock moved higher. So in this particular environment, when the markets have been moving higher, it does make shorting a much more challenging process.

Is this strategy something that ordinary investors should try on their own?

Barglow: Unless you're someone who spends a lot of time looking at your portfolio – you are willing to look at your portfolio on a daily basis [and] have some familiarity with options as well – then I'd say no. You should leave it to a professional investor.

DeSantis: I would underline that and say: No. Let me give you one example. If you go long a stock and suppose you go out and buy a $10 stock, and you're wrong, the most you can lose is $10 because it goes to zero. That same $10 stock, if you shorted it, and the stock goes up, your losses can get pretty high. It goes up, [and] you've lost $10 or $30 or $100. So it's a risky game in isolation. Professionals know how to do it in a portfolio sense.

Watch the entire conversation at: www.csmonitor.com/ethicalinvesting .

For further information:

Derwall, Günster study: "The Eco-Efficiency Premium Puzzle" – hdl.handle.net/1765/1296

Orlitsky, Schmidt, and Rynes study: "Corporate Social and Financial Performance" – www.socialinvest.org/areas/research/Moskowitz/2004MoskowitSummary.pdf

Damon Barglow's socially responsible investing website – www.esgalpha.com

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