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Negative screening no silver bullet for sin stocks

If negative screening worked, stocks in the sin bin should have lower firm valuations, higher future stock returns, and delist more often. They don’t.

While engagement is usually the weapon of choice for institutional investors when it comes to companies in controversial industries like fossil fuels, negative screening still has its fans. The only problem is that it doesn’t seem to work – or that evidence that it does work depends on research design, according to a paper by Robert Eccles (photo at top), Shiva Rajgopal, and Jing Xie.

“The oft-repeated assertion that negative screening hurts sin stocks does not appear to be held in the data when differences between firm fundamentals of sin stocks and non-sin stocks are held constant,” the paper says.

What the researchers call “sin stocks” are those of companies involved in industries like alcohol, tobacco, firearms, gaming, and fossil fuels like coal and gas or oil. If exclusion were to hurt excluded industries, the researchers say they should have observed lower firm valuations (Tobin’s Q in the research, or “the ratio between a physical asset’s market value and its replacement value”) , but that they’re similar to the rest of the market after controlling for firm characteristics.

“The result is a bit nuanced in that sin stocks are associated with lower valuations relative to non-sin stocks in the recent decade since 2010 in an unmatched sample,” the paper says. “However, in the matched sample, sin stocks have significantly higher Tobin’s Q than that of control firms. This enhanced valuation was driven by gas and oil firms, and it exists in both the recent and the earlier decades.”

“Relatively exogenous shocks related to divestment (i.e., when a firm switches from a non-excluded industry to an excluded industry) and the addition of stocks to a “good” ESG index confirm the finding of no apparent impact of negative screening the Tobin’s Q of excluded industries.”

If exclusion were to hurt industries – and keeping firm characteristics constant – the researchers say they should observe a lower current stock price leading to higher future stock returns. But sin stocks don’t earn abnormal monthly returns. They should also delist from the public markets more often owing to their poor performance, but actually have a similar probability of exiting the public market to their more virtuous peers.

“If exclusions were to hurt excluded industries, keeping firm characteristics constant, we should observe negative stock returns for sin stocks when news that damages investors’ perceptions of ESG performance are released for sin stocks relative to others,” the paper says. “Announcement stock returns around the release of socially irresponsible news data from RepRisk for sin stocks are not significantly different from that for other stocks.”

“A potential explanation for our findings is that sin stocks attract demand for their shares from a subset of investors who do not implement negative screening. When the demand for sin stocks is large enough, their stock prices and stock returns, holding firm characteristics constant, are not different from that of non-sin stocks.”

However, the cost of new debt is higher for sin stocks – and they tend to suffer through more ESG proposals from the investors that do hold them, indicating that investors are either actively trying to improve ESG profiles of sin stocks or alternatively “indulging in virtue-signalling of their own.”

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