Rogue Missives Friday, July 11, 1997

American attitudes toward smoking have changed dramatically in the last thirty years. That shift has thrown into sharp relief many of the more complicated questions raised by an economic system in which the general presumption is that companies should be allowed to make whatever products they want and that consumers should be able to buy whatever products they want. It has also, not coincidentally, raised a series of questions for investors interested in excellent returns but concerned about the social consequences of their decisions.

Nowhere has this been more clear than in the deliberations that state pension funds have engaged in over the problem of whether or not to remain invested in tobacco stocks. Tobacco companies -- most notably PHILIP MORRIS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MO)") else Response.Write("(NYSE: MO)") end if %>, but also R.J. REYNOLDS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RN)") else Response.Write("(NYSE: RN)") end if %> and BRITISH-AMERICAN TOBACCO -- have enjoyed solid returns over the last decade, with Philip Morris in particular being a stalwart performer. In fact, were investors not concerned about the possible consequences of litigation, all of these stocks would enjoy considerably higher valuations. Given their increased presence abroad and their commanding presence in the U.S., it's hard to see how tobacco companies can avoid enjoying solid earnings growth for the foreseeable future.

All of which suggests that any reasonably diversified pension fund should probably have some of its money in tobacco stocks. Yet, over the last few months, there's been a growing movement among state governors and pension-fund trustees to have these funds divest themselves of all tobacco holdings. In late May, Florida announced that it would be selling $825 million of tobacco stock from its retirement plan, making it the third state -- after Maryland and New Hampshire -- to divest. Two weeks later, Massachusetts Treasurer John Malone, manager of the state's $18 billion pension fund, said that he wanted the fund to dump all tobacco stocks, and petitioned the state legislature to change the law in order to allow him to do so. Because Massachusetts law instructs managers to consider only the financial interests of the workers contributing to the fund in making investment decisions, Malone felt that only an amendment to that law would allow divestiture to go forward.

Around the same time, the Pennsylvania Public School Employees' Retirement System (PSERS) announced that it would not be adding any tobacco stocks to its current $264 million holdings. State Treasurer Barbara Hafer, who had pushed for the decision, called it a "good first step" toward getting rid of all tobacco shares. In June, the trustees of the Vermont State Teachers' Retirement System voted 4-2 to divest and is now selling off its $10 million in tobacco stock. The Vermont vote was particularly striking, coming as it did after the board had been deadlocked 3-3 before one of the no votes asked for a reconsideration and then voted for divestiture.

What's interesting about all of these decisions is that they seem to represent a return to what is typically called "social investing." The archetypical example of social investing was the divestment campaign of the 1980s that pushed universities and pension funds to sell their holdings in companies that did business in South Africa. Other examples include funds selling stock in companies that made loans to Pinochet's Chile or sold weapons to repressive regimes. In their book on investor activism, Power and Accountability, Robert Monks and Nell Minow describe social investing in this way: "Making investment decisions, and other decisions relating to the exercise of stock ownership rights, on grounds that are unrelated to or in addition to the traditional investment concerns of minimizing risk and maximizing return."

Monks and Minow see social investing as representing a clash in philosophies. "We want to guarantee workers a retirement income," they write, "and to do that the laws speak the language of trust law. But employees want to retire into a world free from pollution and injustice. And why should their money be used to support something they oppose?"

The last sentence in that paragraph speaks to the need for people invested in a pension fund to ensure that their trustees are carrying out their wishes, which is to say it speaks to the need for the same kind of democracy within a pension fund as institutional and individual investors should push for within a corporation. But Monks' and Minow's broader point speaks to the sense that trustees have a hard time fulfilling their so-called "fiduciary responsibility" if they take extra-fiscal considerations into account. Although public pension funds are not bound by the terms of ERISA, the 1974 law that set up guidelines for managing private pension funds, many still follow its key rules. One of those obliges managers to invest "solely in the interest of beneficiaries." That has inspired what many public funds call the "prudent-investor" rule, which militates against social investing.

It was this perspective to which Massachusetts Treasurer Malone was responding when he insisted that only a change in the law would allow him to vote for divestment. Since the state law, clearly modeled on ERISA, requires trustees to seek the highest return, Malone feels obliged to remain invested in tobacco until he's allowed to do differently. Similarly, in Vermont, the advocates of divestment portrayed their decision as a response to the desire of their constituents not to be invested in companies selling carcinogenic products rather than simply a fiscal decision. State Treasurer James Douglas, for example, told Dow Jones, "I think investing public funds in tobacco copmanies is contrary to the values of most Vermonters and is clearly contradictory to the message that the state is sending in other forums."

On the other hand, supporters of divestment have often cited the greater-than-usual volatility of tobacco stocks, their susceptibility to investor overreaction to litigation, and their uncertain future as financial justification for dumping tobacco stocks. Even in light of the potential $368 billion tobacco settlement, they say, it's not clear that tobacco companies are really secure investments. Pennsylvania's Hafer said: ""I welcome PSERS's decision to not increase its exposure in these volatile stocks. As Congress and the American public debate the merits of the proposed settlement, tobacco stocks will continue to be vulnerable to sudden declines." Echoing this sentiment, Florida's treasurer Bill Nelson argued that it wasn't prudent to invest in an industry with as many potential liabilities as tobacco has.

It's possible, of course, that trustees who offer financial rationales for their decisions to sell tobacco stocks are merely attempting to provide themselves with cover for choices motivated purely by social considerations. That, certainly, is what Philip Morris and other opponents of divestment have suggested. But it would be a mistake to skip too lightly over the possibility that the concept of "fiduciary responsibility," if taken seriously, could justify the selling of stocks ranging from Philip Morris to UNOCAL <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: UCL)") else Response.Write("(NYSE: UCL)") end if %> to NIKE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:NKE)") else Response.Write("(NYSE:NKE)") end if %>.

The basic problem in thinking about fiduciary responsibility, as it is the basic problem in thinking about investing in general, is determining what time frame one should use in evaluating a decision. With regard to tobacco, for instance, in the short term -- volatility notwithstanding -- tobacco is probably a solid investment. In the long term, though, it's not clear what will happen if the Food and Drug Administration is allowed to regulate nicotine as a drug, or what the impact of marketing cuts will be, or how many smokers will quit when the price of a pack is raised by forty or fifty cents. These are all questions without an obvious answer, and a plausible case can be made that if you're investing for the long haul, there is a real downside to tobacco stocks.

A more interesting example of the complexities of fiduciary responsibility would be Nike, which has built its empire by manufacturing its shoes in Asian factories while paying its workers just dollars a day. This strategy has certainly been instrumental in allowing Nike to enjoy high profit margins and impressive earnings growth. Over the last year, though, as the American press has begun to pay more attention to the impact of globalization and the reliance of many U.S. corporations on sweatshop labor, Nike has come under considerable fire for its labor practices. 60 Minutes devoted an entire segment to abuses at Nike's Vietnam plants, any number of Op-Ed pieces lambasted the company, and an International Day of Protest is now planned for mid-October.

Given this context, it seems possible that Nike's earnings, and Nike's share price, will suffer in the long run if the company does not adjust its labor practices to conform to consumer expectations. Fiscal health, in that sense, may depend on social health. Of course, consumers have -- as yet -- shown no real interest in translating their concern about Nike's practices abroad into a boycott at home. But it's not a possibility that can be easily dismissed.

In a way, one of the things that has limited social investing is that corporations have, for the most part, been able to avoid paying for their more questionable actions. When the African National Congress was democratically brought to power in South Africa, it would have been perfectly justified in expelling or refusing to do business with those companies that had continued to do business with the apartheid regime. But the ANC took no such measures. Similarly, when the dictator Augusto Pinochet finally stepped down in Chile, his democratic successors would have done well to single out those companies that had provided Pinochet with financial support and refuse to give them access to Chilean markets. Here again, though, Chile's hunger for foreign capital weighed against any such sanctions.

Still, as the number of companies with global reach increases, one wonders how long corporations that violate internationally accepted standards of behavior will be able to prosper. If a democratic revolution is able to topple the dictatorial SLORC in Burma, for example, it would be very surprising if the new regime continued to work with Unocal, which has been singular in its support for the SLORC's repressive practices. And that means that investing in Unocal may be a somewhat dicey proposition.

For all this, though, it's almost certainly true that the best strategy for investors seeking to change a company's policies -- rather than simply refusing to associate themselves with them -- is to assert themselves as owners and look to change the company from within. This is obviously more difficult with Philip Morris than with Nike, since it's hard to see how successful Philip Morris could be if it sold no tobacco at all. But in most cases, the social goals of divestment are more likely to be realized by investor activism. A more nuanced and expansive definition of fiduciary responsibility can be used to justify proxy resolutions on labor practices and CEO pay, just as it can be used to justify the selling of stock. As Monks and Minow put it, "Shareholder resolutions calling for specific action can be more effective -- and more cost-effective -- than divestment." In a world in which almost everything can return to haunt you, there's very little that the prudent investor can afford to ignore.

-- Jim Surowiecki (Surowiecki)

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