Stock Performance Is Affected by a Firm’s Social Responsibility Rating

One argument for favoring socially responsible investments is that they allow investors to do well while doing good. Does this argument hold up?

One argument for favoring socially responsible investments is that they allow investors to do well while doing good. This perception is based on previous studies that have found a link between positive corporate social responsibility (CSR) behavior and reduced financial risk.

A trio of researchers sought to see whether this argument held up when the returns of various stocks are analyzed. Their study focused on the relationship between CSR rating changes and stock prices. The analysis found an inverse relationship between portfolio performance and CSR rating changes.

A strategy of buying stocks that have experienced a CSR rating increase and selling stocks that have experienced a CSR rating decrease underperforms a market benchmark on a risk-adjusted basis. A ‘best-efforts’ strategy of selecting firms that make their best efforts to comply with CSR criteria seems to lower relative portfolio returns. This conclusion is specifically the consequence of the negative relationship between variations in CSR scores and firm risk. Indeed, as in theory, risks and returns are positively related, therefore, an improvement in CSR ratings decreases firm risk and thus stock returns.

Using a sample of 1,621 publicly traded U.S. companies during the period of 1996 to 2011, the researchers found that variations in CSR ratings and diversity scores are significantly inversely related to firm risk. Improvements in CSR ratings imply a reduction in firm risk. The link is most evident among variations in individual strength scores measuring corporate governance strengths, diversity strengths and environmental strengths. The study’s authors noted that these results can be explained by the fact that an increase in CSR efforts and, consequently, an improvement in CSR ratings are likely to decrease the risk of government litigation and reduce the likelihood of an environmental or social crisis that could negatively affect a company’s cash flows.

The study also discovered that the variations in CSR ratings and diversity scores have a positive effect on a company’s price-to-book-value ratio.

Combined, these factors lead to firms with CSR downgrades (and even stable CSR ratings) to realize higher relative risk-adjusted returns. This occurs because investors demand a higher return to invest in companies perceived as being riskier. In addition, because the firms with CSR downgrades have lower valuations, they are more likely to outperform.

Source: “Does It Really Pay to Do Better? Exploring the Financial Effects of Changes in CSR Ratings,” by Mohammed Benlemlih, Jamil Jaballah, Jonathan Peillex; SSRN, April 2020.