Does Social Performance Really Lead to Financial Performance Accounting for Endogeneity - Book Report/Review Example

 Endogeneity and the SP–FP Relationship Does Social Performance Really Lead to Financial Performance? Accounting for Endogeneity Roberto Garcia-Castro, Miguel A. Arin˜o & Miguel A. Canela Article review Table 1: Key terms and abbreviations and formulae used in this article SP Social performance FP Financial performance KLD Kinder, Lydenberg, Domini WG Waddock and Graves BWKJ Berman et al. GW Graves and Waddock WS McWilliams and Siegel HK Hillman and Keim GAC Garcia-Castro et al. OLS Ordinary least squares, a method used in regression analysis for estimating linear models MVA Market Value Added. MVA was calculated as: Market value – Capital Where market value is the firm’s market value or market capitalization and capital is the book value of equity and debt invested in the firm. ROE Return on equity. ROE is calculated as net income over total equity. ROA Return on assets. ROA is calculated as operating income over total assets. Tobin’s Q Tobin's q =  For Tobin’s Q, the authors used the proxy of market-to-book value ratio. Previous studies have used the market-to-book value as approximations to Tobin’s Q. ROS Return on Sales Beta The beta (β) of a stock or portfolio is a number describing the relation of its returns with that of the financial market as a whole. An asset with a beta of 0 means that its price is not at all correlated with the market. A positive beta means that the asset generally follows the market. A negative beta shows that the asset inversely follows the market; the asset generally decreases in value if the market goes up and vice versa.[2] TRS A Total Return Swap (TRS) is a bilateral financial transaction where the counterparties swap the total return of a single asset or basket of assets in exchange for periodic cash flows, typically a floating rate such as LIBOR +/- a basis point spread and a guarantee against any capital losses.  A TRS is similar to a plain vanilla swap except the deal is structured such that the total return (cash flows plus capital appreciation/depreciation) is exchanged, rather than just the cash flows. Leverage In finance, leverage (also known as gearing or levering) refers to the use of debt to supplement investment. Contents Citation 5 Abstract 5 Purpose 5 Design/methodology/approach 5 Findings 5 implications 6 Originality/value 6 Keywords 6 Article Summary 7 Critical reflections 8 How the endogeneity problem affects FP-FP research 8 Application of recent econometric methods to counter endogeneity 9 Research methods 9 Measures 10 Model specification 11 Testing for Endogeneity 11 The Findings 12 Implications 13 Conclusion 13 Appendix 1 15 KLD ratings data 15 Bibliography 16 Citation FTS09: , (FTSE KLD 400 SOCIAL INDEX, 2009), Abstract This superbly researched article brings out a glaring lacuna in the SIM (social issues in management) studies, particularly in the area of establishing relationship between social performance (SP) and financial performance (FP). Despite more than 100 empirical studies on the issue spanned over 30 years, the relationship between the two is far from clear. The results are still mixed. One of the chief reasons for this is because in real life, managers choose SP investment strategies that are based on long-term implications and industry conditions, making this choice as endogenous. On the contrary, empirical models do not account for this and regress performance measures on choice variables are potentially misspecified and their conclusions are incorrect, hence the heterogeneity in the findings. Purpose While dealing with the specific issue of the endogeneity of strategic decisions, the article harps on three important issues, How to explain the heterogeneity of these findings? Is it possible to generalize the positive link between SP and FP found in the majority of previous studies? Does such a positive link hold in the long run and also in the short run? Design/methodology/approach After a thorough review of the relevant literature and a balanced critique of the earlier research framework, a composite combination of OLS, fixed effects and instrumental variable estimation was adopted with the purpose of comparing the present results with previous findings while accounting duly for endogeneity. Findings Three important findings emerge from the studies: Companies with certain characteristics (e.g., good management quality, certain values, a certain culture, etc.) are the ones more likely to adopt KLD1 practices and these unobserved firm’s characteristics are driving the performance. Future research should look at firm-specific characteristics that drive firms to adopt those KLD practices in the first place. Only when the reasons behind adopting KLD by managers is understood adequately, the logical cause-and-effect connection between SP and FP can be established. The findings also suggest the need for a critical examination of the KLD measurement of SP. implications The authors believe that their finding will have profound influence on the future SP-FP research as a whole. The following two implications are noteworthy. There will be a research methodological consequence given the magnitude of bias included by the endogeneity and self-selection problems shown by the authors. The authors believe that a systematic aspect missing in SP indexes such as KLD or SAM (Sustainable Asset Management) is a sound measure of the quality of management. Therefore, the nature of SP indexes and measurement tools adopted so far and their limitations to capture the quality of management is required to be reviewed. Originality/value This paper offers an entirely new dimension to the SIM research, putting serious questions to the studies on the SP-FP relationship undertaken so far, suggesting new ways to look into the aspects of social performance of firms, the quality of the relationships between a firm and its stakeholders and their financial performance. Keywords Corporate social responsibility, endogeneity, financial performance, social performance, stakeholder management Article Summary Does social performance really lead to financial performance? Ever since management scientists have embarked on the mission to establish one of the most intriguing relationships between the social performances of an enterprise vis-à-vis its financial performance, never before an epoch making finding of such nature have come to light. The authors Roberto Garcia-Castro, Miguel A. Arin˜o & Miguel A. Canela in their article “Endogeneity and the SP–FP Relationship: Does Social Performance Really Lead to Financial Performance? Accounting for Endogeneity” try to rediscover answer to some very fundamental questions: How can we explain the heterogeneity of these findings? Is it possible to generalize the positive link between SP and FP found in the majority of previous studies? Does such a positive link hold in the long run and also in the short run? This article deals with the specific issue of the endogeneity of strategic decisions. Explaining the literature so far, the authors introduce the article to the readers superbly by asking to delve into the mystique realm of SP-FP link; explore the relationship between the social performance of firms, the quality of the relationships between a firm and its stakeholders and their financial performance. Is it a corollary of the age old Karma hypothesis, social goodness translated into financial success? In authors’ own words they begin the article as, What is the relationship between the social performance of firms – the quality of the relationships between a firm and its stakeholders – and their financial performance? Over the last 35 years numerous researchers have tried to provide a definitive and clear answer to this fundamental question for the benefit of both academics and managers. The results of these previous studies on the relationship between social performance (hereinafter, SP) and either market or accounting-based measures of financial performance (hereinafter, FP) have been mixed (Griffin and Mahon, 1997; Margolis and Walsh, 2001, 2003; Post et al., 2002; Roman et al., 1999; Ullmann, 1985). Some scholars have found a positive relationship (e.g., Berman et al., 1999; Cochran and Wood, 1984; Coffey and Fryxell, 1991; Hillman and Keim, 2001; McGuire et al., 1988; Waddock and Graves, 1997b). Other studies find more ambiguous or negative relationships (e.g., Alexander and Buchholz, 1978; Aupperle et al., 1985; McWilliams and Siegel, 2000). In the most comprehensive survey performed to date on the link between SP and FP, Margolis and Walsh (2001, 2003) review 127 studies published in articles and books since the early study of Moskowitz (1972). In 109 out of the 127 studies, SP has been treated as the independent variable, predicting FP. Margolis and Walsh (2003) conclude that out of these 109 studies, one half (54) pointed towards a positive SP–FP relationship, 20 showed mixed results and 28 studies reported non-significant relationships. Only 7 studies showed a negative relationship (Margolis and Walsh, 2003, p. 278). The authors go on to say that the in spite of the fact that a majority of the previous research tend to authenticate a positive SP-FP link, such relationship is still far from being well established in the literature. We rummaged the KLD web files to understand the exact nature of the heterogeneity[FTS09]. Source: http://www/:KLD Research_files/0606Acad.jpg Critical reflections The article then delves deeper into find how the endogeneity problem affects this particular field of research and then discusses application of recent econometric methods to deal with the problem of endogeneity. How the endogeneity problem affects FP-FP research The authors bring out that while the endogeneity issue is quite well known to researchers and is frequently taken into account in many fields such as economics, where econometric techniques are applied to rectify errors due to endogeneity. According to them the use of econometric techniques in strategic management research has so far been limited. The endogeneity problem is well known, and is typically taken into account in fields such as economics where econometric techniques exist to correct – at least partially – for endogeneity (Greene, 1993; Heckman, 1974). However, the use of these econometric techniques in strategic management research has so far been limited (Hamilton and Nickerson, 2003). Explaining further they opine that the basic problem is due to the need to convert an unobserved managerial strategic decision to a statistical number. In real life managers make strategic decisions with much deliberation (many of them are unobserved and can be called as the unobservable variables) and not randomly as assumed in many studies undertaken so far. For an external researcher conducting statistical analyses it becomes difficult to appreciate why a manager’s internal factors such as firm culture, internal configuration of capabilities, CEO’s personal values and so on, have generated expectations on how the managers’ choices will affect future performance. Therefore, these unobserved variables (if they are not included in the model’s specification as control variables) can suffer from biased coefficient estimates. The biases arise due to omitted variables correlated with both the strategic decision and firm’s performance. The authors say, The basic problem lies in that managers make strategic decisions not randomly – a standard assumption in many cross-sectional regression models – but based on expectations on how their choices will affect future performance (Hamilton and Nickerson, 2003). These expectations arise from internal factors that managers, presumably, know very well but are difficult to observe by external researchers (e.g., firm culture, internal configuration of capabilities, CEO’s personal values, …). The problem arises because any statistical analysis that does not take into account these unobserved variables (if they are not included in the model’s specification as control variables) can suffer from biased coefficient estimates. The biases result from omitted variables correlated with both the strategic decision and firm’s performance (Hamilton and Nickerson, 2003; Wooldridge, 2002). Application of recent econometric methods to counter endogeneity Research methods Sample and data. The authors have used a conscientious research method by taking a panel based on the 658 US based firms included in KLD2 database of 3000 covering a 15 year time horizon (1991 – 2005). They collected the financial data and firm level control variables from Datastream. The authors have carefully circumvented sample selection bias by including firms listed in S&P 500 and Domini 400 social index. Besides, they also obviated the common method bias by choosing data for the independent and dependant variables. Estimation methods. While the previous studies have used standard OLS regression analysis to test the hypothesis that KLD measures social performance have a positive impact on financial performance, the authors used a combination of OLS, fixed effects and instrumental variable estimation, thus enabling a fair comparison of their results accounted for endogeneity with those of the previous findings. Figure 3: Estimation methods used diligently by the authors Measures The authors used the dependant, independent and control variables assiduously so as to obviate the endemic errors while being homologous with the previous findings. Table 2: Variables used in the study Dependant variables Independent variables Control variables To homologue with those of the previous research, the authors used the following four measures of financial performance: Return on Equity (ROE) Return on Asset (ROA) Tobin’s Q Market value-added (MVA)3 Five categories of the KLD instrument: Employee relations Customer/product issues, Community relations Diversity issues and Environmental issues In accordance with previous studies of stakeholder management and firm’s performance, the authors used control for Size, Industry and Risk effects The authors admit the limitation of the KLD instrument while they chose for independent variables as, While the KLD index thus constructed is not exempt of problems and some alternative approaches have been suggested more recently (e.g., Mattingly and Berman, 2006), at least it ensures the comparability of our results with previous findings which is one of the main purposes of our study. Model specification Baseline Model. The authors’ baseline model is an OLS pooled cross-sectional estimation with the following specification: Where, ∏it = ROE, ROA, Tobin’s Q or MVA of firm ‘i’ in time ‘t’ KLDit = social performance of firm ‘i’ in time ‘t’ = Σ Community relations + Employee relations + Diversity policies + Environmental concern + Product (customer concern) of firm ‘I’ in time ‘t’, Riskit = Beta of firm ‘i’ in time ‘t’, Salesit = Total sales of firm ‘i' in time ‘t’, R&Dit = R&D expenses over sales of firm ‘i' in time ‘t’, Leverageit = Total debt over total equity of firm i in time t, Industryj = 9 time-invariant dummy variables, i = 1,…, 658 firms, t = 1991–2005, j = 1,…,9 industries, θi is the time-invariant error term and εit is the time-varying error term. The authors designated the estimation of this model as pooled ordinary least squares (OLS). In this estimation, they took each cross section of each year as if they were independent random samples from the relevant population. Comparison Model. Fixed effect model was selected as the comparison model, which is given as, In the comparison model, the authors introduced a different intercept αi for each (i), thus controlling in this way for unobserved firm’s characteristics. In the baseline model, the effect of θi (time-invariant error term) on performance is not accounted for, thus, the coefficients of the other covariates on the right side of the equation to be biased upwards or downwards. Testing for Endogeneity The authors used two tests to ascertain the existence for endogeneity in their data. These are, Hausman’s test4 - produced a non-positive definitive covariance matrix of the differences between the random and the fixed effects, making it impossible to compute the test. Mundlak’s test5 - Four dependent variables used - ROE, ROA, MVA and Tobin’s Q. The four regression coefficients proved to be significant (p Read More