Bryan Cunningham ENDOGENEITY AND THE SP–FP RELATIONSHIP Does Social Performance Really Lead to Financial Performance? Accounting for Endogeneity An article review PRESENTED BY

Endogeneity and the SP-FP Relationship Does Social Performance Really Lead to Financial Performance?

DOES SOCIAL PERFORMANCE REALLY LEAD TO FINANCIAL PERFORMANCE? ACCOUNTING FOR ENDOGENEITY Roberto Garcia-Castro, Miguel A. Arin˜o & Miguel A. Canela ARTICLE REVIEW E NDOGENEITY AND THE SP–FP R ELATIONSHIP

Contents  Article summary  Critical reflections  Findings  Implications

Purpose  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?

Three important purposes of this article Explantion of heterogenity Generalisation of the positive SP-FP link Does such positive link hold good in both long and short run

The key players in the SP-FP Link The mystique link of SP-FP link Social performance Quality of firm- stakeholder relationships Financial performance

Heterogeneity in KLD research Far from clear

Sample and data  Panel based on the 658 US based firms included in KLD database of 3000 covering a 15 year time horizon (1991 – 2005).  Financial data and firm level control variables from Datastream.

Neutralizing sample selection bias  Neutralized sample selection bias by including firms listed in S&P 500 and Domini 400 social index.

Neutralizing Common Method Bias  Obviated the common method bias by choosing data for the independent and dependant variables.

Comparison between methods of estimation Previous studies Present study Instrumental variable estimation Fixed effectsOLS Standard OLS regression analysis

Dependant variablesIndependent variablesControl 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) 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 Variables used in the study

Baseline Model ∏ it = α + β 1 KLD it + β 2 Risk it + β 3 Sales it + β 4 R&D it + β 5 Leverage it + β 6 + β 14 (Industry j ) + θ i + ε it Where,  ∏ it = ROE, ROA, Tobin’s Q or MVA of firm ‘i’ in time ‘t’  KLD it = 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,  θ i is the time-invariant error term and  ε it is the time-varying error term.

Testing for Endogeneity  Hausman’s test  Mundlak’s test

Hausman’s test  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 test  Four dependent variables used - ROE, ROA, MVA and Tobin’s Q.  The four regression coefficients proved to be significant (p<0.01) for the means of the KLD variable.  Hence, we can reject the null hypothesis of no endogeneity. This result confirms the relevance of endogeneity in this kind of research and the need to account for endogeneity in our sample.

Comparison Model ∏ it = α i + β 1 KLD it + β 2 Risk it + β 3 Sales it + β 4 R&D it + β 5 Leverage it + β 6 - β 42 (Industry j ) + ε it

The Findings

The findings of the study The positive SP-FP link found in previous studies is doubtful Future research should more critically examine the firm specific characteristics adopted for KLD practices Serious examination of KLD measurement of SP is required to rule out the missing dimensions of quality of management

Finding #1  The positive impact of of social performance on financial performance found in previous studies is mainly due to the fact that firms adopted high standards of KLD self-selected themselves.  These positive effects are diluted when endogeneity is taken into account appropriately.

Finding#2  The future research should critically examine the firm-specific characteristics that prompt firms to adopt those KLD practices in the first place.  Only when the reasons behind KLD adoption by managers is understood, the logical cause-and- effect connection between SP and FP can be established effectively.

Finding#3  A critical examination of the KLD measurement of SP is required to rule out the possibility of missing the dimensions related with quality of management.  Future methodology developments to measure a firm’s SP should look more carefully at the management quality dimension if they are to improve their predictive power in terms of FP in the long and the short run.

Implication

Research implications Significant improvemnt in SP- FP research methodology Significant improvement in SP indexes and measurement tools

Implication#1  There will be a research methodological consequence given the magnitude of bias included by the endogeneity and self-selection problems shown by the authors.

Implication#2  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.  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.

Conclusion  The authors assert in this article that there is a more powerful reason for the heterogeneity of previous findings that may affect all of them.  The decision of the top management to improve a firm’s SP (i.e., decisions oriented to improving the quality of the relationships between the firm and its stakeholders) is endogenous.

 The authors urge that very little progress has been made to advance our knowledge about the interaction between quality of management and SP.

 In their article they suggest that such an interaction may be not only important for theoretical purposes but also in that it may affect empirical findings, therefore vigorous research initiatives may be required to establish the exact nature of SP-FP relationship.