The author hypothesizes that for inefficient markets, in which investor sentiment prevails over rational investor utility maximization, corporate social responsibility signals by firms typically incur more noise trading. The increased noise trading, in turn, leads to excess market volatility and excess market valuations.
What’s Inside?
Corporate social responsibility (CSR) is often regarded as an innocuous governance mechanism, mostly appealing to those interested in socially responsible investing (SRI). But given the difficulty in linking CSR with a firm’s economic fundamentals, CSR signals may have a harmful impact on equity markets characterized by asymmetrical information and driven by investor sentiment. More specifically, the inherent ambivalence in interpreting CSR-related information exacerbates noise trading, thereby resulting in higher trading volumes, excessive volatility, and mispricing of CSR-sensitive stock prices.
How Is This Research Useful to Practitioners?
The author provides a descriptive theory, based on the behavioral finance paradigm and asymmetrical information assumption, suggesting that CSR will have an unintended negative impact on equity markets in terms of market volatility and stock pricing.
The author identifies the two main characteristics of CSR that will generate noise in stock valuations, which he defines as the deviation of a stock price from its fair value. First, given the uncertain economic impact of CSR, it is difficult to predict whether more CSR will bring positive net cash flows and thus higher value to the firm. Second, because business executives know more about the actual CSR characteristics of their operations than do outside investors, the former might exploit this informational asymmetry to send false market signals about their strategic commitment to CSR.
The author argues that because investor sentiment can drive stock valuations, investors will be ineffective at filtering CSR-related noise out of public information and thereby end up trading on CSR signals unrelated to company fundamentals. Exacerbated noise trading will drive trading volumes higher, which, in turn, will add excess volatility to the market. The more investors disagree on CSR signals of particular stocks, the more trading volume and price volatility will increase, especially in markets where CSR is widely accepted as a reliable indicator of sound corporate management.
Finally, in institutional settings in which investors attach a distinct positive value to CSR, it is expected that high-CSR firms will be traded higher than comparable firms, regardless of whether the CSR-related price increases can be justified by company fundamentals. Moreover, the perception that stock price increases of high-CSR companies predict future price increases will have an amplifying feedback effect, raising the possibility that a price bubble of socially responsible firms will emerge.
Given the possibility of negative unintended implications of CSR as highlighted by the author, investment professionals must not take CSR’s benevolence for granted when it comes to market valuation. Firms announcing CSR initiatives or upgrades in SRI ratings must be evaluated with caution, and their positive CSR signal must be juxtaposed with the company’s perceived capability of free cash flow generation. The valuation of stocks afflicted by CSR-related noise trading volatility may include a CSR risk premium that reflects the increased riskiness relative to comparable stocks.