Wednesday, October 26, 2005

Some Economics of Divestment

Much has been made about divestment of Dartmouth's endowment from companies that do business in the Sudan. I applaud the sentiment, but I think the arguments overstate the case for what divestment by itself is likely to accomplish.

Here's an example from The Dartmouth's editorial board from last spring:

Dartmouth's investments in Siemens and Alcatel, both of which hold government contracts and are categorized by the Darfur Action Group as being tacitly complicit with the genocide, present a cause for concern. Though the Advisory Committee on Investor Responsibility is not prepared to recommend divestment in these companies for lack of information, we recommend that it obtain the needed information as quickly as possible. This issue should be a pressing concern for every human being. In particular, ACIR needs to consult the Conflict Securities Advisory Group, which specializes in these situations. Should CSAG provide evidence that Dartmouth's endowment in any way facilitates the genocide, Dartmouth must divest immediately.

The last sentence makes the ethical point quite well, and I couldn't agree more with the recommended course of action. Two paragraphs later, the editorial continues:
Dartmouth's divestment, moreover, could have a ripple effect upon the financial decisions made by similar institutions. A wave of divestment would put pressure on the Sudanese government to take action to end the genocide and would deprive the Janjaweed rebels of much-needed funds. Moreover, according to the report submitted by the DAG to ACIR, the companies in which the College invests restrict most of their activities to Khartoum and provide non-essential services, thus ensuring that divestment would not harm those it is meant to help.

This paragraph confuses old and new capital, to the detriment of its argument. Once a share of stock is issued, then who collects the cash flows due to ownership is largely irrelevant to the operations of the company. I don't believe that the sentence that I highlighted in red, particularly the part about depriving the rebels of funds, is true. Consider the following simple example:

Suppose that, based on the projected cash flows from selling its products, the company in question is worth $100 per share. Now imagine that a large group of current shareholders decide that they are going to divest the stock. What happens to the stock price? Let's say they are very successful, and it goes down to $80. Since the business operations of the company have not changed, the future cash flows of the company still have a present value of $100 per share. All that the divestment has done is to open up a $20 per share profit opportunity for a new investor in the company. The most natural candidates to see the opportunity and take advantage of it are the existing management or the remaining (less ethical?) shareholders.

Continuing to focus on the capital markets, the way to damage the company is to deny it access to new capital, not to spend a lot of time debating who should own the shares on the existing capital. The $80 share price would matter, for example, if the company intended to issue new equity and had to take a 20% capital loss on all new shares. But very few companies issue new shares in a given year, and for well capitalized multinationals, there are other financing options that don't even require the equity market. So I am very doubtful that the capital market can be used productively in this endeavor, contrary to the conjectures of the editorial. (Similar conjectures are made in a well intentioned op-ed yesterday.)

Moving beyond the capital market, the way to get the company's attention is to boycott its products, which does change its business model because it lowers the future cash flows that support the $100 per share price. That's real pain to existing capital owners. And it would involve real sacrifice to those advocating for reform--doing without some products that they would otherwise consume, rather than engaging in fair-market value transactions and excluding a few companies out of several thousand from their portfolios. But that is to be expected if you intend to be an activist for positive change.

So whenever I hear of calls to divest, I think that the emphasis has been misplaced, and what is really needed is a boycott. But, of course, if you are planning to launch a boycott, the prudent investment strategy is to divest first.

Hat tip to Joe's Dartblog for bringing this issue to my attention.

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Alan said...

I think I understand the argument, but I wonder if there may not be some additional factors at work. It is my impression that when a stock declines, the existing shareholders tend to get annoyed and complain to the company's management. When they are large shareholders, the company may respond even if it is not planning a new capital offering.
Perhaps the shareholders who complain are suffering from some information problems -- the investment managers realize the true value of the company has not changed but their clients do not --, or perhaps it is some kind of liquidity preference by investors, or whatever. But I'm not so sure that there is such a disconnect between stock price and pressure on management, and from them to pressure on the Sudanese government.

Anonymous said...

in addition to a boycott...

how about a long-shart arb position? (long the substitute company and short the boycotted company)

Nathan Kaufman said...

The URL above is not my blog. The author is currently a chief-of-staff for an elected state representative in IL. The author is also a U of C law school grad.

Arun Khanna said...

The law of unintended consquences should be considered before disinvesting. Disinvestment by western firms and institutions is likely to lead to projects in Sudan becoming owned by investors from countries with spotty human rights records. Such investors are unlikely to pressure Sudan to change policies.

Niral Shah said...

I appreciate your consideration of the merits of divestment Professor Samwick. As with any well-intentioned effort, we try to constantly audit ourselves and evaluate our actions, to make sure they are effective.
When you say divestment is a good place to start, you're right on. The ripple effect that we are hoping for actually has less to do with the economic consequences than maybe we portray. Last spring, as we pressed the ACIR, we helped State Sen. Dunne of VT put together a bill for divestment of the state pension fund. Illinois, Jersey, and Oregon have passed divestment bills. While estimates of state pension funds invested in corporations active in Sudan are somewhere in the range of $100 billion, this is also about political capital.
There is no way that a nationwide divestment movement could pass under Washington's radar. I really believe it would prompt something more than the largely symbolic Darfur Accountability Act, whether building some kind of coalition to intervene, or more extensive funding for the AU.

Also, there is a bit of history of back and forth posts between Joe's Dartblog, the Review's Dartlog, and The Little Green Blog about divestment from last spring which tackles many of the counterarguments.

Niral Shah said...

Unintended consequences:
As Talisman was beginning extraction operations in Sudan in the late 1990s, they were targeted with the predecessor of this divestment campaign. (The genocide was in Southern Sudan at the time, not Darfur). The approximate 30% drop in share prices was attributed to the divestment campaign, and Talisman pulled out. Who went in?
PetroChina and India's ONGC Videsh.
This is regrettable, but I believe things are different in this situation.
1. In 2003, due to negative press and human rights complaints, Sweden's Lundin oil halted operations in Sudan. Having sunk enough funds into the project, and seeing it as being ultimately profitable enough, the company decided to comply with pressure, and not further pursue these operations until some kind of peice is acheived.
2. Regarding corporations like Siemens (targeted by State campaigns, but not universities as much) building so-called infrastructure, the projects have begun, and these individual companies are the only ones with the capacity to finish the projects.