It Pays to Be Naughty

I read a headline this week that left me shaking my head in disapproval.

In a grandiose display of high-minded social responsibility, Japan’s Government Pension Investment Fund, the world’s largest pension plan, decided to ban the shares of the stocks it owns from being borrowed by short sellers. (In order bet against a stock by selling it short, a short seller must first borrow the shares from another investor.)

Apparently, the fund didn’t like the idea of shares it owned being used by hedge funds for supposedly nefarious ends. The horror!

Where do I even start in ripping apart that argument…

Money Is Lost

To start, the pension’s first priority is to the retirees whose money it manages. Allowing short sellers to borrow shares netted the fund around $300 million over the past three years. That’s money that will no longer be available to fund the retirement of elderly Japanese pensioners.

Arguably worse is the precedent it sets.

Short sellers may come across as dodgy characters at times, but their trading adds liquidity to the market. A healthy market needs both buyers and sellers. If other large pensions feel pressured to follow Japan’s lead and restrict shorting, market liquidity dries up and execution gets worse for all investors.

It’s another case of the road to hell being paved with good intentions.

But believe it or not, that’s actually not the worst case of do-gooding run amok I’ve come across this week.

Enough Is Enough…

Activist hedge fund TCI threw down the gauntlet and threatened boardroom proxy battles with any company that didn’t publish detailed reports on their carbon dioxide emissions.

In plain English, TCI threatened to fire the boards of directors of literally any company, anywhere in the world, that didn’t share their sense of urgency about global warming.

Now, I’m all for corporate responsibility. If you can quantify the damage that a company does to the environment, it only makes sense to make them pay. It’s not fair that a company can pad its profits while damaging the world we all have to live in.

It gets ridiculous when you look at some of the “polluters” TCI singled out.

At the top of the list was Moody’s.

Yes, Moody’s. The bond rating agency…

Moody’s isn’t an oil fracker or a coal plant. It’s a company that creates credit reports for bonds.

I’m struggling to comprehend how company full of white-collar analysts with spreadsheets is causing the polar icecaps to melt with excessive carbon dioxide emissions. It’s also my understanding that a money manager’s job was to make money, not engage in meaningless virtue signaling. But what do I know…

We all have our pet issues, and business shouldn’t be immoral. There’s a reason why some industries are illegal and others are strictly regulated. But high-mindedness can be taken to an extreme.

And when it is, it creates opportunities for those of us with a level head.

Profiting from the Politically Incorrect

In their 2007 white paper, The Price of Sin: The Effects of Social Norms on the Markets, Princeton Professor Harrison Hong and New York University professor Marcin Kacperczyk found that the taboos associated with investing in politically incorrect industries such as tobacco, alcohol, and gaming led these sectors to be priced as perpetual value stocks.

This perpetual discount means attractive pricing and dividend yields, which in turn meant market-beating returns for investors willing to be a little naughty.

In other words, by being socially responsible, you end up with lower returns. But by being a little less judgmental, you put yourself in a position to profit quite well.

Historically, socially-responsible investing tended to focus its disdain on tobacco.

Today, I’d argue that energy companies are viewed as the greater evil. And this has created fantastic opportunities for income investors like us.