Thursday, October 17, 2013

The price of producing in a sinful sector

Many people avoid investing in certain types of firms they associate with unethical or sinful behavior. That would include tobacco companies, high polluters, alcohol, fire arms and defense industry, etc. That should lower the stock market return of these firms, but there is of course some arbitrage that negates these return differentials. Yet, is there some way in which being in a sinful sector is detrimental?

Stergios Leventis, Iftekhar Hasan and Emmanouil Dedoulis found one, and that is the cost of auditing. Auditing firms are extremely sensitive to their own reputations, and who they do business with is part of their reputation. The authors also argues that auditing firms perceive that sin firms bear higher business risk, perhaps because they deviate from social norms and require more scrutiny (risk of litigation, need for higher cash reserves). In the US, such companies end up paying a whooping 20% more in auditing and consultancy fees. I wonder where else they face higher costs (it is known they have higher capital costs). This means that their stock price should still be affected despite arbitrage.


Anonymous said...

If some investors aren't willing to own "sin" stocks, risk is shared among the remaining investors. This leads to HIGHER expected returns (see Merton (1987) "A Simple Model of Capital Market Equilibrium with Incomplete Information").

Anonymous said...

This is also conformed by empirical papers (see Hong and Kacperczyk (2009) "The price of sin: The effects of social norms on markets").