By Ellie Winninghoff

How does a responsible investor cut through a company's green-wash? Focus on performance.

Consider BP, which hyped its solar investments and dubbed itself "beyond petroleum." In 2005, the oil giant had a major accident in Texas City in which 15 workers were killed. And between June 2007 and March 2009, the Occupational Safety and Health Authority issued 760 egregious willful citations to BP across its five refineries in the US. That compared to one egregious citation issued across the other 145 refineries in the US.

"We decided not to approve them [in 2005], " says Domini Social Investments General Counsel Adam Kanzer.  "And every year since, when we looked at them, [the accident profile] got worse and worse."

Worker health and safety is one of hundreds of key performance indicators, or KPIs, that Domini uses to assess corporate sustainability. They are part of a broader framework the fund has developed to support its twin goals of universal human dignity and ecological sustainability. The intent is wealth creation for all of a company's stakeholders, not just its shareholders.

In the early 1990s, SRI pioneer Amy Domini, along with Peter Kinder and Steve Lydenberg, started SRI research firm KLD Research & Analytics, Inc. They created the Domini 400 (now the MSCI KLD 400,) an index of socially-screened U.S. companies, and launched the Domini Social Equity Fund (DSEFX) to track the index.

By 2005, when Domini started an international fund, there were more environmental and social data available. Lydenberg joined the mutual fund to lead its new international sustainability research. It was an opportunity to start with a clean slate, and since late 2006 the U.S. fund also has been actively managed using the same newer approach.

Different Alignments
How well does a company's core business actually align with Domini's twin goals of universal human dignity and ecological sustainability? That's the first question the fund asks.

There are four categories, ranging from "fundamentally aligned" (companies like renewable energy) to "fundamentally misaligned" (industries like tobacco and nuclear power.)  About 90% of companies, however, fall in the middle two categories.

Take mining, which is "partially misaligned." While its commodities are useful to society, Kanzer says, they come with a high social and environmental risk. A mobile phone service firm, which has fewer social and environmental risks, can be "partially aligned," or even "fundamentally aligned," if most of its business is in an emerging market where phones are used to empower poor people.

Domini also wants to understand a company's "stakeholder model," or how it treats "business partners" like employees, suppliers, customers, investors, communities and the ecosystem.

Here's the kicker, though: the less a company's core business aligns with Domini's goals, the higher the fund's stakeholder standards. And the more a company's core business aligns with Domini's goals, the lower the fund's stakeholder standards.

"If [your business] is fundamentally aligned [with our goals] and is neutral with respect to your safety record or use of toxic chemicals, you will make it onto our buy list," says Domini president Carole Laible.

A Deeper Look
How do you make consistent and meaningful decisions within this broader framework? Domini's answer was to create KPIs that reflect each industry's most pressing sustainability challenges.

The fund realized, however, that there are also huge differences within industries as defined by the Global Industry Classification Standard, which helps make sector-based investing possible. For example, the conventional materials industry includes precious metals, industrial and commercial metals, specialty chemicals, commodity chemicals, mining, cement, forest products and packaging.

"From a sustainability point of view, these are very different," Laible says.

The fund sub-divided each of the 24 conventional industry classifications into between four and seven "sub-industries" and also invented new categories altogether. In terms of sustainability, for instance, snacks such as candy and beverages differ from other companies that provide food. Then, based on each sub-industry, it created about six KPIs: three regarding business alignment; and three related to its stakeholder model.

Although KPIs like workplace safety reflect environmental and social risk, others represent positive impact. In the homebuilding industry, for example, Domini wants to know what percentage of sales or units built meet energy standards, are located on brownfields or redeveloped land (something that saves more land for green spaces), and serve low-income customers.

But not all KPIs are quantifiable. Supply chain labor conditions--whether or not a company has a code, reports that code and engages in monitoring--could be an entire area of research, Kanzer says. "It's a qualitative assessment, and there are lots of judgments along the way."

Of course, most large-cap companies are conglomerates that consist of several sub-industries.  And that's the hitch because a decision about whether to approve a company like JP Morgan Chase, currently the fund's third-largest holding, can hinge on the thorough analysis of 30 to 40 KPIs. As a result, Domini's decisions can be either extremely nuanced and fair or watered down, depending on your point of view.

"You shouldn't be looking at this as a stamp of approval," Kanzer says. "Chase is a tough call. We're wrestling with a lot of really difficult issues."

Call In The Quants
Domini assesses 2,500 companies, which are rated internally on a scale of one to five. Companies rated one to three, or roughly 60% of the entire lot, are approved for Domini's buy list. Quantitative analysts at Wellington Management, the fund's sub-advisor, make all the investment decisions. Domini's U.S. fund currently includes 148 companies; its international fund comprises 88 companies.

Why is an SRI fund turning over its actual investment decisions to quants? "Although we believe more ethical companies are more likely to outperform in the long run and are going to run into less trouble, a lot of other things impact corporate performance and the way the stock market moves," Kanzer says. "A lot of it is not rational or predictable, or related to what the company actually does. Wellington's quants are dedicated to understanding that."

According to Kanzer, it's possible to identify when each partner--Domini and Wellington--adds value to the portfolio, quarter by quarter. Even so, the two processes remain independent, and Domini's sustainability analysts and Wellington's financial and quantitative analysts may not speak to each other.  

"It helps us make a decision independent of whether or not it helps the portfolio," says Domini senior analyst Tessie Petion, noting that Domini's goal is to enhance wealth for all stakeholders. "There is a danger that if you are considering the financial, the financial will weigh heavier."

A former investment banker and veteran financial reporter, Ellie Winninghoff is a writer and consultant. Her work about responsible and impact investing can be found at her blog, www.DoGoodCapitalist.com and she can be contacted at: ellie.winninghoff (at) gmail.com.