Sixteen years ago, CalPERS, the nation's largest public pension fund, vaulted to the forefront of the social investing movement by voting to dump its $671 million in tobacco stocks.
Judged strictly by investment return, the decision turned out to be a loser. Now the California Public Employees' Retirement System is considering jumping back into tobacco. Next to the question of whether that's morally the right thing to do, the biggest issue may be: Would its timing be even worse now?
Tobacco stocks have been on a tear in recent years, a development that has some investment managers salivating; but just as the fund may have sold the stocks just before they started gaining, they could be buying just before the sector runs out of steam.
The CalPERS board will ponder a return to tobacco investing at a meeting Monday, armed with a staff analysis recommending an end to all restrictions on the investments and taking steps to add tobacco companies to the system's portfolio.
Tobacco investments present CalPERS with perhaps its toughest dilemma. The sector can't be viewed strictly on stock market terms. Its products are lethal and addictive, and impose medical costs on state and local governments that end up affecting CalPERS' own finances.
"What sense does it make for CalPERS to be an investor in companies that cost the state billions of dollars?" asks Phil Angelides, who as then-California state treasurer and a CalPERS board member spearheaded the divestment drive in 2000.
Another factor that can't be overlooked is the state government's role as a policy-setter on health and social issues. "It would be a strong statement in favor of the use of tobacco if CalPERS re-entered tobacco investment," says California Treasurer John Chiang, a current CalPERS board member. "It would be like going back to the 1960s or 1970s, when people didn't understand the profoundly negative consequences of smoking." Chiang estimates that Medi-Cal and other state programs spend some $27 billion a year to treat tobacco-related illnesses.
Investing in tobacco stocks would doom CalPERS to hopelessly incompatible policy positions. In 2014, for instance, the CalPERS board praised CVS for ending the sale of tobacco products at its drug stores. "The health of our members and their families is a top priority for our organization and clearly the use of tobacco is a key driver in the costs of healthcare," the statement read. "CVS' leadership helps promote a culture of wellness and health in our communities across the nation." How would that taste coming from an organization trying to make investment profits from the very companies CVS evicted from its stores?
The CalPERS staff argues that sidelining investment in tobacco conflicts with "our duties as fiduciaries" — that is, the mandate to invest strictly in the interest of the state and local employees who are members of the retirement system.
But advocates of divestment say the system's fiduciary responsibilities extend to the social costs of tobacco use. "We cannot separate the benefits to the fund of investment in tobacco from … the lost productivity borne by health insurers, taxpayers and employers due to tobacco use," Chiang wrote in a blistering letter opposing the staff recommendation. "As part of my fiduciary duty as a Board member, I must take that into account."
The staff also raised questions about whether divestment is even effective at influencing tobacco company behavior. Divesting may be "an ineffective strategy for achieving social or political goals," its analysis says, "because the usual consequence is often a mere transfer of divested assets from one investor to another." CalPERS generally prefers to influence corporate behavior from the inside, as an investor, the staff observed — but it acknowledged that it's unlikely that CalPERS policies aimed at "the drastic reduction or elimination of tobacco use" would gain much of a hearing from executives at tobacco companies such as Altria or Reynolds American.
CalPERS launched its divestment initiative in October 2000. At that time, the fund owned about $671 million in tobacco stocks, which accounted for less than 0.4% of its $172-billion portfolio.
What's often overlooked today is that CalPERS didn't actually eliminate all tobacco holdings, only those managed by its own staff. Because outside investment managers are still authorized to invest, the fund now owns about $547 million in tobacco stocks, or almost 0.2% of its $290-billion portfolio; Chiang says those holdings render the divestment concept a "charade." One option the board will consider at its upcoming meeting is whether to order those holdings sold, too, as Chiang advocates.
The divestment decision in 2000 wasn't based entirely, or even chiefly, on social considerations or morality. It also reflected concerns over burgeoning pressures on the tobacco industry that were expected to make these stocks serious underperformers. The industry faced billions of dollars in lawsuits from smokers, regulatory pressures at all levels of government in the United States and abroad, and a secular decline in smoking that was beginning to spread from the developed world to underdeveloped countries. These factors reinforced uneasiness about the social implications of a public agency investing in an addictive, deadly product while offering practical reasons to dump the shares.
"We recognize that the tobacco industry is under unusual threat and we don't think it's worth taking the risk," Angelides said at the time.
By some reckonings, this turned out to be a miscalculation. The tobacco companies proved to be more resilient than anyone had expected. Yes, smoking declined, but cigarette-makers made up for their shrinking market by raising prices — which they found fairly easy to do, since the addictive qualities of their product meant that remaining smokers were relatively insensitive to price increases. The advent of electronic cigarettes promised a new market and new revenues for the companies. They cut costs and maintained handsome dividends, keeping many investors on board.
From 2002, when CalPERS divestment was complete, through mid-2016, tobacco stocks turned in double the annualized return of the broad market. Currently, their premium over the broad global market is at a near all-time high of 20%.
In an analysis of the cost of divestment produced for CalPERS in June (and updated last month), Wilshire Consulting placed the system's total foregone investment gains at more than $3.6 billion. In 14 of the last 16 years, Wilshire found, the absence of tobacco stocks in the fund's portfolio reduced its returns.
None of that guarantees that the time necessarily is ripe to pile back into tobacco stocks. The recent run-up in shares could signal a peak. Government regulations in the United States and abroad could be heating up: On election day, California voters approved steep new taxes on cigarettes and e-cigarettes via Proposition 56, part of a decades-long policy to stamp out the habit. Britain this year imposed stringent new rules stripping logos and bright colors from cigarette packs, substituting generic lettering, warning labels featuring horrific photos of diseased human organs, and a nausea-inducing color scheme.
Cigarette use in the United States has been on the decline for roughly a half-century. The trend doesn't appear likely to reverse any time soon, and is increasingly matched in other countries, including in the Third World. The industry's ability to raise prices to make up for its shrinking market isn't infinite; that's why cigarette makers Philip Morris and Reynolds invested $70 million to defeat Proposition 56, which more than tripled the state cigarette tax to $2.87 per pack from 87 cents. They failed miserably, as the measure passed with 64% support. There can be few products viewed as widely by governments as both noxious and ripe for revenue-plucking as cigarettes.
The confluence between socially-responsible investing and prudent investment analysis may yet exist for tobacco. The CalPERS board would be well-advised to keep looking ahead toward a tobacco-free world, rather than bailing back in because of regrets about the past.