Measuring Business Social Irresponsibility: The Case of Sin Stocks

Negative screening (of ”sin” stocks) is one of the most common strategies used by socially responsible investors. There is a debate about whether (and how much) these exclusions affect the cost of capital for targeted firms. The existing literature identifies sin companies using industry classification codes (IC). We propose an alternative continuous measure of firms’ exposure to sin activities (sinfulness) based on textual analysis (TA) of their annual reports. Sinfulness captures both cross-sectional and time-series variation in firms’ exposure to sin activities. The correlation between the IC and TA sin indicators is only 0.69, with twice as many sin stocks in TA than in IC. TA reveals several important false positive and numerous false negative sin stocks in IC. While equal- and value-weighted portfolios of TA-identified sin stocks reveal no abnormal returns, a sinfulness-weighted portfolio earns an annualized Fama-French 6-factor alpha of 5%. Further tests suggest that the abnormal performance is not explained by crash risk or mispricing, but is significantly related to litigation (legal) risk.