Governance Pays

By Ben McClure AAA

If corporate collapses like Enron, Global Crossing and World Com have taught us anything, it's that investors can't afford to ignore the issue of corporate governance. When conducting fundamental analysis, investors need to keep a close eye on the way that companies keep management in check and ensure financial disclosure, board independence, and shareholder rights. Recent studies suggest that the benefits of scrutinizing governance extend beyond simply avoiding disasters. Good corporate governance can increase a company's valuation and boost its bottom line.

What Is Corporate Governance?
Corporate governance is a fancy term for the way in which directors and auditors handle their responsibilities towards shareholders and other company stakeholders. Think of it as the system by which corporations are directed and controlled. Typical corporate governance measures include appointing non-executive directors, placing constraints on management power and ownership concentration, as well as ensuring proper disclosure of financial information and executive compensation.

Surprisingly, corporate governance has been considered a secondary factor impacting a company's performance. That is, as opposed to a company's financial position, strategy and operating capabilities, the effectiveness of governance practices was largely seen as important only in special circumstances like CEO changes and merger-and-acquisition (M&A) decisions.

But recent events prove that governance practices are not merely a secondary factor. When the company's share price tanks because of an accounting scandal, the importance of good governance practices become obvious. Corporate disasters show that the absence of effective corporate controls puts the company and its investors at tremendous risk.

What the Studies Prove
For years, investors ignored corporate governance because academic research found no clear causal link between governance and financial performance. But that is starting to change. A paper by Harvard and Wharton business professors entitled "Corporate Governance and Equity Prices" (2003) concluded that investors that sold U.S. companies with the weakest shareholder rights and bought those with the strongest shareholder rights earned an additional return as high as 8.5%.

The study analyzes 1,500 companies and ranks them based on 24 corporate governance provisions. Those companies with the lowest rankings were less profitable and had lower sales growth. Moreover, the returns on these companies lagged far behind those of higher ranked firms. The paper also shows that for each one-point increase in shareholder rights, a company's value increased by a whopping 11.4%.

Meanwhile, a study produced in 2000 by global consultancy McKinsey found that 75% of the 200 institutional investors it surveyed regard board practices as important as financial metrics for assessing companies. The study showed that companies that moved from the worst to the best governance practices could expect a 10% increase in market valuation.

Investors Are Starting to Take Notice
Amid all the hand wringing about corporate governance, investors are getting help in steering clear of misgoverned companies and finding well-governed ones. Governments, stock exchanges and securities watchdogs are coming up with new rules and regulations that try to put a stop to some of the worst cases of corporate failure. Proposals at the New York Stock Exchange and the SEC that push for more boardroom independence and greater financial expertise in audit committees certainly accelerate improved practices and reassure investors.

At the same time, a veritable cottage industry has sprung up among ratings agencies and consultants issuing corporate governance ratings. Investors can turn to Standard & Poor's Corporate Governance Score and Institutional Shareholder Services' Corporate Governance Quotient. Both of them report and grade public companies' governance practices. In addition, the Investor Responsibility Research Center, along with corporate governance watchdogs like the Corporate Library and Governance Metrics provide governance performance ratings.

While new regulatory proposals and rating systems are valuable to investors, they are no guarantee that companies are well run. Investors need to evaluate corporate governance for themselves. Here is a quick list of key issues for investors to consider when analyzing corporate governance:

  • Board Accountability - Boards of directors (BODs) are the links between managers and shareholders. As such, the BOD is potentially the most effective instrument of good governance and constraint on the top managers. Investors should examine corporate filings to see who sits on the board. Make sure you seek out companies with plenty of independent directors who have no commercial links to the firm and who demonstrate an objective willingness to question management choices. A minority of independent directors make it difficult for the board to operate outside the sphere of management influence. Do directors own shares in the company? If not, they may have less incentive to serve shareholders' best interests. What are directors' attendance records at board and committee meetings? Finally, does the board adhere to a set of published governance principles?
  • Financial Disclosure and Controls - Investors should insist that corporate structure includes an audit committee composed of independent directors with significant financial experience. Ideally, the committee should have sole power to hire and fire the company's auditors and approve non-audit services from the auditor. Persistent earnings restatements or lawsuits challenging the accuracy of financial statements provide a clear signal to investors that financial disclosure and controls are not functioning properly. Top management compensation should be determined by measurable performance goals (shareholder return, ROE, ROA, EPS growth), and, if possible, the compensation rate should be set by an independent compensation committee and fully disclosed.
  • Shareholder Rights - Be wary of companies with dual-class stock. Class A and B shares can place major constraint on shareholder rights, enabling insiders to accumulate majority power by virtue of owning vote-tilted class B shares. Voting should always be routine through mail, telephone and Internet, and shareholders should have the right to approve major transactions, including mergers, restructuring and equity-based compensation plans.
  • Market for Control - Management power can become entrenched by strong takeover defense provisions, such as poison pills or the issue of blank check preferred preferred stock. These mechanisms protect against hostile takeovers and subsequent management change, but investors should cheer poison-pill plans only when fully trusting and supporting management.

    Be aware also that directors - especially executive board directors - have a habit of granting generous stock options to top managers. While stock options offer management an incentive to perform well, overloaded stock-option accounts create the possibility of unwanted share value dilution. The more stock options management owns, the bigger the drop in share value will be when these options are exercised.

Because the quality of corporate governance determines how a company allocates shareholder rights and aims to maintain the value of shares, investors should vigilantly analyze and evaluate the governance of their current and potential investments.

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