How Corporate Governance Matters
How should investors regard corporate governance?
From an investor perspective, our own work has established several findings. The first and perhaps disappointing one is that, through time it is hard to find a consistently positive relationship between the quality of governance and investment returns. There are periods, often long ones, where companies with lower governance rankings can outperform those with quality governance rankings.
Since detailed data on corporate governance indicators first became widely available about 25 years ago, evidence has emerged that simple top-down strategies favoring well-run companies could yield outperformance. However, probably because this effect became known to many investors, that relatively simple approach seems to be no longer effective. Nonetheless, we do identify some ways in which investors can still adopt strategies that may be able to take advantage of corporate governance indicators.
From a top-down quantitative point of view, we find that governance matters most as a ‘style’ when stock dispersion is elevated (page 18). These findings seem to capture the sense of the thought from JK Galbraith that ‘recessions capture what auditors miss.’ At a more detailed sector level, Giles Keating and Antonios Koutsoukis also analyze returns from hundreds of companies over many years of data, showing that outperformance may be possible using strategies focused on those sectors where governance matters most, and by emphasizing particular aspects of governance rather than broad-brush indicators.
Outwardly it seems that a great deal of the governance literature concerns itself with mechanisms, such as shareholder voice and the actions of the Board of Directors. Relatively little attention is given to the process by which management invests the firm’s capital, possibly because there is little freely available data on this most essential activity. In this respect, two contributions of this paper are to first outline the principles and shortcomings of the capital allocation process, and then secondly, where we use Credit Suisse’s proprietary HOLT® governance scorecard, to interrogate the outcomes of capital-allocation decisions across thousands of firms.
One rather significant complication in the field of corporate governance is the way in which the nature of capital providers has changed so much in recent years. There are several new trends, perhaps chief amongst them is the arrival of what are generally known as ‘activist’ funds. Our interpretation of this is to continue to categorize these funds as being ‘active investors’ rather than outright governance-oriented investors, though many activist funds cloak themselves in the jargon of corporate governance. Activist funds are concentrated in the USA, where the absence of a governance code has perhaps led to their rise. In some instances, the desires of activist funds can run counter to the aims of longer-term shareholders, thereby introducing a new governance angle.
At the same time that activist funds are on the rise, we also witness a more passive approach by other investors. The rise of computerized trading, passive mutual funds and exchange traded funds (ETFs) means that, in many quarters, there are fewer shareholders who would classify themselves as active monitors. An additional complication in the market place has been the now numerous quantitative easing (QE) programs launched by the world’s major central banks. In most cases, early rounds of QE had positive market and economic effects, though at the same time they have arguably produced less discriminate investment strategies where investors are induced to, for example, buy higher-yielding equities and, in some cases, the incentive to distinguish between good versus bad governance companies has diminished.
Building investment strategies based on good corporate governance
• We believe that governance indicators can be used to design investment strategies that may outperform the market, but simple broad-based approaches that seemed to work in the past appear to be no longer valid.
• We think that more refined strategies, focused on better-governed companies only within those sectors where governance matters most, still have the potential for outperformance.
• We also believe that strategies based on detailed aspects of governance, in particular good versus bad accounting, are potentially able to outperform.
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