The first two posts on market predictability focused largely on how asset classes behave over time. This post looks at patterns within asset classes, also known as cross sectional returns. Specifically, I look at equity markets and a factor very close to my heart, corporate governance.
"Stocks with the best governance outperformed those with the worst by an astonishing 8.5 percentage points per annum"
I believe that well-governed companies produce better returns for shareholders over time than poorly-governed companies. On its own however this belief would not be much use as it says nothing about the extent to which differences in governance are reflected in share prices. Thus, I also believe that good governance is a quality that is systematically under-appreciated by investors.
I think of corporate governance as the extent to which decisions are taken in the interests of all stakeholders. Good governance means that all stakeholders are treated fairly. Poor governance means that some stakeholders are prioritized at the expense of others. As investors, it is important to ensure that one will get a fair share of revenues and to continue checking once invested. But I think it makes good investment sense too. If, as a minority shareholder, you are not getting your fair share of the revenues, it follows that stronger revenue growth has to make up the deficit, a big ask by any standard. History is littered with stories of big corporate failures but poor governance only rarely ends in bankruptcy. More often than not it happens insidiously, and investors remain frustrated by the poor performance, but essentially unaware of its cause. Governance can be poor at companies with large controlling shareholders. Minority shareholders in Essar Energy have been angered recently by what appears to be a cynical move by 78% owner Essar Global Fund Limited to take advantage of the 84% fall in the share price and bid for the shares it doesn't own. Opinion is split between those who argue there should be laws in place to protect investors from such predatory action and those who suggest that investors in the company's IPO in 2010 only have themselves to blame.
Regardless of your stance, research conducted by S&P Capital IQ for the FT about the performance of companies with a dominant shareholder has something for both sides. The median return over five years of 8,000 listed companies in which a single investor owned more than 50% was 60% compared with 116.2% for the MSCI World Index. Stripping out penny stocks that distort the data and you're still looking at a median return of 99.1%, 17.1 percentage points behind the index. The FT article went on to note that "While active fund managers have the power to sidestep companies with dubious owners and ropey corporate governance, passive funds have no choice but to hold such stocks if they are a constituent of the index they track." And by the time such stocks are driven out of the index because of poor performance, the damage to passive funds will already have been done. The 2003 paper Corporate Governance and Equity Prices written by Paul Gompers, Joy Ishii and Andrew Metrick also provides strong support for screening stocks on the basis of corporate governance measures. Stocks with the best governance based on 24 factors outperformed those with the worst governance by an astonishing 8.5 percentage points per annum. They also found that "firms with stronger shareholder rights had higher firm value, higher profits, higher sales growth, lower capital expenditures, and made fewer corporate acquisitions." These findings are supportive of my two beliefs that not only does better governance produce better corporate performance, but that this better performance is under-appreciated by investors. Countries from Brazil to Japan have in recent years begun to promote good governance by constructing indices for better governed companies only. Brazil's Corporate Governance Index has been in existence only since June 2001 but it has produced a total US$ return over that time of 600.5% versus 220.2% for the broader Ibovespa index. Japan's Prime Minister Abe has followed suit, proposing a similar index for well-governed Japanese companies as part of his so-called Three Arrows initiative to breathe life into the economy. The JPX-Nikkei 400 members are chosen based on return on equity and cumulative operating profit, which each account for 40 percent of the selection criteria. Market value makes up the remaining 20 percent. Subsequently, companies that don't meet corporate-governance criteria may be replaced. For a country that has for so long ignored the rights of minority shareholders, the creation of this index is a ground-breaking move. While it is understandable why better-governed companies produce better business performance, it is less clear why such superiority is not rewarded by the market and thus represents a price anomaly to be taken advantage of. Perhaps it is because good governance is part of a company's culture and thus something that endures far longer than investors are prepared to admit. It may also be the case that companies that are not acquisitive nor incur large capital expenditures do not tend to make the headlines and as a result do not attract as much investor attention. Whatever the reason, the tortoises of the corporate world may not have the glamour of the hare-like headline makers, but they do tend to produce better returns for shareholders.
Published in Investment Letter, March 2014
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.