Active Management and the Predictability of Markets Redux: Corporate Governance
Updated: May 17, 2022
This post is the final of four in a mini-series on the subject of active management and the predictability of markets. The first three focused largely on the predictability of the performance of asset classes over time (time series analysis). This letter looks at patterns relating to patterns within asset classes i.e. cross-sectional returns. Specifically, it looks at how corporate governance standards can influence a company’s stock price.
"Good governance simply means that all stakeholders are treated fairly"
We believe that well-governed companies produce better returns for shareholders over time than poorly governed ones. In other words, good corporate governance is a quality that is systematically underappreciated by investors.
Corporate governance can be thought of as the extent to which decisions are taken in the interests of all stakeholders. Good governance simply means that all stakeholders are treated fairly. Poor governance on the other hand means that some stakeholders are prioritized at the expense of others. As fund managers, we have a duty to ensure that when we invest in a company, a fair share of its revenues accrues to the funds under our management and thus to our clients. We must then monitor on a regular basis that this remains the case.
History is littered with stories of big corporate failures, but poor governance only rarely ends in insolvency. More often, it happens insidiously, and investors may remain frustrated by poor share price performance, and very possibly oblivious to its cause.
Governance can be poor at companies with large controlling shareholders. Back in 2014, minority shareholders in Essar Energy were angered by what appeared to be a cynical move by 78% owner Essar Global Fund Limited to take advantage of the 84% fall in the share price to bid for the shares it didn’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 had themselves to blame.
According to research conducted by S&P Capital IQ for the FT, 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. Strip 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 that cited the S&P Capital IQ research 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. The authors 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.”
Countries from Brazil to Japan have in recent years begun to promote good governance by constructing indices for better governed companies only. In the case of Japan, Prime Minister Abe proposed an 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 constituents are chosen on the basis 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 for so long ignored the rights of minority shareholders, the creation of this index was a ground-breaking move.
While it intuitively makes sense that 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 where it exists, good governance is ingrained in a company’s culture and thus something that endures far longer than a typical investor’s time horizon. It may also be the case that companies that are neither acquisitive nor incur large capital expenditures tend to be more profitable than those that divert cashflow to new ventures or expansion that may, respectively, be risky or unnecessary. Since companies that do nothing do not generally make the headlines, their share prices may be systematically cheaper and thus future returns systematically higher.
Whatever the reason, the tortoises of the corporate world may not have the glamour of the hare-like headline makers, but they often win the race and produce better returns for shareholders.
Published in Investment Letter, November 2019
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.