Good governance is the unsung hero of investment returns

Management strategy, successful products, economic growth, and low interest rates are often the core drivers of investment returns. Sometimes, experts will go as far as to commend the corporate culture or CEO’s vision to explain the abnormal returns from a stock. However, investors tend to overlook the importance of good corporate governance.

Robust corporate governance is the antidote to an issue academics like to call ‘the agency problem’ (Sunit Shah, CFA Institute Research Foundation, 1 March, 2014). The agency problem is an inherent conflict of interest between those who run the company (management) and those who own it (shareholders).

The owner-manager relationship is fraught with misaligned incentives and asymmetric information. The responsibility of closing this gap and resolving the conflict lies with the shareholder-appointed board of directors. A healthy dose of oversight from an independent board could check the management’s tendencies to waste resources, cut corners, overpay themselves, or dilute the stock.

The board promises to uphold the rights of shareholders and safeguard their interests. It seems intuitive that stronger oversight and shareholder rights should lead to better performance. Indeed, recent studies have managed to establish this link.

A study of shareholder rights at 1500 large firms during the 1990s found that companies with a better score on the ‘Governance Index’ made fewer corporate acquisitions, had higher profits, lower capital expenditures, and better sales growth (Gompers et al., Quarterly Journal of Economics, February 2003). In other words, the value of the firm was noticeably enhanced by better governance.

Fortunately, measuring corporate governance at publicly-listed companies has become easier with the Institute of Director’s annual publication of the Good Governance Index (GGI). The GGI measures corporations based on 47 different governance indicators ranging from the percentage of CEO pay in stock to the frequency of board meetings every year.  In the latest report, Diageo Plc. came out on top with a score of 837. GlaxoSmithKline Plc. scored the least - 627 (IoD, Good Governance Report, 2017).

The GGI provides a window into the boardroom for retail investors. Leveraging these tools could help investors monitor their company managers more closely, mitigate the risks and moral hazards of owning a piece of a large company, and perhaps enhance their investment performance.

The value of investments and income from them may go down as well as up and you may not get back the original amount invested.