S&P says good governance determines stock performance over time

CORPORATE GOVERNANCE COMMENT: By Michael Olympios

 

Ever since the collapse of Enron, WorldCom, and many more well-known and lesser-known companies, investors have been paying more attention to corporate governance than at any other time in history. The enactment of the Sarbanes-Oxley Act in 2002 was long due by many proponents of good governance like Arthur Levitt who advocated that good governance is good for the markets.

In Standard & Poor’s view good governance pays off. S&P’s global equity research departments assess the quality of corporate governance based on three broad categories. The board of directors’ organizational structure is first and foremost. When looking into this category, S&P analysts evaluate factors such as board independence and separation of the chairman and CEO posts.

Executive compensation is another important issue, and S&P analysts ask several important questions relating to it: are executives compensated in ways that hurt shareholders?

Another category is shareholder rights. For example, is a “supermajority” vote — which is determined by each company and could be two-thirds or three-quarters of the votes — required to affect change at the company? The requirement of a supermajority, as opposed to a simple majority of more than half the votes, restricts shareholders’ ability to make changes.

In Cyprus for example, controlling shareholders – even if they control just 30%, can exert enormous power over smaller investors and push forward corporate action that may benefit them more than the rest of the shareholders let alone measures that could reasonably allow a board to exercise more effective oversight. Controlling shareholders in Cyprus have their own idea of good governance which boils down to appointing friendly ‘independent’ directors.

Kenneth Shea, head of S&P global equity research, believes that there’s a close relationship between a company’s management commitment toward the ethical and responsible stewardship of shareholder assets with that of the firm’s stock performance over time. Research has been done to quantify the quality of a company’s corporate governance with long-term investment returns. In a study entitled The Correlation Between Corporate Governance and Performance (January, 2004), Lawrence Brown and Marcus Caylor show that stocks of companies with strong governance enjoy superior returns on a 3-, 5-, and 10-year basis. This study also found a positive correlation with strong financials as assessed by return-on-equity, return-on-assets, return-on-investment, and net profit margin. The data show that better governance leads to lower volatility, a higher price-to-book ratio and lower operating cash flow to current liabilities.

Research into the relationship between corporate governance and performance has been extensive but it faces significant methodological and evidentiary difficulties, according to a study entitled Corporate Governance and Performance (published in 2005) by Hermes Pensions Management Ltd. The authors of the report argue that the problem that researchers face is not only to define what is meant by ‘corporate governance’ but also what amounts to ‘good’ or ‘bad’ corporate governance. They too, however conclude that there’s a link between a company’s corporate governance and its performance. Bank of Cyprus could be a good case here but more time and evidence is still needed. Perhaps more companies than we think are following BOC’s steps. However a significant difficulty exists, particularly with opinion-based research, due to its reliance on circumstantial and subjective evidence.

 

Michael S. Olympios is Chief Consultant at Allied Business Consultants

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