Does good governance pay?

Mar 31, 2016
<p>The answer is yes &ndash; for small and mid-caps, says PIRC</p>

‘We want to understand what the key factors are that change a company’s [corporate governance] rating within our model from E to A,’ says Alan MacDougall, managing director and founder of Pensions & Investment Research Consultants (PIRC), at the corporate governance and shareholder advisory consultant’s recent seminar.

He was talking about the governance risk rating model that PIRC, which advises institutional investors with assets in excess of £1.5 tn ($2.2 tn), has developed, rating companies across UK, US and European developed market indices from A for good governance to E at the lowest end of the governance spectrum.

‘We fundamentally believe all companies exhibit governance risk,’ MacDougall says. ‘Obviously some exhibit much greater risk than others.’

But having assigned companies a governance rating that MacDougall acknowledges ‘is a PIRC view, based upon our view of the value of the governance indicators we look at’, the firm wanted to find out what these governance ratings meant in terms of the share price, so it joined forces with Rick di Mascio from financial data analysis firm Inalytics.

Governance and share price

‘We wanted to know whether there was actually an economic point to doing this, as distinct from a social good perspective,’ explains di Mascio. ‘In other words, [we wanted to] answer the very simple question: does good corporate governance actually lead to good share price performance?’

And after collecting two years of data (they now have five years of information to go on) what they found was that it is indeed true: the better the corporate governance, the better the share price performance.

‘The really interesting thing from our perspective in terms of the specific results is that there is a clear and strong relationship between the A-rated stocks and outperformance,’ says di Mascio. ‘As you then drop from A to B, the performance worsens and when you get down to the Ds and the Es, it is terrible. So there is a one-to-one relationship: as you drop down the ratings, you also drop down the performance table.’

There is a catch, however: it doesn’t apply to big companies. What di Mascio saw is that the relationship between governance and share price performance simply becomes more random at large and mega-cap companies. Where the relationship is strongest is in the bottom 20 percent of the index, at the small and mid-cap companies.

‘And that makes a lot of sense,’ di Mascio says. ‘If you’re running a small or mid-sized company, your reputation really matters. It is a material factor and I think the management at mid and small-sized companies actually have an interest in [good corporate governance].’

Why would you own Es?

Di Mascio and his team found another association as well – between governance and volatility. ‘Not only are the Es absolutely terrible performers but they’re also significantly more volatile and risky,’ he explains. ‘They’ve got terrible returns and very high volatility.

‘The other interesting thing is that the As have the second-highest level of volatility, but because the returns are so significant, the information ratio is actually above one. You would have to really question why you own Es over As.’

Increasing engagement

For MacDougall, risk-based portfolio analysis could add a new dimension to stock selection, but what PIRC is really pushing for is greater engagement. Knowing whether the governance at any given company also runs parallel to poor share price performance should spur pension funds and other asset holders to ask questions.

‘It’s a basis for saying to a client, ‘You’ve got 25 stocks in the E category here in your UK equity portfolio. We think that on this assessment, they exhibit the greatest governance risk,’ MacDougall says.

As di Mascio adds, there may be a good reason to own these stocks – they could be recovery stocks for example – ‘but you need to know that you own them and you need to know whether they’re actually justifying themselves economically.’

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