The exponential growth in investor interest for ESG opportunities has been a multiyear trend that is showing no signs of slowing down. Among ESG factors, governance (the “G” of ESG) has become an increasingly important factor, and particularly so for active managers. Do you evaluate the management and policies of companies that you are either invested in or are considering investing in?
While many people know of and have opinions of well-known executives at large companies, individual investors are oftentimes unaware of who runs the companies they invest in and, perhaps more importantly, the governance policies of those same companies. Here are some ways you can incorporate governance research into your system.
Consequences of bad management
Poor corporate governance systems can be catastrophic for investors. Think Enron, WorldCom, and numerous other companies whose scandals can be attributed, in some part, to poor governance policies.
While it's critical to assess the underlying business metrics of a company (e.g., revenue, earnings, and cash flow growth), overlooking governance policies can be a mistake. And according to research from MSCI, governance concerns are prevalent for many companies worldwide (see Percentage of global companies with governance concerns chart).
Not surprisingly, governance quality is becoming an increasingly important factor for professional investors, but is oftentimes overlooked by individual investors.
Tips for evaluating management
So what makes up "good governance?" Obviously, management and board members should have the needed experience and qualifications to execute on the company's short- and long-term goals. Companies with good governance typically exhibit accountable and transparent governance policies, with diverse and independent boards, offer compensation incentives that align with shareholders, and have sound capital allocation policies. Strong corporate governance systems address potential conflicts of interest among stakeholders (e.g., managers implementing policies that benefit themselves, rather than shareholders).
Here are some other good governance guidelines and qualities you might look for:
- The board meets at least annually and without the presence of management.
- There is an annual review of the board, and directors are elected annually (i.e., not on a staggered schedule).
- The auditor does not have conflicts of interest with the firm.
- Performance of the company dictates compensation reviews for management, and not the compensation packages of comparable companies.
- The company's board members are not interlinked with other company board members. For example, a member of the board of Company A and a member of the board of Company B should not be on each other's boards.
- The board doesn't allow pro-forma earnings (essentially, earnings "before the bad stuff") for public use.
- The board uses independent counsel (i.e., not in-house counsel) when needed.
- Board actions generally do not limit shareholder rights, including proxy access and attendance at meetings.
- The company doesn't use anti-takeover provisions (like classified boards and supermajority vote requirements).
Of course, there are other factors that you could look at, and there are different frameworks that can be utilized. If you want to know what professional investors are looking for, the graphic below illustrates some of the key governance factors that some funds place a particular emphasis on to help avoid stocks with significant corporate governance risks.
Tools and strategies for G research
A systematic approach
There are several ways you can dig into the governance policies of a company. Public filings contain much of this information, as well as public statements issued by the company.
Additionally, some data providers offer ESG ratings—including ratings for governance policies. Other financial institutions, including Fidelity, offer ESG funds based on proprietary ratings (see sidebar). If you are interested in ESG investing and don't have the time or experience needed to do this research, you might consider ESG funds that focus in part on evaluating governance policies.
If you are looking to more closely align your principles with your investments by incorporating an ESG approach, looking at management and their governance policies may help you avoid making a costly mistake and achieve better investing outcomes.
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