By Christopher Burba Ever since the fallout of financial scandals at Enron, WorldCom, and other well-known and lesser-known companies, investors have been paying more attention to corporate governance than at any other time in history. But little, in Standard & Poor's view, has been said about how to incorporate the evaluation of governance into an investment strategy -- and whether it even pays off to do so.
"I believe 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," says Kenneth Shea, head of S&P global equity research.
THREE CRITERIA. 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? Can stock options be repriced to benefit the manager, regardless of his or her performance?
The third 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.
LOWER VOLATILITY. 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.
We note that some of these findings are debatable, and other studies argue that no relationship exists between quality of corporate governance and investment returns. Shea says this discrepancy is largely due to insufficient historical data needed to evaluate governance quality.
REDUCING RISK. However, from the standpoint of S&P's equity research, the bottom line is simple: Poor corporate governance introduces risk factors that must be incorporated into analysis. Strong governance reduces risk.
"By analyzing the state of a firm's corporate governance, the analyst may ascertain whether the company supports effective management and governance practices that promote higher returns on shareholder capital," says Shea.
He notes that corporate governance quality can influence relative valuations determined by S&P's analysts. And discounted cash-flow models can be adjusted for a risk premium, based on weak governance, where necessary. S&P equity analysts evaluate corporate governance by reviewing companies' public filings such as 10-K forms and proxy statements.
A MATURING BULL. Analysts also incorporate data from third parties such as Institutional Shareholder Services (ISS). ISS, which ranks companies against a benchmark index as well as peers, categorizes its evaluation into four areas: Board composition, management issues, audit issues, and takeover defenses.
Incorporating corporate governance into investment decisions is particularly important in the current environment, says Sam Stovall, chief investment strategist for S&P. The stock market advance that began in October, 2002, is now well into its third year. And capital appreciation tends to be less broad-based as bull markets mature. According to Stovall, this puts pressure on the investor to find stocks of companies where earnings, balance sheets, and governance are of higher quality than the rest of the pack.
Among stocks in the S&P's coverage universe with 5-STARS (strong buy) rankings, 10 have corporate-governance quality rankings of 90 or higher relative to the benchmark index, and 90 or higher vs. peers, based on ISS data. A ranking of 90 or higher compared with the benchmark index, such as the S&P 500-stock index, means the company outperforms at least 90% of the components in the index. A ranking of 90 or higher vs. peers means the company outperforms at least 90% of its industry peers.
The 10 companies are AES (AES), CIT Group (CIT), Colgate-Palmolive (CL), Cooper Companies (COO), Fifth Third Bancorp (FITB), Guitar Center (GTRC), Kaydon (KDN), Microsoft (MSFT), Powerwave Technologies (PWAV), and Elizabeth Arden (RDEN). Burba is a reporter for S&P Global Editorial Operations