A Crash Course On Corporate Governance

26th Jun '19 by Jack Brumby

5 comments 3952 reads

We should be thankful that stock analysis is generally quantitative. The net profit margin is net profit divided by revenue. A company’s gearing is the ratio of debt to equity. Corporate governance, on the other hand, is a little trickier to gauge.

How do you assess the independence and objectivity of a company’s board of directors? And how to judge the aptness of a chief executive’s remuneration? As shareholders, we are the owners of these companies. We are the bosses of the bosses (in theory, at least) and we deserve to know how our companies are run - because when they are governed poorly, things tend to blow up.

So why does looking at board structures, considering executive compensation and the rest of it sometimes feel like an afterthought? It is an important part of not just the risk equation, but also the potential reward.

‘Good’ corporate governance and why it matters

Studies have repeatedly drawn a link between superior corporate governance and positive share price performance. A study in 2007 found that the best-governed companies (according to the ISS Corporate Governance Quotient, which rates publicly traded companies in terms of the quality of their corporate governance) generated returns on equity 23.8% better than those of poorly governed companies during the year reviewed (‘Corporate Governance Study: The Correlation between Corporate Governance and Company Performance’, Brown and Caylor, 2007).

This makes sense given that a good corporate governance system should 1) mitigate conflicts of interest among stakeholders (especially between managers and shareholders), and 2) ensure that the assets of the company are used productively and in the best interests of the investors and other stakeholders (‘do you really need the corporate jet for that, Dave...’).

Other responsibilities include: describing the rights of shareholders; defining manager and director governance responsibilities to stakeholders; ensuring fair treatment between stakeholders, and promoting transparent and accurate disclosures concerning trading operations, risk, and financial position. We can get a reasonable impression of corporate governance by looking at a company's annual reports.

What to do now

Steps you can take to gauge the quality of a company’s corporate governance include investigating the following:

How is the Board composed and are members sufficiently independent? Looking at the annual reports, the Board profiles on the company’s website, and doing a little googling can help here. Is the Board professional or does it look like an old boy’s club? Do members…

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Mike888

27th Jun '19

It's a peculiar thing governance, its existence, structure and content give you confidence, and yet it's only ever as good as the quality of the members within it. A qualification tells you nothing other than that person can study and retain that knowledge. Age tells you nothing other than that person is either young, old or somewhere in between.

When I invest, I invest in management, as it is management that can sink the unsinkable or rescue the unrescuable. However I do not look at how the board is structured, I pay little regard as to who is on it, although a change to it will always trigger my attention.

So how can I say I invest in management if I don't expend any effort in getting to know them, by quite simply measuring them on their ability to achieve what they state they will. By having regulatory reports that are easy to understand and are honest and transparent. A company that continually over promises and under delivers, or publishes an RNS requiring a Mensa IQ to understand, then I'm afraid, in my book, their management is poor regardless of the governance structure they sit within. They do their company a disservice and do not deserve my investment in them

Trident

28th Jun '19

It maybe useful to have within Stockopedia to have a metric based on certain key info Corporate Governance,

The difficulty is that dodgy management have an infinite inventiveness for avoiding corp gov perameters, so perhaps a 'Trust' guide

pj8

I write about corporate governance in the Investors Chronicle - and the latest "No Free Lunch" highlights the very problems (at £JD.) that Jack highlights: an executive chairman who's also the chief executive, who chairs three other companies, including QUIZ (LON:QUIZ), and who's being awarded an excessive pay rise (£6m). You can form your own view about how independent the directors are. The award is due to be confirmed by shareholders at the AGM on 3 July (probably a foregone conclusion because the Pentland Group owns 57% of the shares).

When high pay hits the headlines, it's often because of performance-linked share awards (LTIPs) awarded three years earlier. The performance criteria should be triggered as the company achieves its strategy - successful outperformance generates a double whammy: the awards vest in full and the share price goes up. Share awards are much more common than share options - and prudent companies buy the underlying shares in the market at the time of the award. JD does not do this, but had it awarded a million shares a few years ago, it would have cost it in cash less than £1m and by the time the award vested, the shares would have been worth £6m. In other words, for successful companies, "pay" is driven by investment gains - and it's the market, not the company, that funds most of the awards.

cic

1st Jul '19

The article seems to confuse corporate governance with good directorship. A company can tick the corporate governance boxes but still have corrupt managers. I always check out other companies that directors have been involved with at Companies House. Don't just take the disclosures in the Annual Report - some directors have a habit of conveniently forgetting about past associations that may show them in a poor light. Almost whatever the quantitative metrics of a company, if due diligence on directors throws up something I don't like, I will not invest. .

Jack Brumby

3rd Jul '19

Hi cic,

Good point about Companies House. It would be quite interesting to draw up a checklist of things you can do to quickly investigate managers and I'd put that on the list. That's probably an article right there, actually...

As for confusing corporate governance with good directorship - I'm not sure I agree. One quite naturally leads to the other seeing as one of the key points of corporate governance is to ensure the company is run responsibly.

I tried to keep this article high level and away from specific rules and processes as I'm not sure there is a 'one size fits all' solution in terms of specific policies, but there are perhaps more universal things to look out for regarding inputs and outputs of corp gov such as board composition, executive compensation, etc.

I agree that good corporate governance does not necessarily equal satisfactory management (and that, often, you stand to learn more doing DD on the latter than the former).

A crash course on corporate governance

‘Good’ corporate governance and why it matters

What to do now

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Jack Brumby

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