Tuesday, 31 May 2011

Stocks & Board Governance - Do the Good Guys Finish First or Last?

Many investors take a keen interest in the ethics and business practices of the companies in which they invest. Leading institutional investors think that taking into consideration so-called Environmental, Social and Governance factors and even active involvement with companies to further such goals can enhance long-term investment returns. For example, the Canada Pension Plan Investment Board's pursuit of Responsible Investing evidently takes up much time and effort because it believes that "... responsible behaviour regarding environmental, social and governance factors by these companies can have a positive influence on their long-term financial performance and therefore, to our investment return". Internationally, many major pension funds subscribe to the United Nations Principles on Responsible Investing, as is evident in the reports on the PRI website.

All investors object to being taken unfair advantage of by crooked or avaricious company insiders. To prevent that happening, shareholders rely upon a company's Board of Directors, in other words the Governance part of ESG. In Canada, the Clarkson Centre for Business Ethics and Board Effectiveness within the Rotman School of Management at the University of Toronto publishes annual ratings for Board Shareholder Confidence that assess various aspects of Board best practice and give an indication of how likely it is that a company Board will serve shareholder interests well. There are two sets of ratings: 1) Companies in the TSX Composite Index for 2003 to 2010; 2) Small and Medium companies for 2009 and 2010.

The big question is how well do the rankings correspond to investment results? Does governance best practice earn the best returns, or at least good returns? To get an idea, we've compiled a few tables below. Note that it is by no means a definitive scientific answer. A Board that is good today may not have been so five years ago; future results are really what we would need to compare, while we compare with past investment performance. Our unproven assumption is that the best Boards today would generally have been better in past years too as improvement happens gradually.

Investment Performance of Top-Rated 2010 Boards - Mixed Results
Taking all 19 companies in the top two ratings CCBE governance categories of AAA and AA shows us that excellent ratings have not guaranteed success. Four top-rated companies have not even managed a positive total return over the past five years. Manulife (symbol: MFC) has had particular trouble. On the other hand, eight companies of the companies on the list have regularly and steadily increased their dividend payouts, as further detailed below. Almost are solidly profitable and the worst rating by professional analysts is Hold, no Sells at all.

Investment Results of TSX Companies vs Board Ratings Overall - Advantage to the Good Guys
When the latest ratings came out in the autumn, the Globe and Mail's Report on Business published Board Games 2010, a series of articles on the ratings which are well worth reading. The material published includes a different version of the TSX table that includes 5-year returns for each company. Filtering through the list, we find that amongst the top 25 scoring companies, 16%, or four, had negative 5-year returns. However, in the entire list of 187 companies, a greater proportion - 26% or forty-eight companies - had negative returns. The well-governed-Board stocks have done better overall.

Dividend Growers & Board Governance - No Discernible Effect
Since we recently reviewed stocks that have been steadily increasing their dividends - here for low-yielders and here for high-yielders - we decided to look at them too. We added the CCBE rating against this select group of potentially attractive stocks to see if they all have high Board ratings. Result: not so at all, as there are just as many dividend growers with the terrible lowest "C" Board rating as with the high AA and AAA ratings. Nevertheless, all the companies with high rated Boards showed quite healthy five-year returns and none had negative returns while none of the losing negative return stocks had high ratings.

Bottom Line
Good governance seems to have had a mild positive effect so far on stock returns but it is not a guarantee of success. It is a useful addition to the mix of factors for a stock investor to assess. Perhaps its best role is to provide a measure of risk to investors on the chances that bad things may or may not come from within the company, either from management or dominating majority shareholders, at the expense of the average individual investor.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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