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Poor corporate governance can lead to ineffective strategic decisions and a weak culture and management that can ultimately lead to increased environmental and social risks. For investors, such risks can destroy the value of a business, irrespective of the attractiveness or price of its assets or its market share.
Investors are increasingly recognising the importance of governance in their investment decision-making. Given the consequences of governance failure on corporate value, they are looking more closely at indicators of governance qualities such as the board, its approach to compensation, and shareholder rights to identify risk factors that could have an impact on performance.
There is a growing focus on governance as a driver of quality, especially in emerging markets. We think governance quality begins with the board of directors.
According to our research, which is based on Institutional Shareholder Services’ QuickScore product, improving governance can help European and US companies outperform. In Europe we found that firms that improved their board scores outperformed the Stoxx Euro 600 index by 2.5 per cent between 2014 and 2016, while those with improved scores for their compensation practices outperformed by 3.5 per cent.
For the US, it is the improvement in the overall governance score that matters rather than the sub-scores for the board, compensation, audit practices and shareholder rights – the reverse of what we found in Europe. Using QuickScore assessments, our analysis showed a 12.7 per cent outperformance of the S&P 100 index between 2013 and 2016 for US companies that improved their overall governance score by at least three points on a three-year average.
Governance is increasingly viewed by asset owners and investment managers as useful in spotting factors that may impact risk, performance and profitability over the longer term. But it is not simply a box-ticking exercise. It involves a qualitative evaluation of corporate practices and of the people involved in their development and outcome. It is also concerned with the evaluation of complex issues, varying in size and scope from the quality of management to effective risk-management.
Many of the corporate scandals of the past decade resulted in a reshaping of the governance landscape on a global basis. Reforms include revised corporate governance codes across Europe and the US and increased investor attention to issues such as board independence, accountability and diversity.
And at individual companies, governance failures have often led to culture change, with the introduction of new management plus increased accountability and supervision at board level, with the removal or appointment of non-executive directors. Some of the biggest governance failures of the past decade have highlighted a weak risk culture as a primary cause.
The challenge for investors lies in understanding how the culture of an organisation is driving its strategy and risk-taking. And this is where the board has a vital role to play.