30 November 2022
In the world of Environmental Social and Governance (ESG) investing, many people typically think about the E and climate change and increasingly the S, particularly with the cost-of-living crisis in the UK. The G is often poorly understood yet governance is at the heart of delivering shareholder and stakeholder value. Without proper checks and balances, directors may behave in a way that maximises their gain at the expense of shareholders, stakeholders (employees, contractors etc.), its wider community and the planet. Poor corporate governance poses a substantial risk to the long-term performance of companies, potentially leading to hefty fines and even bankruptcy.
Recent corporate governance scandals illustrate this. The board of a national construction firm failed to adequately manage the company’s principal risks by allowing it to take on high debts while trading on low margins leading to liquidation. This resulted in loss of revenue for many subcontractors and thousands of employees worrying about job security. The board of a major UK fashion retailer was found to have failed in its oversight duty for poor working conditions at its warehouses, including paying less than minimum wage and punishing staff for taking water breaks and time off for illness.
At CCLA we adopt a rigorous process to identify and remove companies with high governance risk from our investment universe, so our portfolios are biased against companies with low corporate governance ratings. We have developed a process that includes bespoke quantitative and qualitative analysis to identify and remove companies with weak governance from our portfolio.
Good corporate governance on the other hand, not only protects against the worst-case scenario but can be an indicator of financially healthy firms too. Our rating incorporates metrics related to:
- Capital stewardship: management quality, the ability to generate cash and manage growth.
- Accounting quality: the quality of the company’s financial statements.
- Board composition.
- Ownership structure.
We correlated our governance indicators against financial metrics which reflect CCLA’s quality and growth investment style. Many of our financial indicators are cash based:
- The Price to Book ratio. Firms with low price to book ratios are often referred to as ‘value companies’ and firms with a higher price to book ratio are often referred to as ‘growth companies’.
- Cash Flow Return on Investment (CFROI) which is an aggregate measure to look at how profitably a firm can generate cash from its projects.
- The HOLT Growth Factor which gauges the degree to which a company is likely to have higher or lower future cash flow growth relative to its peers. This is a forward-looking measure based on previous CFROI trends and other cash related indicators.
- Operational quality which assesses the relative attractiveness of a company based on the variability of CFROI.
- Dividend yield.
CCLA seeks to avoid the worst scoring companies
Source: CCLA as at 31 July 2022.
*Represents securities held in CCLA portfolios in all asset classes.
Our indicators are taken from MSCI and HOLT Credit Suisse. Our results showed that well governed companies enable management to allocate capital in a way that is profitable, thus making efficient investments that create shareholder value. Similarly, good governance was positively correlated with a firm’s ability to generate cash from projects. This is an important measure of creating shareholder value. There was a weaker but still significant correlation with the likelihood of future cashflow growth and good governance.
Governance and quality financials go hand in hand
Source: CCLA
** Analysis based on 9,305 companies between July 2019 and July 2022.
It is therefore no surprise that if well governed firms are better able to generate cash and profits from projects, they are also more likely to pay out dividends. We must note however, that dividend pay-outs are a two-edged sword, signalling profitability and the lack of growth opportunities, the correlation was significant but much weaker. Finally, while price to book was also positively correlated with good governance, the relationship while significant was less linear. ‘Value companies’ are not always out of favour due to poor governance practices.
However, there are exceptions to this rule. We identified some slight variability between industries. For example, in utilities, accounting quality was less correlated with financial indicators and in the real estate and material sector the same was true for board composition. In the energy sector, broader ownership was not significantly correlated with better financials.
As with all models, they are only an approximation of reality. Because of this divergence, we currently (as at 30 November 2022) hold a handful of companies that are ‘high risk’ on our governance score. This could be due to unconventional governance structures to protect from the short-termism of wall street, or businesses owned in a large block by the founding family. In these cases, our review shows that, for example, other accountability mechanisms have been put in place or a long track record of respecting minority shareholders. In these cases, we seek approval from our investment committee.
We conclude that good governance is an indicator for good financial prospects and therefore helps us in our selection of quality companies, as poorly governed companies present a more significant financial risk.