Wednesday, July 11, 2007

Governance Metrics: predictor of corporate performance?

From an article in the WSJ: Governance Metrics claims that its ranking of corporate behavior is a good predictor of investment returns.
The graphic on the right indicates that companies with above-average scores appear to have significantly positive investment returns compared to companies with below-average or average scores.

The reasons why not everyone's convinced:

- Many of the governance-related studies are sponsored by governance consulting services and others with vested interests.
- The measures chosen are not systematic and vary depending on the study. As a result, top ranked companies by one measure may be poorly ranked by another. Case in point: Google.
"The company made the 2007 "World's Most Ethical Companies" list of governance-tracker Ethisphere, because of its strong code of conduct and positive customer views of its behavior. But Audit Integrity Inc., which scrutinizes accounting behavior and litigation risk, ranks Google poorly. One recent red flag: Viacom Inc.'s copyright lawsuit against Google and its newly acquired YouTube video-sharing site. "

- On my part, I do not have any indication whether the numbers on the left are statistically significant, adjusted for other predictors of returns etc. It is well known in the academic community that it is not easy to find corporate governance variables that are consistently and strongly related to corporate performance.

The rebuttal:

- Just like with any other predictor, once information about a company's governance practices is known, it is quickly priced into the stock.
- From the article: Audit Integrity Chairman and founder James Kaplan says the company tried -- and failed -- to find a connection between share performance and corporate governance alone. After including the accounting analysis, however, the firm's top-rated large companies posted better returns than the Standard & Poor's 500-stock index.
The link between accounting quality, litigation risk and corporate performance is harder to refute based on several academic studies on the topic.
- Some governance variables - such as the number of antitakeover provisions in the charter - may be more remotely related to corporate performance than others such as disclosure transparency. These studies help direct our attention to what matters.

1 comment:

Kathleen said...

Sam, agreed that the market adjusts for knowledge of questionable governance or accounting practices. However the utility of something like Audit Integrity's model is that it mines financial reporting and news for nothing but integrity issues -- i.e. management behaviors that appear to diverge from the best interess of the shareholders. This concentrated focus, especially applied to a universe of 8,000 plus public firms, suggests there is a good chance it's ahead of the market in awareness of potential problems.

I work for Audit Integrity, so take this with a grain of personal bias, but I've seen their internal research of results compared to the market. Month over month, the average returens of very high risk companies are significantly lower than market averages. The very low risk companies have a marked alpha over the averages. There have been occasional exceptions, notably in extremely bullish markets.

There has been third-party verification as well. Within the last month, Audit Integrity put their highest and lowest risk scores in competition with the buy and sell recommendations of the 42 equity research firms on Investars. With judgements based solely on accounting and governance factors, they did better than two-thirds of the other firms in producing market returns. In negative recommendations alone, they ranked at the top or near-top of most cuts of indices/time period.

This suggests that the analyst firms -- from the big investment banks to the independent quant shops -- aren't fully factoring in these issues in their analyses.

Looking solely at corporate integrity, in terms of management alignment with shareholder interests, offers a very different perspective than traditional approaches to equity analysis. Clearly it is often a contrarian viewpoint, but it also can point to potential time bombs in a portfolio and suggest companies that are worth a second look, either for buy-and-hold or for shorting.

The risk profiles they produce are very transparent in terms of how they came to their conclusions. If you'd like to view a sample risk profile or learn more about the methodology, their site is If you'd like to see a profile on a specific company, contact me and I'll send it to you.

BTW, the Wall Street Journal article illuminated an emerging confusion about what corporate integrity means. Obviously the definition of integiry is going to reflect the interests of the group that is make the judgment. There are community and sustainability issues, employee practices, product quality and customer relations.

However, the prime directive in the business world is to make money in an efficient way that sustains the business entity and generates profit for the owners. If that basic level of success doesn't exist, there's not much else to discuss, except perhaps how gracefully the remains will be dealt with. Likewise, if management can't be trusted to deal honorably with the owners of the company, how can they be trusted in any other way?