Question

Will investors pay extra for the shares of a company with good corporate governance? give a study cases

Answer 1

Corporate Governance can be simply described as the system by which companies are directed & controlled. More specifically, it is concerned with the structures & processesassociated with management, decision-making & control in organisations.

Before the Industrial Revolution, businesses tended to have only one active owner, or a small no. of active owners. The Industrial Revolution brought about a need for large amt.s of capital to be raised & led to the emergence of the "incorporated" corporations. These had the advantage of being distinct form the owners,thus permitting a large no. of shareholders (in the case of companies) & enabling interests in the enterprise being bought & sold without affecting its ongoing continuity..However, these arrangements definitely made doing business more complex as compared to the past where businesses were run be sole owners and, thus led to some form of regulation & control to protect the interests of the owners/shareholders. Corporate governance arrangements then got embodied in the various company legislations & common law.

Corporate Governance has become even more important today, as many Americans recognize the need to develop a more robust corporate governance regime in the aftermath of the financial crisis 2007/2008.  There is ample evidence that poor corporate governance, including weak risk management standards at many financial institutions, contributed to that crisis. For example, it has been reported that senior executives at both AIG and Merrill Lynch tried to warn their respective management teams of excessive exposure to subprime mortgages, but were ignored. These failures of oversight proove that good corporate governance is essential to the stability of the capital markets as well as the economy, & hence for the protection of investors. After the recession period, many Americans lacked trust not only in the stock market, but also in financial institutions and the U.S. economy. According to researchers at the University of Chicago, trust in America’s financial system at that time was at about the 24% level, with many investors expressing concerns regarding both excessive compensation and a lack of integrity among top corporate managers. Only 17% of those surveyed expressed trust in America’s large corporations. It was concluded from the research that a key driver of greater trust of investors is the oversight that comes from robust corporate governance.

Corporate Governance is important for the investors for the following reasons:-

Investors as Owners and the Source of Capital

It is the investors who provide the capital that businesses need to grow, succeed, and create jobs. They are, actually, the fuel that keeps the engine of any economy moving. The vast majority of investors invest their money in the stock markets through a mutual fund, a pension fund, or a 401(k) plan etc. About half of all U.S. households participate, either directly or indirectly, in the stock market; and invest in stocks, bonds, and mutual funds in order to save for retirement, or meet up various expenses.

Corporate governance mean for investors that the owners of the company are those who have paid to own the company’s stock, and that management are merely their employees. The separation of ownership and control is the basis of the modern corporation. It would be neither possible nor desirable for the widely-dispersed shareholders of any public company to come together and manage that company’s business and affairs. As a result, full-time management is essential for public companies to operate, whose efficiency is very much important for the shareholders. That is why shareholders elect a board of directors to represent their interests. Good corporate governance helps shareholders and their representatives to hire the right managers who would be accountable to the shareholders.

Accountability- When corporate governance embodies the principle of accountability, shareholders know that performance will be measured. One important measure of accountability involves executive compensation & a good corporate governance should align compensation with performance. The board of directors is responsible and accountable for creating a framework that best suits the business conduct with its stated objectives. The ultimate goal of good CG is reducing conflicts of interests and acting in the best interests of stakeholders such as shareholders, customers, suppliers, banks, government, society, etc.

Transparency

A second principle of corporate governance is transparency. Without transparency, it is difficult to have accountability. Shareholders can only hold corporate directors accountable if they know what is going on at the companies they own.

The SEC promotes this principle of transparency by requiring that public companies make public disclosure of various types of fully audited informations, including descriptions of a company’s business, its board and management, and financial and operating data, both historical and forward-looking.  

Engagement

A third principle of corporate governance is engagement, that, the shareholders need a way to ensure that their voices are heard. Traditionally, the primary opportunity for shareholders to communicate with directors and management takes place once a year at the Annual General Meeting of Shareholders. However, for most shareholders, it is not practical to attend the annual meeting. To address shareholder concerns, many public companies have recently increased their efforts to engage with shareholders & the shareholder-management meetings and other forms of engagement have increased in recent years. For example, shortly after Johnson & Johnson received a weak 57% approval rate for its “say-on-pay” proposal in 2012, the company’s compensation and benefits committee met with representatives of many of the company’s institutional investors to discuss their concerns. Electronic shareholder forums were created to engage with the retail shareholders. In recent years, common topics for shareholder proposals have included executive compensation, environmental issues, majority voting for directors, and eliminating classified boards.

Therefore, to identify well-governed companies one should look at the following aspects which are generally available for any listed company :- Disclosure practices, executive compensation decisions and details, dividend policies, disclosure of related party transactions, procedure for reconciling conflict of interest between company, members in the board and shareholders.

Apart from the above, investors should check corporate governance principles on treatment of all shareholders equally and fairly; legal, contractual and social obligations to non-shareholders such as employees, vendors and society; number of complaints received from shareholders in a year and how many of them were addressed and how many are still pending and reasons for the same; number of independent, non-executive and women directors in the board and their proportion to the total board size, frequency of board meetings, attendance in the board meeting by various directors, etc. Also whether the company has stated a code of conduct for board members and executives and disclosed it to relevant stakeholders, is an important factor.

Good corporate governance practice is essential for sustainable equity returns. An easy way to check is the corporate governance scorecard of exchanges. For instance, Bombay Stock Exchage has collaborated with the International Finance Corporation (IFC) Washington, for developing a ‘CG Scorecard’ for Indian corporates. This will help companies to benchmark themselves on their corporate governance status as well as provide investors a standardised measure of the corporate governance status of any company. Apart from BSE, many other credit rating agencies such as CRISIL and ICRA also have their own corporate governance indices. Investors can use these reference lists and index to assess the corporate governance practices of firms. In addition to the above,the investors should pay attention for the presence of many large volume related party transactions, inter-corporate loans, especially loans to their own subsidiaries who have poor financials and performance, etc.

In 2000, McKinsey & Company conducted a series of surveys to discover how shareholders perceive and value corporate governance in both developed and emerging markets. Undertaken in co-operation with the World Bank and the Institutional Investor's regional institutes, the surveys gathered responses about investment intentions from over 200 institutional investors, who together manage approximately US$3.25 trillion in assets. Forty percent of the respondents were based in the U.S.

The key findings of the survey are as follows:-

• Three-quarters of investors say board practices are as important to them as financial performance when they are evaluating companies for investment. In Latin America, almost half the respondents consider board practices to be more important than financial performance.
• Over 80 percent of investors say they would pay more for the shares of a well-governed company than for those of a poorly governed company with comparable financial performance. (For the purpose of the surveys, a well-governed company is defined as having a majority of outside directors on the board with no management ties; holding formal evaluations of directors; and being responsive to investor requests for information on governance issues. In addition, directors hold significant stockholdings in the company, and a large proportion of directors' pay is in the form of stock options.)
• The actual premium investors say they would be willing to pay for a well-governed company differs by country. For example, investors say they would pay 18 percent more for the shares of a well-governed UK company than for the shares of a company with similar financial performance but poorer governance practices. They would be willing to pay a 22 percent premium for a well-governed Italian company, and a 27 percent premium for one in Venezuela or Indonesia.

According to S&P, those companies with good CG practices have more stable earnings per share. Due to globalization of capital, companies that seek to attract investors need high scores on governance rating systems if they are to obtain low cost finacing. Long term investors seek markets where their legal rights are protected & those who are using their money can be held accountable. Well managed corporations generally deliver high shareholder value.

For example, academics constructed a CGI (CG index) for all the Korean public Companies & reported strong evidence that higher CGI is correlated with higher market values.Moderate improvements in the CG resultin an increase in market capitalization by 16% of the company's book asset value or 35% of the company's value of common equity. This study suggested that an increase of 1 standard deviation in the CGI increases the level of buy-and-hold return of that firm's share by about 5% for the holding period of the year 2001. Also evidence showed that a qualitative increase in CG increases the level of buy-hold return by 4 to 6% over a year period.

According to KLSE - PWC corporate governance survey in 2002 covering the Malaysian market, it was reported that the institutional investors have indicated their willingness to pay a premium of 10-15% for companies with excellent CG performance records.

Good Corporate governance helps to maintain overall market confidence, renew the country's industrial bases, attract long term investment capital, sustain economic growth and ultimately enhance the nation's economic wealth. As per CLSA, CG is reflection of the quality of management that keep a checks and balances in their company to prevent corporate abuse & mismanagement while ensuring long term sustained high operating performance. Thus investors use CG benchmarks as their investment yardsticks.