Corporate governance (CG) may look very technical and dry, but it is the key to understanding how a company is operating. To portfolio investors, understanding corporate governance can open a clear view of how a company operates. This guide simplifies the essentials, helping you make informed investment decisions.
About Corporate Governance (CG)
Corporate governance is a set of practices, norms regulatory procedures to control of a business. It describes the paradigm by which corporations achieve their objectives and who to account for (shareholders, workers, customers, and the community). In first instance, corporate governance ideally guarantees responsible and ethical conduct of corporations. It serves as a shield against mismanagement and fraud which can have a devastating effect on shareholders.
Why Corporate Governance Matters to Investors?
Proper corporate governance has a considerable impact on both the performance and the reputation of the company. It is also a measure of whether a company is capable of managing crises, adapting to change, and growing over the long term. According to a McKinsey study, 79% of investors indicated that they are willing to pay a premium for companies with solid governance practices.
For instance, a well-governed company is more likely to:
- Deliver consistent returns.
- Manage risks effectively.
- Align management’s interests with shareholders’ goals.
Key Elements of Corporate Governance
- Board of Directors: Corporate governance is of paramount importance by the board of directors. A robust, independent, and diverse board can guarantee that the actions of management serve the interests of shareholders. Non-executive directors on the boards should also be non-biased to give an unbiased oversight. Companies having more than 50% independent directors tend to have been financially more successful. Research from Harvard shows that diverse boards can increase profitability by up to 19%.
- Disclosure About Transparency: Transparency is one of the important aspects of good governance. Rather, we can say the result of corporate governance is transparency. Businesses should present accurate information about their overall operations, financial performance, and future plans.
What to look for:
- Regular publication of audited financial reports.
- Clear communication regarding executive compensation.
- Open acknowledgment of challenges or risks.
- Shareholder Rights: Good governance is the practice of ensuring that shareholders are involved in major company decisions. Such things as voting rights on issues such as mergers, board membership, and executive compensation.
- Risk Management: Effective risk management practices ensure that companies can identify, assess, and mitigate potential threats. These risks may extend from and involve financial risks to environmental risks. Companies that focus on risk management are less likely to suffer drastic fluctuations of the stock price.
Red Flags for Poor Corporate Governance
Warning signs of bad governance should be taken into consideration by an investor. These include:
- Excessive Executive Compensation: High pay without performance-based criteria is a red flag.
- Related-Party Transactions: Deals benefiting insiders rather than the company are concerning.
- Limited Disclosure: Companies that withhold information may have something to hide.
A research paper by PwC reveals that companies lacking solid governance structures are 70% more likely to be subject to regulatory sanctions.
How to Evaluate Corporate Governance?
Investors can use the following methods to assess governance quality:
- Review Proxy Statements: These materials, on a company's website, or the SEC's EDGAR database, include information about board membership, executive compensation, and voting privilege.
- Examine ESG Ratings: Environmental, social and governance (ESG) ratings, issued by companies such as MSCI or Sustainalytics, can give us a picture of what a company is doing with its governance.
- Attend Annual General Meetings (AGMs): AGMs allow shareholders to interact directly with company leaders. They also give an idea of the way in which the company responds to its shareholder questions.
The Financial Impact of Good Governance
Companies with strong governance practices consistently outperform their poorly governed peers. A study by Credit Suisse found that firms with good governance achieved returns on equity (ROE) 3% higher than those with weak governance over a decade. In addition, these businesses also typically have low cost of capital and high access to financing. For example, Unilever’s governance reforms in the early 2000s helped reduce its borrowing costs by 2%, saving millions annually.
The Role of Investors in Shaping Governance
Investors are not a silent audience; they can shape governance behavior in the following ways:.
- Engagement: Actively communicating with boards to address concerns.
- Proxy Voting: To endorse resolutions by voting on those that support open and accountable governance.
- Collaborations: Joining investor coalitions (as examples for the Principles for Responsible Investment (PRI) to demand improvement of rules.
Final Thoughts
Understanding corporate governance is essential for anyone looking to invest wisely. Through achieving transparency, accountability, and ethical behavior, investors can contribute to portfolios that are attractive to companies that promote sustainable growth. Good governance is not only concern for the stake holder; it is a rule book for the future. For an investor, looking at governance can save you from mistakes and highlight opportunities that others might miss. So, the next time you consider investing in a company, take a closer look at its governance practices it might just be the edge you need.
