Investors should look at how companies are run

Date: January 6, 2021

First published in Business Times on 22 November 2020

Picking firms with strong governance will reduce risk of loss due to corporate misbehaviour

When it comes to choosing stocks, most investors use traditional financial metrics such as earnings, return on equity and net asset value. Some might look at charts while others use a combination of fundamentals and technical indicators.

It is about time retail investors looked at another important aspect – the company’s corporate governance. This is because companies that are well governed tend to perform better than those with weak or poor governance.

A research paper, “Good governance driving corporate performance?” by Deloitte and Nyenrode Business University, found there is conclusive evidence that good governance variables – namely, board independence, diversity, remuneration, characteristics of the chief executive officer, oversight and ownership structure – are all important in enhancing corporate performance.

In 2017, a Boston Consulting Group study noted: “An analysis of more than 300 of the world’s largest pharmaceutical, consumer goods, oil and gas, banking and tech companies found that those with more ethical operations… make bigger profits and are more highly valued than competitors.”

In that same year, a Singapore Management University study noted that the Singapore Corporate Governance Award winners over a period of four years outperformed the Straits Times Index.

Importance of governance

Corporate governance practices have gained more prominence since the high-profile collapses of a number of large corporations such as Enron and WorldCom and, lately, Wirecard, most of which involved accounting fraud and corporate misconduct.

In Singapore, there have been several high-profile corporate scandals that can be traced to weak governance, starting with the Pan-Electric crisis in the mid-1980s, to China Aviation Oil, Citiraya Industries and Accord Care Customer Services in the early 2000s, followed by the S-chips debacle between 2004 and 2010.

In many cases of corporate failures, the root problem was insufficient risk controls.

In a study of listed companies’ annual reports, the Securities Investors Association (Singapore) or Sias found that:

Given the current Covid-19 pandemic and the added stress and risks that companies are faced with, the lack of a risk management policy and guidance of risk by the board can result in mismanaging possible opportunities while underplaying potential threats.

To illustrate the importance of having proper risk controls, consider that the distress which water treatment firm Hyflux finds itself in can be traced to insufficient attention to the risk of diversifying away from its core business into power generation.

Questions to ask

As it stands today, basic investor education mostly focuses on the traditional financial metrics. This is the old textbook approach.

What investors must learn also is that to obtain a complete picture of their investments, they should take into account corporate governance practices. To do so, they have to go beyond finance-based principles.

Most importantly, they must understand that companies are only as good as their employees and, in this regard, that senior management and the board are particularly crucial in instilling a culture of transparency and honesty.

Investors should begin by familiarising themselves with the principles and provisions of the Singapore Code of Corporate Governance – not just its letter but also its spirit.

When considering a company as an investment, they should ask how closely it adheres to the code and, among other factors, look at issues such as whether there is enough of an independent element on the board, how much diversity is present and how it treats its shareholders.

Make use of available resources

A good starting point would be to use the Singapore Governance and Transparency Index (SGTI) scores that are provided on the extreme right-hand column of the Singapore Exchange’s Stock Screener pages under the heading “GTI”.

The SGTI is compiled by the National University of Singapore’s Centre for Governance, Institutions and Organisations (CGIO) and is aimed at assessing companies on their corporate governance disclosure and practices, as well as the timeliness, accessibility and transparency of their financial results announcement.

Companies are scored on the basis of board responsibilities, rights of shareholders, engagement of stakeholders, accountability and audit, and disclosure and transparency.

Just to illustrate, some of the questions the SGTI asks are whether the chairman is an independent director, whether at least one of the independent directors has experience in the industry the company is in, and whether shareholders have the opportunity to approve remuneration for the non-executive directors.

Similarly, investors can augment the SGTI with Sias’ Corporate Governance Awards framework, which rates companies based on five areas, or Stars: shareholders’ rights and equitable treatment; transparency and disclosure; accountability and audit; responsibilities of the board; and stakeholders’ roles.

The Stars scoring system was developed with the CGIO and categorises companies into five bands. Data is also provided for previous years so investors can track whether the governance practices of prospective companies have improved over time.

By familiarising themselves with the SGTI and Stars, investors will learn how to take an active interest in the businesses they are putting their money into and to ask the right questions when evaluating companies and their managements.

If they are unable to do so, they can rely on the questions Sias poses on every company’s annual report.

If more shareholders do this, then the corporate sector will have an incentive to improve and change for the better. Governance-savvy investors, through their actions, can also help instil proper market discipline, which is especially important in a regime that is heavily reliant on disclosures.

Today, good corporate governance has evolved to include not just strong internal accounting and risk controls that would mitigate the chance of financial loss, but also a whole range of ethical, honest and transparent practices.

A well-governed company is one that manages its relationships properly, particularly how its management, board of directors, its employees, its stakeholders and shareholders deal with one another.

There should be mutual respect on all counts and this should also extend to external relationships with customers, regulators and the wider community, the ultimate goal being to reduce conflicts of interest and to ensure the company acts in the best interests of stakeholders.

There is, of course, no guarantee that strong governance will definitely translate to higher stock prices. But picking companies with strong governance will help reduce the risk of loss due to corporate misbehaviour and it would complement the traditional approaches of using fundamentals and technical analysis. As a result, investors would surely be better off.

  • The writer is David Gerald, Founder, President and CEO of the Securities Investors Association (Singapore)