05.30.10
Is Corporate Governance a ‘Religion?’
A consultant raised the question on the LinkedIn network, “Are Corporate Governance Ratings more like Religion than Science?” He linked to a number of studies which purported to indicate that governance ratings can be capricious or arbitrary, and I had the impression that the goal of the exercise was to debunk the role of governance rating services. The methodology of many of the studies cited was somewhat suspect, and while I have never doubted that there is a great deal of arbitrary judgment involved in arriving at a particular rating, in my experience the services have been good at identifying lists of companies whose governance required further attention: among those companies have been a high percentage of truly dangerous situations, and many of the catastrophes of recent years among them. Obviously, we are dealing with small numbers here and granular statistics; fortunately, companies don’t blow up every day, and one would need to have forty or fifty years of evaluations before one would have enough data points to come up with incontrovertible evidence of clear correlations between governance screening and corporate failure. Instead of tackling the ratings question (which should really be worded, ‘Is Trust in Particular Corporate Governance Ratings more like Religion than Science?’), I responded to the underlying issue, which I believed to be whether corporate governance had become a religion for those active in the field.
Corporate governance may be like religion for some, but it needn’t be. Most of the studies attempting to discredit governance have two fundamental flaws: first, they assume that there should be evidence of governance “events” affecting price performance in the short- to medium-term, and second, they always look for evidence that higher governance standards have a positive effect upon the economic performance of companies adopting them.
WEAK GOVERNANCE IS A RISK FACTOR. It primarily manifests itself in corporate catastrophes, and secondarily in secular declines of companies. As one of the best early studies of governance and performance ever done, the Gompers, Ishii, and Metrick study of 2003, clearly showed, the principal driver of outperformance was avoidance of companies headed for disaster. As more recent studies, as well as the ongoing outperformance of The Governance Fund indicates, excess returns can also be made from improvements in the standards of companies which had been hampered by poor governance, BUT ONLY WHEN THERE ARE OTHER PERFORMANCE DRIVERS AS WELL.
No one is going to buy a company merely because it is well-governed any more than they will entrust their wealth to an investment advisor or their bodies to a physician merely because he is law-abiding. The point is that if he is known not to be, they would be taking foolish risks by trusting him, and the same thing is true of corporations. Companies with substandard governance (assuming it IS substandard, and not merely at some variance from a compliance-defined norm) are at risk of nasty things happening to them. They may also be at risk of long-term decline, due to poor internal policies, and a corporate culture that makes appropriate response to problems difficult or impossible.
To the extent that the market becomes aware of governance risk (evidence is that most investors could not care less, because no one on the sell side tells them to) weak governance could conceivably become a drag on performance, but being innately long-term, it would seldom dominate over a sexy growth story or an exciting new product. It does mean that there might be a time bomb ticking inside the company, and wise investors would do well to keep this in mind in determining how much of their wealth they want to risk that the bomb does not explode while they are involved.
To look for other sorts of correlations and performance links is probably futile, because that is not how risk management works. I would suspect many of these studies come from a pre-determined desire to debunk the whole enterprise. I would turn the proposition around, and ask “Is disbelief that corporate governance may be an important factor a religion?”