Thursday, April 2, 2009

Governing Governance

In a previous post, we discussed the potential pitfalls of investing in companies with poor corporate governance structures. But how can an investor protect himself? There are two basic ways. First of all, the investor can become knowledgeable about what makes for good corporate governance, and then study up on each company in which he is interested in order to make sure it follows practices in accordance with sound corporate governance. The second method is to take advantage of the information published by the companies that specialize in rating and reporting on the governance practices of public companies.

A full discussion of what makes for good corporate governance is beyond the scope of what can be provided in this one article, and we have covered some of the basic points in previous articles on corporate governance. Therefore, this article will focus on what's available for those interested in pursuing the second method.

Governance Metrics International (GMI) is a company that has developed a proprietary corporate governance rating model that it has applied to over 4000 companies. The premise behind the company is that firms with superior corporate governance practices generate superior returns. GMI can be contacted for those who wish to receive a sample report.

Standard and Poor's also produces a Corporate Governance Score (CGS), based on the following criteria:

  1. Ownership structure
  2. Shareholder rights
  3. Transparency and disclosure
  4. Board effectiveness
Based on how a company is rated in the above four factors, it is given a CGS rating between 1 and 10. A sample report of S&P governance can be viewed here.

While it's easy to gloss over corporate governance elements, the wisest investors always keep them top of mind. With the first rule of value investing being "Never Lose Money", ensuring sound corporate governance practices can increase the likelihood of being able to follow that rule successfully.


Mike Kazmaier said...

Hi Saj,
Great post about corporate governance I was just wondering, do you think you can judge management team effectiveness as above average if a company's ROIC is consistently higher than the industry average?

Saj Karsan said...

Hi Mike,

You'll likely have to judge that depending on the situation. For a company that sells commodities where the management team has been there for a while, I would say yes. For a company with already established intangibles (e.g. Coke) or products developed long before the current management team took office (e.g. pharma) it's not so easy to tell.

Anonymous said...

a depressing line in security analysis comes to the mind "objective tests of managerial ability are quite few..." what do u think barel?

Saj Karsan said...

Hi Anon,

I would agree