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6/10/2010
Attention to Corporate Governance Can Improve Investment Returns
   by Robert Kropp

A new study by The Corporate Library constructs a hypothetical portfolio based on its corporate governance rankings, which significantly outperforms a Russell 1000 benchmark.
 
SocialFunds.com -- Last week, SocialFunds.com spoke with Cary Krosinsky of Trucost about the apparently undeserved reputation for sustainability enjoyed by BP before the Gulf of Mexico oil spill disaster. Krosinsky observed that if the governance ratings of companies compiled by The Corporate Library included foreign firms, BP%146s reputation for sustainability might have been calibrated more realistically.

Based in Portland, Maine, The Corporate Library is an independent research firm that focuses on corporate governance. Kimberly Gladman, the Director of Research and Risk Analytics at The Corporate Library, told SocialFunds.com, %147We look at the shareholder model of corporations, and look for agency problems. We ask, where do we think there is a diversion between the board and the shareholders? That%146s the question we ask of every company, and we think we have a group of indicators that help see in patterns of public disclosure.%148

Agency problems refer to conflicts of interest between shareowners and corporate boards as to how a company should be run.

%147The two most important things we look at are board composition and executive compensation,%148 Gladman continued. %147For instance, are the CEO and other top executives going to get rich no matter what happens to the company over the long term? These two components make up 80% of our governance rating.%148

The Corporate Library recently published a report, entitled %147Finding Value in Corporate Governance,%148 which constructed a hypothetical portfolio using governance screens that excluded high-risk companies listed on the Russell 1000 Index of large cap, US-based companies. Backtested to 2003, the study found that the portfolio outperformed its benchmark by 275 annualized basis points from 2003 to 2010.

The report found that 121 of the annualized basis points were stock-specific, and directly attributable to The Corporate Library%146s governance risk ratings.

The Corporate Library uses an Average Rating system to rank companies according to the quality of their corporate governance (CG). However, %147because it has historically spent most of its effort deciphering the critical cutoff point between the C & D levels,%148 according to the report, %147the signal can generally be looked at as a binary indicator between the good (A,B,C) and bad (D,F) CG firms.%148

Quantitative Services Group (QSG), an provider of independent global equity research, was commissioned by The Corporate Library to %147isolate the signal,%148 as Gladman described it.

The most concentrated portfolio in the report employed the most restrictive standard, by which companies with low scores in any of the ratings for overall performance, board quality, and compensation practices were excluded. The resulting portfolio %147is underweight both financial and energy stocks, while overweight technology.%148 However, the report continued, %147The averages were the result of a consistent over/under weight, and not due to a few periods of extreme positioning.%148

%147We%146ve avoided a lot of the big financial companies for years,%148 Gladman said, %147Because of their outrageous compensation packages.%148

Addressing concerns %147that ESG screening might restrict the investment universe too much,%148 Gladman said, %147We excluded all the companies that had high risk ratings in either of our subcomponents, and on average we still had about 500 companies in our most restricted portfolio.%148

The report observed, %147While selecting companies on the basis of those having the highest TCL [The Corporate Library] rating alone provides some level of outperformance, adding an additional filter for poor compensation policies and board representation dramatically improves results.%148

%147The strategy we are offering is to avoid the bad ones,%148 Gladman said. %147We always want to serve the investment market, and we%146re always asking the question, would we want to hold this company or not? Bad governance can wreck a good thing. So we%146ve put our energy into identifying the bad ones. It%146s about constructing a portfolio that avoids the worst companies.%148

The report observed, %147Investment managers relying on standard portfolio theory have been reluctant to embrace a CG-based investing doctrine.%148 However, the report concluded, %147Despite widespread skeptical attitudes towards governance investing, we present evidence that a stock portfolio consisting of companies categorized as least risky by The Corporate Library sizably outperformed the broad benchmark over the period 2003-2010.%148

Gladman said of the report, %147It%146s a theoretical study. We%146re not investment managers, we%146re researchers. What we%146re trying to say to the investment community is, if there%146s this much alpha from a simple application of our ratings, what do you think you could do with it with your own strategy and your own value indicators?%148

%147It has a potential alpha connection that hasn%146t been recognized yet by the market,%148 she added.


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