It sounds nice: Making money by investing in companies guided by enlightened executives. But do companies that play nicely really outperform those companies who are controlled by selfish and greedy executives?
The Corporate Library chief analyst Ric Marshall explains how the system works:
It's not simple. In the real world, a portfolio run by The Corporate Library's (TCL) predecessor Lens Investment Management from 1996 to 2000 (the fund's last year of existence) returned an average of around 34 percent a year compared to the S&P 500's total average annual return of 21 percent. But let's face it: Lens' management picked stocks by using other analytical techniques in combination with governance ratings and then sought to unlock hidden shareholder value by active involvement with each firm. Similarly, TCL's A-, B- and C-rated stocks have consistently outperformed D- and F-rated stocks every year since 2002.
These corporate governance ratings aren't meant to be the sole measure for buying stock. Simply going long the best-rated stocks for good corporate governance and shorting the worst rated isn't always a reliable method for achieving consistent, long-term outperformance. That said, our ratings can prove to be an important input in your buy/sell decisions, and can help you pick winning stocks and avoid stocks poised to underperform. Here are some key factors included in our corporate governance analytics.
Skin in the game: Companies with dominant shareholders (concentration of voting stock) isn't necessarily a bad thing. Indeed, high insider ownership is often a good sign, because management and shareholder interests tend to be aligned. All other things being equal, we have found that companies with principal (i.e., dominant) shareholders holding more than 30 percent of the voting shares will consistently outperform most others; we have found that the poorest performers will often include stocks where no single shareholder owns more than 1 percent to 1.5 percent of the company. Publicly traded firms controlled by families shouldn't automatically turn you off. But here is where it gets tricky: You have to avoid companies with dominant shareholders who report questionable “related party transactions,” like loans to family members, on their proxies. The lesson: Beware of private companies masquerading as public ones.
Enlightened governance isn't a cure-all. Overall market trends, as well as individual industry conditions, will often skew potential returns. Right now, for example, even the most poorly governed oil companies are going to do well, while even the best-governed airlines will likely disappoint. Serious investors have to filter out such overall market “noise” to get the best possible results.
One arrow in the quiver: Combining corporate governance analysis with other analytical tools is important. We have found that our ranking system used along with value or growth investment methodologies will generally show the best returns. For example, a typical value screen might uncover companies that could be poised for a turnaround. But such screens don't show that a company is out of favor because its insiders are running it like a personal piggy bank. Those can be uncovered by simply cross-referencing such screens' results against our ratings. In general, the best long positions will generally be marked by a combination of strong business operations, as indicated by a one- to three-year history of steady revenue growth, a strong (A, B or C) board effectiveness rating and, if they pay them, a strong dividend history.
Board effectiveness is a moving target. Many boards are either on the rise or in decline. Identifying the direction and likely rate of such changes is crucial to making effective governance-based investment decisions, particularly when trying to identify potential short positions. As a specific example of a successful investment program based primarily on our ratings, we've run a small experimental hedge fund (see table nearby) over the past two years that has consistently outperformed the standard hedge fund benchmarks. The fund is comprised of 10 long/short pairs of stocks, carefully matched by industry and market cap, where the long positions are all A-, B- or C-rated companies, and the shorts all rated D or F, periodically rebalanced on the basis of either value-based share price targets or changes in governance rating.