As major U.S. firms deal with the fallout from the coronavirus crisis, both in terms of the effect on their workforce and their ability to function and generate revenue, corporate leadership has rarely mattered more. Sound decision-making, independent ideas and robust but responsive organization will likely be the hallmarks of companies that weather the storm.
The value of sound leadership goes beyond the current public health emergency and demonstrates the role of good governance in investment performance. As advisors navigate these difficult times with their clients and look for high-quality investment opportunities in the coming months, the case for good governance has never been stronger.
“Governance is about quality of management. Today that is measured in the ability not just to manage financial capital, but also environmental and social capital, in order to unlock value,” says Julie Moret, global head of ESG at Franklin Templeton.
Portfolio managers have been analyzing the governance practices of U.S. corporations for decades, factoring into their evaluations the strength of a firm’s leadership, the robustness of its controls and processes, and their ability to execute strategy effectively, thus delivering shareholder returns over the long term. But with ’G’ now bracketed alongside ‘E’ and ‘S,’ financial advisors are posing numerous questions as they look to reinforce client returns via good governance.
“Governance is the table stakes of ESG,” says Matt Orsagh, director of capital markets policy at CFA Institute.
Governance inevitably covers a broad spectrum. Board expertise and independence have always been solid indicators of a firm’s ability to mitigate its most material risks and pursue business opportunities. But other common factors wax and wane, with cybersecurity rising up the agenda over the past decade. Analysts increasingly ask about the board’s cybersecurity expertise, the number of recent breaches and the effectiveness of responses. Firms such as Target and Equifax can attest to the potential value destruction wrought by cybersecurity missteps.
So how can an advisor determine whether a company has strong governance? One tool to consider is the Sustainability Accounting Standards Board’s voluntary disclosure standards based on the financial materiality of governance and other risks in particular industries. The SASB standards ensure a level of relevance that is not necessarily the case for governance scores developed by vendors to benchmark individual stocks. However, because firms are free to select disclosure topics and associated metrics, the SASB reporting can favor firms with the resources to paint a positive picture.
More than 100 firms report using SASB guidelines, including GM, Merck and Nike. “Voluntary initiatives will act as a catalyst for improved disclosure over time, but currently the range of governance data, especially on environmental issues, is patchy and based on estimates,” says Moret.
As such, data is secondary to spadework, both for advisors and managers, and is best used to cross-reference qualitative inputs. But separating good from bad governance is challenging for any financial professional, concedes Michael Young, education programs manager at the Forum for Sustainable and Responsible Investment. There were few red flags ahead of Wells Fargo’s cross-selling scandal before incentives practices overwhelmed corporate culture.
“The lesson is that good governance structures are one thing, but delivering continuous improvement is quite another,” he says.
For most portfolio managers, says Moret, there are few substitutes for bottom-up research to assess governance standards. This requires face-to-face meetings with management to understand their thinking as well as other forms of fieldwork.
The resulting qualitative assessment is reflected in discounted cash flow models and other valuation techniques. This means assessing the impact on revenue calculations, margins and capital expenditures of predicted costs — for example, the development of new procedures to minimize water usage. Governance factors can also weigh on costs of capital. A bond issuer with a high incidence of safety issues might be punished by investors demanding a higher premium.
How does an advisor know how a fund manager views governance? Portfolio managers can use proxy voting and shareholder activism to affect management changes that influence investment performance. But some managers prefer to work behind the scenes, either by flagging issues in one-on-one meetings, or collaborating with management to draft proposals for shareholder approval.
“Relationship-driven engagement with issuers offers the best scope for strong governance standards, leading to better outcomes for all stakeholders. Responsible stewardship of our clients’ capital entails active engagement to unlock value in the long term,” asserts Moret.
The Business Roundtable redefined the purpose of the corporation last August, widening its responsibilities from shareholders to stakeholders. This shift in focus from quarterly earnings to long-term value may have informed some corporate responses to the coronavirus pandemic.
Firms that know how to respond and communicate in a crisis, that can attune themselves to the needs of the hour, can reasonably expect to reap the rewards when recovery comes. Goodwill from stakeholders will benefit shareholders too.