A new report from CLSA examines the relationship between governance and performance
Math whizzes at CLSA Asia-Pacific Markets are the latest people to claim to have found a direct positive relationship between corporate governance and shareholder returns. Consultants and advisers whose business it is to promote governance changes have long sought to prove a direct correlation between improved governance standards, board function and corporate performance.
Many reports and studies, some reputable and some not, have claimed to prove this connection in the past but, generally speaking, the investment world remains unconvinced. The CLSA report is one of the first to examine governance structures and relative performance of Asian companies.
Using CLSA’s own corporate governance score – an annual rating of governance standards for Asian companies – the quantitative research team finds a statistically significant relationship by looking at the scores of 875 Asian companies over the past five years, excluding correlated factors such as market, industry and company size.
In a regulatory climate where corporate governance is all the rage in the US following the passage of the financial reform bill, the report certainly comes at an opportune time. European countries have increased corporate disclosure laws and implemented mandatory governance standards, and many Asian regulators are examining those changes in an attempt to determine value before examining their own laws.
Several leading academics interviewed by Corporate Secretary, the sister publication of IR magazine, voice concerns about the report, however, due in part to the practical difficulty of measuring corporate governance accurately and effectively.
Not an exact science
David Larcker, professor of accounting at the Stanford Graduate School of Business, is an expert on corporate governance issues. He comments that measuring corporate governance is a very imprecise science, and that people might be reading too much into such governance ratings.
‘My view is that we don’t actually know how to measure corporate governance, so we look at all these kinds of structural things – how many people do this and that, does a company have any takeover protections, are the CEO and chairman the same person, things like that,’ Larcker explains. ‘Exactly how all that translates into performance is not so clear. I’m kind of at the point where I’m not sure those questions actually provide much insight.’
Chris Lobello, head of quantitative analysis at CLSA, is the lead author of the report. He counters Larcker’s point by saying that although governance
ratings are imprecise, they are not completely useless.
‘Think of the difficult task of measuring the quality of students at a school,’ he suggests. ‘Professor Larcker would likely recognize that as a difficult task given the broad definitions of what makes a good student, but I suspect he still hands out grades and that he and his colleagues still look at GMAT scores when judging applicants for his program. Just because something is difficult to measure, it doesn’t follow that we can’t do something to quantify it, if somewhat imprecisely.’
Even if governance can be measured, it is even more difficult to postulate the impact it may or may not have on corporate performance. Ian Gow, professor of accounting and information at Northwestern University’s Kellogg School of Management, says it is also difficult to determine exactly how corporate governance practices affect shareholder returns, as there are so many factors that can have an impact on this area.
‘I think shareholder performance is a good measure for certain purposes,’ Gow says. ‘If I’m a portfolio manager looking to choose stocks, it’s what I care about. This report seems to be directed at investors of this kind. For a board of directors, however, it perhaps isn’t as helpful to know that firms with ‘better’ governance have higher returns. The question is: why do they enjoy higher returns? Is it because they have higher operating performance? Does the market not fully appreciate the benefits of good governance?
‘I’d say that one problem with research on corporate governance is that it has been hard to identify the channel through which corporate governance affects returns – if, in fact, it actually does.
‘I don’t see any obvious defects in the report, which seems to document an interesting relationship between governance and shareholder returns. One issue is that there isn’t the level of detail one would expect to see in an academic paper, so it’s hard to be completely comfortable with the results.
‘Another more conceptual issue concerns the question of why the markets don’t seem to understand the effects of governance on corporate performance. If badly governed companies will have worse operating performance in the future, and if markets understand this, then it will be reflected in prices today and won’t necessarily show up in future returns. It would be interesting to know how the market ‘learns’ about the effects of governance.’
In spite of his concerns, Larcker has praised the report for its statistical methodology and robustness. ‘I think, relative to other studies of this kind, CLSA has done a pretty good job,’ he says.
Not everyone is skeptical, however. ‘Increasingly, people are looking at governance factors from both a risk management perspective and an alpha perspective,’ points out David Smith, head of corporate governance research for the Asia-Pacific region at ISS. ‘The research from CLSA provides evidence for something many investors have believed for some time: that good
corporate governance at Asian companies can translate into performance and returns.’
It is worth bearing in mind that ISS makes its money promoting governance changes and selling ratings based on a range of governance criteria.
Measuring up
While Larcker has his reservations, he does not deny the positive impact of governance. ‘My view is that good governance is probably correlated with better
shareholder performance,’ he states. ‘The problem is, how do you measure good corporate governance?
What you want to know is whether the board, when confronted with some sort of governance dilemma, will do the right thing. However you measure these
variables, the leap of faith is whether you believe those measurements are going to tell you about the ability and propensity of those people to do the right thing or not. I have a lot of difficulty with that.
‘The important thing to get across is that if you can measure corporate governance well, it probably is correlated with performance. My view, however, is that we actually don’t know how to do that.’
Lobello accepts some of this argument, but has a counter-argument. ‘How the score translates into return is really quite clear, as measured over the six-year sample period using the defined methodology,’ he notes. ‘I’ll certainly agree that the act of measuring corporate governance is an imprecise effort, but what measure we can assign does seem to be linked to future returns. That is the key here, as these corporate governance scores were generated in advance and the returns we are measuring are over the following quarters.’
‘My guess is that the results found in this report may not carry over to the US, in part because there is, in many ways, less variation in governance practices in the US than there is across Asia,’ Gow concludes. ‘It may be that the variation observed in Asia is needed to observe relationships that may be hard to discern when firms have similar governance practices, say, due to Sarbanes-Oxley and the like.’
