Good Corporate Governance pays off! Well-governed companies perform better on the stock market Institutional investors are thus encouraged to account for corporate governance in their investment strategy. April 2003 Rob Bauer and Nadja Guenster Rob Bauer is Head of Research at ABP Investments and associate professor at the University Maastricht. Nadja Guenster is a researcher at the Rotterdam School of Management, Erasmus University. Introduction Corporate Governance deals with agency problems arising in the modern corporation due to the separation of ownership and control. There are different disciplining devices to protect shareholder interests and thus reduce agency costs. Examples of such mechanisms are the legal framework, the board of directors, and an active takeover market. How effective these mechanisms are depends on listing rules, corporate law, articles of association and market liquidity. Furthermore, shareholders can actively collect information and monitor management to ensure that they act in their best interest. In a bull market, like the 90s, the corporate governance discussion focused mainly on the role and the responsibilities of the bodies of the company, such as the board of directors, the supervisory board and the Annual General Meeting of shareholders (AGM). 1 In a bear market, witnessed for the past two years, the attention shifted towards the intermediaries between the corporation and the shareholders, such as accountants, banks and institutional investors. 2 A rather new development is the institutionalisation of equity ownership. Insurers, pension and investment funds, as well as other institutional investors hold an increasing percentage of shares outstanding 3. Since these institutional investors are usually minority shareholders, the takeover market and the supervisory function are no feasible disciplinary mechanisms. So far, these institutions make in practice only limited use of their rights as shareholders. In case of scandals, such as the recent Enron and Ahold debacle, they generally sell The attention recently shifted to the parties between shareholders and a company: accountants, banks, institutional investors. The question whether these institutions should incorporate corporate governance into their investment policy becomes increasingly relevant. 1 Please refer to: The forty recommendations, Commissie Corporate Governance, the Netherlands, 1997. 2 Please refer to: Corporate Governance 2002, de stand van zaken, Nederlandse Corporate Governance Stichting, 2002. 3 Source: National Accounts 2001, pp 210-217, CBS, 2001. Page 1 of 6
their shares, also known as voting with their feet. 4 In this way, badly governed companies are explicitly penalised and well-governed companies are implicitly rewarded. In our research, we investigate the explicit penalisation and reward in an investment context. More specifically, can institutional investors achieve superior results following a strategy of over- weighting well-governed companies in their portfolios? 1 Purpose and methodology of the research Within this research, we examine the impact of corporate governance on stock returns, firm value and operating performance for firms incorporated in member states of the European Monetary Union (EMU). The methodology of our study is comparable to Gompers, Ishii and Metrick (2001, see textbox). To indicate a firm s governance standards we use in our study Deminor Corporate governance ratings. Deminor Rating 5 (hereafter, Deminor ) bases its score on approximately 300 criteria, which can be subdivided into four categories: Rights and duties of shareholders Range of takeover defences Disclosure on corporate governance Board structure and functioning The relative importance of the different criteria is established based on a survey held among institutional investors. The advantage of the Deminor ratings is the wide range of underlying criteria, the disadvantage is the limited time-span of ratings: 2001 and 2000. In the following paragraph we will summarise the empirical results of our study. Scientific research on the effects of corporate governance is mainly dedicated to finding the link between corporate governance and the development in stock price, valuation and profit of a company. In general a positive correlation was observed 6, but it should be mentioned that the majority of corporate governance studies focuses on one very specific variable, usually antitakeover amendments or the specific composition and functioning of the board of directors. Additionally, most studies are short-term oriented (so-called event studies) and refer to US data. 7 The first two remarks do not apply to the study of Gompers et al. (2001) 8. They We measure the impact of corporate governance on stock returns, firm value and financial performance. This research uses Deminor Rating s data to measure the corporate governance performance of companies. The sample is the FTSE Eurotop 300 over two years. 4 In the United States, public sector pension funds had to vote their shares as part of their fiduciary duty as early as 1975. In the United Kingdom, they are encouraged to do so since 2001 (Myners Report). In January 2002, the Dutch ministry of finance called for a similar measure. The Winter Commission (2002) recommends that institutional investors be responsible for the way they use their voting rights. The American Securities and Exchange Committee (SEC) recently published rules compelling asset managers to inform their clients on their voting practice. 5 http://www.deminor-rating.com. Deminor Rating s Corporate Governance Ratings are designed to assess the corporate governance performance of listed companies based on public information. 6 For a recent overview, see M. Becht, P. Bolton and A. Roëll, Corporate Governance and Control, SSRN (see www.ssrn.com), 2002. 7 Some exceptions are studies covering the Netherlands: A. de Jong et al., The Role of Self-Regulation in Corporate Governance: Evidence from the Netherlands, SSRN, 2002, Russia: Black, Does Corporate Governance Matter? A Crude Test Using Russian Data, University of Pennsylvania Law Review, 2001, vol. 149 and R. Laporta et al., Page 2 of 6
used 24 different corporate governance criteria for about 1,500 companies from September 1990 to December 1999. Its most important data source was the Investor Responsibility Research Center (IRRC). 9 The study only dealt with US companies. Gompers et al. found that an investor can earn an annual excess return of about 8.5% holding a zero investment portfolio composed of a long position in well-governed companies and a short position in badly governed companies. 2 Empirical results 2.1 The impact on equity returns Following Gompers, et al. (2001) 10, we compare the return of a portfolio consisting of well-governed companies to the return of a portfolio composed of badly governed companies. Our sample consists of Euro zone companies included in the FTSE Eurotop 300 index. The above-mentioned categories used by Deminor are highly correlated. Companies with a high score for Disclosure on Corporate Governance usually also have a high score for Rights and Duties of Shareholders. The average correlation is larger than 0.70. Therefore we will use the sum of all four ratings in our research. The Deminor ratings also seem to be stable over time. The majority of companies has a similar score for both years. Based on this evidence we assume in our empirical analysis that the total rating for the year 2000 was also valid in the period 1997-1999. Hence, the study covers the period 1997-2002. 11 To construct the portfolio, we go long (buy) in the good governance companies and short (sell) in the bad governance companies. Table 1.a Summary of empirical results (annual percentages) a. Difference in return between good and bad governance portfolios standard (i) 2.10 % corrected for risk (ii) 1.58 % Good governance portfolios outperform bad governance portfolios by 2.97% annually. corrected for risk and sector-neutral (iii) 2.97 % *** significant (1%), ** significant (5%), * significant (10%). In table 1a we first simply compute the difference in annual return, without accounting for differences in portfolio characteristics. (Standard: i). We then correct the returns of both Investor Protection and Corporate Valuation, NBER, 2001, which compares 27 countries. 8 See P. Gompers, J. Ishii and A. Metrick, Corporate Governance and Equity Prices, NBER, 2001. 9 http://www.irrc.org/ 10 See P. Gompers, J. Ishii and A. Metrick, Corporate Governance and Equity Prices, NBER, 2001. 11 Unfortunately, there is currently no better database available for this type of research. Nevertheless, a company s ratings are correlated from year to year. We therefore consider, as did W. Drobetz et al., Corporate Governance and Expected Stock Returns: Evidence From Germany, Working Paper, University of Basel a research on the added value of corporate governance in the German context - that the governance ratings were constant in the recent past (<3 years). Page 3 of 6
portfolios for risk factors: the difference in market risk, firm size and a variety of other factors, which influence both portfolios (given by: corrected for risk: ii). Finally, we additionally adjust for sector effects (given by: corrected for risk and sector-neutral: iii). This procedure allows us to distinguish the impact of corporate governance from the impact of other factors on the portfolio returns. All results refer to the 1997-2002 period. The methodology adopted for the research is similar to that of Gompers, Ishii en Metrick (2001), originally presented by Fama en French (1993) and Carhart (1997) 12. Table 1a presents the results of the long-short strategy based on the total Deminor rating. We hold a long position (buy) in the good governance portfolio and a short position (sell) in the bad governance portfolio. A positive difference in return between these two portfolios implies that a high Deminor rating has a relatively positive influence on the share return of a company. The results in table 1a clearly demonstrate that the good governance portfolio performs better than the bad governance portfolios. The difference in performance after correction for sector influences is approximately three percent annually. 13 An investment strategy based on over-weighting companies with good governance and under-weighting companies with bad governance will create value for investors. 2.2 The influence on the valuation of the company Like Gompers et al. (2001) we investigate the influence of corporate governance on the valuation of a company. Firm value is measured by Tobin s q, which is defined as the market value of a company s assets divided by their replacement value. A high (low) q implies that investors are willing to pay relatively more (less) for a company compared to its book value. Table 1.b Summary of empirical results (annual percentages) b. Corporate governance and the valuation of the company (Tobin s q) Influence of corporate governance rating on Tobin s q 0.14 % *** *** significant (1%), ** significant (5%), * significant (10%). Table 1b shows the impact of the Deminor ratings on firm valuation, after controlling for the influence of other factors. An increase of the Deminor rating of 1% equals an increase of 0.14% of the market value of a company s assets divided by their replacement value In table 1b we present the relation between Tobin s q and the total Deminor ratings after accounting for other factors influencing q. The coefficient of the governance rating is statistically significant and positive: 0.14. A one- percent increase in the Deminor rating translates into a 0.14 percent increase in firm value. Investors seem to be willing to pay more for a company with a higher 12 E. Fama en K. French, Common Risk Factors in Stock and Bond Portfolios, Journal of Financial Economics, vol. 33, 1993, pp. 3-56 and M. Carhart, On Persistence in Mutual Fund Performance, Journal of Finance, vol. 52, 1997, pp. 57-82. 13 The α s are positive but not statistically significant. This is due to the short time frame and the relatively small sample. It is also important to bear in mind that we did not take transaction costs into account. Page 4 of 6
rating: an improvement in the corporate governance rating of a company leads on average to a higher value on the stock market. This result coincides with the conclusions of Gompers et al. and with the findings of a survey among institutional investors recently -published by McKinsey 14. 2.3 The impact of corporate governance on operating performance The final point of interest in our study is the relation between corporate governance and operating performance, as measured by net-profit-margin (NPM) and return-on-equity (ROE). Table 1.c Summary of empirical results c. Corporate governance and operating performance Influence of corporate governance rating on net-profit-margin -0.11 *** Influence of corporate governance rating on return-on-equity -0.07 ** *** significant (1%), ** significant (5%), * significant (10%). Table 1c presents the influence of Deminor ratings on the net profit margin and return on equity respectively, once again after controlling the influence of other relevant factors. The results in table 1c demonstrate that there is a negative correlation between the Deminor ratings and NPM as well as ROE. At first glance it may seem odd that companies with a high corporate governance score deliver a higher return and are valued higher, but achieve inferior (or worse) operating performance (or operating profitability). A possible explanation would be that NPM and ROE are based on accounting figures (namely profit), which can be influenced by management. Our hypotheses for bad (good) performance of companies with a high (low) corporate governance rating, is that companies may be more (less) prudent in their accounting standards. A validation or refutation of this hypothesis requires further investigation. Limits of the study, such as limited historical data, call for more research. But the current results are promising. 14 See: Global Investor Opinion Survey: Key Findings, McKinsey & Company, July 2002: www.mckinsey.com. Page 5 of 6
3 Conclusion In conclusion, the results of our research seem very promising: portfolios of companies with high corporate governance standards perform better than companies with worse standards. Investors value well-governed companies significantly higher. The limited history of the Deminor ratings requires cautious interpretation. In our opinion a lot more energy and time need to be invested into the expansion and perfection of databases and the stimulation of further research. The encouraging results (or findings) of this study should convince institutional investors to account for corporate governance standards in their investment process. In the future, institutional investors should rather vote with their head reward well-governed companies and punish badly-governed companies than merely vote with their feet! The encouraging findings of this study should persuade (or convince) institutional investors to include corporate governance in their investment process. Rob Bauer and Nadja Guenster Page 6 of 6