It is no secret that good corporate governance results in better productivity and thus higher long-term profitability both for the companies concerned but also for the societies in which they operate. The rules and processes that constitute the relations between the government, the society at large, shareholders, the board of directors, managers and employees are all part of the governance package. Furthermore, we have found that good corporate governance makes companies more resilient in times of crisis such as during the COVID-19 pandemic.
When we invest in companies we focus on trying to improve the companies’ ESG footprint, with governance usually being the most important part. We found that good corporate governance combined with good environmental and social practices strongly influences future decision making, performance and valuation. For example, faced with the current extraordinary crisis the majority of companies in our portfolio rose to the challenge and took robust actions. These ranged from cutting compensations for the board and management, suspending dividends and buybacks to extending health care to employees families. Most importantly measures were clearly and transparently communicated to shareholders.
So if good governance is of such importance when it comes to companies’ performance, resilience and risk profile, as investors we have to ask what factors influence good governance within a company. I thought I would share with you what we have found in over 30 years investing in emerging markets:
First of all, the ownership structure of companies matters. For example, studies show that affiliates of multinational companies, consistently outperform domestically owned firms in management practices quality. Furthermore, local listed firms perform better than unlisted ones. .
In our investment universe of small and midcap businesses in emerging and frontier markets we often find companies are family owned or controlled. These companies are frequently lagging behind when it comes to corporate governance. One key reason for this is that family owned firms appoint family members to senior management positions instead of recruiting professional managers externally. As they are not necessarily chosen by merit, family members can sometimes be less efficient than experienced managers. On the other hand we have found that often these family companies are very open to positive change since they are looking at the long term and want a viable business for generations to come. That makes them such an interesting investment and creates a lot of potential for improved governance and performance.
One of the first key recommendations we have for family firms is for them to appoint independent directors to their board of directors. It is important that board members are not afraid to challenge management during normal times as well as during times of crisis. Board members chosen from the inner circle of the founding family might not be in a position to critically question the management. Similarly, in emerging countries there are many listed firms where the government is the controlling shareholders. These companies often appoint key personnel not based on qualification but political standing. This is where strong and outspoken independent directors are critical to governance success. They need to hold management accountable and challenge them on strategic and operational decisions. Furthermore, we have found that the diversity of the board influences the effectiveness of its supervisory function. If the board includes women, people of different nationalities and different professional backgrounds, the results are bound to be better.
Investors often put too much attention to only the financial reports of a company and not enough attention to the non-financial disclosures. This includes such things as the composition of the board of directors and the qualification of the people sitting on them as well as the specific responsibilities and powers of the board of directors. Another area that normally needs further disclosure are the key performance indicators (KPIs) used to assess the top management as well as what rewards/compensation are offered to all staff for meeting their KPI’s. Firms whose managers are aware of their KPIs are more likely to have better management practices. Other important non-financial information would include subjects like how often do managers meet with the shop floor workers, suppliers, and customers, how do they allocate their time, what tasks do they undertake themselves and which ones do they delegate etc. As active investors we devote a great part of our time to investigating these non-financial issues. They can be very telling when it comes to looking at the future potential of a company.
There are also “external” factors that influence the corporate governance of a company.
For example, companies that are facing international competition or are involved in international trade tend to have better management practices. These companies need to keep up with or even outperform their peers, and they are much more likely to do so with good corporate governance in place.
Furthermore, companies that are facing onerous labour regulations, tend to have poorer management practices. This is not surprising. Companies faced with such rules are forced to tolerate poor employee performance as they are often unable to terminate badly performing workers or are constrained in their ability to move workers to different positions.
The level of a firm’s indebtedness is a critical factor in determining its success in implementing good governance. Firm with high debts become beholden to their creditors and are under pressure to accede to the desires and direction of those creditors. This can be to the detriment of good corporate practices for the long term interests of the firm. State-owned firms are often subject to such pressure and, since they have the implicit guarantee of the government, tend to pile up debt. When these firms are privatised, very often their debt declines and governance improves.,
The rule of law and the general level of a country’s legal system impacts governance for obvious reasons. If a company is subject to laws and regulations not respected by every other firm in the country, particularly their competitors, there tends to be a breakdown of governance. In this respect enforcement of contracts is important. So, for example if a firm is unable to enforce suppliers’ contracts as a result of slow or corrupt courts, then decision-making is upset and costs rise.
The above mentioned factors play an important part when we invest in emerging market companies, first, when we look at the companies and their potential and second, when we engage with them on improving their governance performance. In the many years investing in emerging markets around the world we have found that a strategy focusing on working closely with management teams to improve their governance has brought the best results. For investors, the companies and the societies in which they operate. Good governance is a win-win.