Better governance, Better returns

Numerous academic and industry research papers support the view that effective corporate governance has a significant impact on the performance of that company as an investment. So when we spoke with their Natalie Tam from Aberdeen Standard Investments, we asked her how she thinks about this issue. 

She told us: “Governance is a really important part of our stock selection process, and that's because we believe that companies with good corporate governance will outperform companies with poor corporate governance. And that's been our experience over many decades of investing”. In this short interview (with transcript) she runs through 4 red flags they look for in their due diligence of a company’s corporate governance.  

Edited transcript 

“We take a lot of time to understand governance and the risks and opportunities around that, because we have seen that it leads to better informed investment decisions. 

And I think if you look at the Royal Commission into banking, I think often there's a perception that small caps by definition have poorer corporate governance. But the Royal Commission has shown us that actually governance is an issue that extends right through corporate Australia and right up into the largest financial institutions that we have. 

So when we look at corporate governance, some of the things and issues that we consider are things like related party transactions. So sometimes we see directors selling family businesses into the listed companies, and sometimes at inflated valuations; or selling businesses out of the listed entities into their own family businesses. Now that can be a red flag, and it's worth looking at those quite closely. And often I've mentioned that to clients and other people and they think that that's a rare event, but actually we've seen it happen in ASX50 companies. So it does happen. 

The other thing that we look at is remuneration structures. Because at the end of the day, how bonuses are paid will influence how management teams behave. So we look at those quite closely, and there have been cases in some small caps and some tech stocks that we've looked at in the past where the incentives and the hurdles that management teams are required to achieve actually aren't disclosed at all. So there's full opacity about what's driving and incentivizing management teams. So that is not something that we could invest in from the corporate governance point of view. 

And then if they do disclose the hurdles, you've got to look at them quite closely. So some companies might just have an EPS growth hurdle, earnings per share growth hurdle. And that's fine, and we do want to see earnings per share grow. But if it's not tempered by something that captures gearing or the financial risk that that management team may be undertaking to achieve that EPS growth, then you can obviously see that this company could be headed for problems. 

And the other thing that we spend a lot of time looking at is board structures. We engage with boards; so chairmen and independent directors to understand their thoughts on the business. The separation between the chairman and the CEO is really important. 

And even simple things such as how engaged non-executive directors are. So we've been to an AGM a couple of years ago where one of the independent directors was falling asleep. And this was a company that had actually had a large profit downgrade only a few months before. So it's pretty disappointing, and it is a red flag that really the level of engagement isn't there. And so those are the types of companies that we try to avoid. 

And at the end of the day, corporate governance does add value to investment, so we do focus on it quite heavily.”