Exploring the ‘G’ in ESG: why governance is very important to investing
In the second part of our two-part series on ESG investing we examine the issue of governance and unveil an ESG portfolio to help develop investment ideas which tap into this increasingly mainstream theme.
When you buy a share in a company you are actually obtaining a portion of a business, thus making you a part owner.
And as an owner you want to have confidence that you are getting the full picture of a company’s performance and prospects, decisions are being made in your interests, and that money is being put to good use. You don’t want to see it frittered away on value-destroying acquisitions or ill-fated business ventures.
The key is corporate governance, which is the system through which a business is directed and controlled.
IMPACT ON INVESTMENT RETURNS
A piece of research published in 2003 by Harvard academic Paul Gompers looked at the performance of US companies in the 1990s. It found an 8.5% better return per year from public firms with the best corporate governance on its measures compared with those which scored worst.
This makes sense as without good governance the risks of investing in a company are significantly higher. Think back to any of the big corporate scandals of the past decade, such as the cheating on emissions tests at Volkswagen to Facebook’s misuse of data and BP’s (BP.) Gulf of Mexico oil spill. Governance failings are likely to be at the heart of them.
All these examples saw significant damage wrought on the respective companies’ share price and investing in just one company with inadequate governance can do significant damage to your investment portfolio.
Under pressure from regulators and other stakeholders, companies have got better at talking the talk in this area but not all businesses are walking the walk.
PAYING LIP SERVICE TO GOVERNANCE
Advisory group PIRC recently cited the example of gambling group GVC (GVC) where there have been consistent rebellions against executive pay followed by acknowledgements of the need to listen to shareholders.
Ahead of GVC’s latest annual shareholder meeting on 5 June, PIRC said: ‘In the run-in it has stressed its engagement with shareholders and willingness to listen to their concerns about executive pay. On an entirely different subject, in 1971, The Who sang: “I’ll get on my knees and pray we don’t get fooled again”.’
Sure enough, when the meeting arrived 40% of shareholders voted against the remuneration report and GVC was yet again promising to listen.
While regulators and major shareholders can play a part in the stewardship of a company, the board of directors are the ones with the responsibility for corporate governance and for this reason it’s important to have a diverse board with strong independent directors.
Sacha Sadan, director of corporate governance at Legal & General Investment Management, says: ‘This doesn’t just mean things like gender diversity, which are important; I’m often asking questions to companies like “why are there only financial people on the board when you are a customer service business?”. You need directors who can challenge businesses to make better decisions.’
Sadan says this requires a split of the executive function between chief executive and chairman, with a company’s chair ultimately playing the most crucial role in a company’s governance.
WHY THE CHAIRMAN MATTERS
The chairman should have responsibility for the hiring and firing of CEOs and Aviva Investors’ chief investment officer for equities David Cumming says this is still an area where there is significant room for improvement.
‘Companies are still slow to exit underperforming CEOs. As a shareholder there is plenty of evidence of CEOs doing damage for too long. (Boards) often take the right decision in the end but it takes too long.
‘The Kingfisher CEO said they were stepping down, (after) there was a long period of underperformance; the boss of BT has gone, you could argue they should have gone sooner; and the Kier CEO went recently and should probably have gone sooner.’
He adds that Aviva Investors, like other institutional investors, will often seek to apply pressure in private but there are occasions where a lack of response forces matters into the open.
Cumming was vocal about Unilever’s (ULVR) thwarted attempt to shift its primary stock market listing and headquarters out of the UK. ‘They lost, and it did quite a lot of damage. That was an example of a company not listening to shareholders and there were consequences for that,’ he says.
Failure to properly hold chief executives to account puts them in an overly dominant position. These can be particularly acute when the CEO is also the founder, with recent examples including the misconduct allegations facing Ray Kelvin at Ted Baker (TED) and the acrimonious departure of Martin Sorrell at WPP (WPP).
Cumming notes that a chairman can themselves often be more difficult to fire and adds that ‘if you have a weak chairman and CEO then it can be difficult to effect corporate change’.
He also says ESG issues and the extent of the changes in the last 18 months to two years are still underappreciated at board level.
TACKLING EXCESSIVE PAY
When board failings saw Jeff Fairburn, the former chief executive of housebuilder Persimmon (PSN), trouser a £100m bonus (later trimmed to £75m), it was chairman Nicholas Wrigley who first fell on his sword. He stepped down in December 2017, months before Fairburn eventually departed.
Cumming says despite progress on executive remuneration, this is still a big issue. ‘At Ryanair, for example, does O’Leary deserve £100m if things work out when he’s been very hawkish on employee pay?’
Legal & General’s Sadan notes bonus schemes solely linked to adjusted or core earnings per share ‘where all the bad stuff has been taken out’ are particularly concerning.
This type of situation can encourage management to focus too heavily on short-term earnings performance and potentially to massage these figures to paint them in a more positive light.
An extreme example of this situation can be with café chain Patisserie which involved alleged criminal activity on the part of finance director Chris Marsh.
Patisserie did run a bonus scheme linked to earnings per share targets, and in February 2018, both Marsh and then-chief executive Paul May exercised options granted in 2014 and immediately sold the shares acquired for a total profit of £2.9m.
The good news according to Sadan is that the lion’s share of businesses are attempting to implement sound governance.
‘Most companies are good, not great. When you don’t know what’s going to happen with domestic politics, for example, it’s not always easy to make the right decisions but most companies are at least trying.’
And for the businesses which fall short, there is growing pressure from activist investors, who buy large stakes in a business to drive a change in strategy which they hope can deliver an improvement in the share price.
Institutions may play a different role but Sadan says Legal & General would not be afraid to back activists if their interests are aligned.