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Corporate Governance and Equity Return

Article | 12 February 2018

Measuring Corporate Governance

Investor interest in responsible investing (RI) is growing. According to the Global Sustainable Investment Review, in Australia and New Zealand from 2014-2016 RI assets grew at an annual rate of 86.4%, and as at 2016 the Responsible Investment Association Australasia estimates responsible investment assets under management at more than $600 billion. It could therefore be inferred that many investors care about the impact of their investments.

At the moment, one of the issues surrounding RI is measurement. It is difficult to compare investment processes, and different analysts can have differing views on the same issue. That said, metrics such as number of board meetings per year, workforce diversity, or shareholdings of directors are directly measurable. In fact, governance in general has better, less ambiguous, data than environmental or social metrics. This makes governance a good starting point.

Data for listed Australian companies is often hard to come by. Together with Dr Paul Docherty (a lecturer at Monash University), we compiled a comprehensive corporate governance database that covers the ASX 300 from 2001. It covers six broad areas of internal governance: the board of directors, audit committee, remuneration committee, nomination committee, external auditor, and risk management. We distil these areas into 24 governance related variables, all of which are publicly available (see Appendix). From these measures, we create a composite corporate governance score, which we use to examine the relationship between governance and share prices.

Does Corporate Governance affect valuation?

We begin by investigating the relationship between firm characteristics and our governance score. We construct five portfolios of listed stocks, sorted by corporate governance.

The portfolios with strongest governance have a statistically significant higher price-to-book ratio than that of the market. The average price-to-book ratio of firms with strong governance is 14% higher than that of firms with weak governance. We find a similar result for return-on-equity. The average return-on-equity for the strongest governed firms is 20.4%, compared with 14.1% for poorly governed firms.

We extend the analysis to look at the relationship between the change in corporate governance and the change in price-to-book and return-on-equity. After controlling for strong past returns (price momentum) and size , we show that changes in corporate governance are positively related to changes in price-to-book and return-on-equity. Therefore, this evidene suggests that firms with strong corporate governance tend to have superior operating performance.

Despite evidence of a relationship, the explanatory power of change in corporate governance appears to be limited. In addition, we find that one year after forming portfolios based on governance, poorly governed companies generally remain poorly governed and vice-versa. For example, 68% of the worst governed stocks remain in the worst governed portfolio one year later (Table 1).

Table 1 (Source: Brooke et al): Percentage of stocks that migrate across governance-sorted portfolios from time of rebalance (labelled 0) to one year later (labelled 1).
[1] Detailed in Brooke et al. (2015)

Is there a link between corporate governance and future returns?

There is a strong, positive relationship between average returns and strength of governance. Companies with strong governance outperform those with weak governance by 7.4% per annum, and with a lower tracking error. Better governed companies produce more returns for less risk.

Weak Governance P1 P2 P3 P4 Strong Governance P5 Market
Annual Return 4.12 3.35 8.01 9.59 11.52 8.24
Annual Tracking Error 15.18 12.41 9.52 8.83 6.44 0
Annual Volatility 22.7 21.24 17.92 17.97 15.41 13.12

Table 2 (Source: Brooke et al): Risk and return characteristics of five portfolios, sorted by corporate governance.

Chart 1 (Source: Brooke et al): Cumulative returns to $1 invested in five governance portfolios, where P5 (P1) consists of companies with strong (weak) governance.

There is some structure that underlies this performance. When the market as a whole performed well during the global financial crisis, rallying hard off the March 2009 low, the best governed firms underperformed those with the weakest governance by 52.4%. This is evidence that the relationship between governance and equity prices is time varying, and conditional on the market state.

We apply standard techniques to test the robustness of the alpha of better governed companies. We control for the returns of the governance sorted portfolios using the Carhart (1997) model, which accounts for momentum (stocks with strong past 12 month returns outperform those with weak returns), size (smaller companies outperform larger ones), and value (cheap stocks outperform expensive stocks). The alpha of the strongest governed stocks in Table 2 cannot be explained by any of these, which indicates that the relationship between internal governance and equity returns is not explained by well-known risk factors.

Flights to quality and governance

Over time, firms with strong internal governance earn higher risk-adjusted returns. However, during negative market periods, investors generally show a preference for high-quality and safe assets. In these environments, better governed companies are more likely to outperform poorly governed companies.

Weakest Governance 2 3 4 Strongest Governance Strongest - Weakest
Business Confidence Low -0.69% -1.40% -0.10% -0.11% 0.05% 0.74%
Business Confidence High -0.05% 0.03% 0.08% 0.24% 0.34% 0.39%
Equity Market Negative -0.80% -1.20% -0.29% -0.28% 0.13% 0.93%
Equity Market Positive 0.17% 0.26% 0.23% 0.43% 0.37% 0.19%

Table 3 (Source: Brooke et al): Outperformance of governance sorted portfolios in up markets and down markets, and when business confidence is low or high

The reverse is also true. Across the 12 months to December 2008, the portfolios comprising stocks with the weakest governance generated the largest negative alpha, but during the subsequent market rally in 2009, stocks in these portfolios recovered the most, generating significant alpha.

We also looked at business confidence, sourced from the index produced by NAB. Better governed companies outperform poorer governed companies more during periods when business confidence is low than when business confidence is high.

Summary remarks

Using a novel hand-collected database, we find evidence of a positive relationship between corporate governance and equity prices. We show that better governed companies are typically less risky, and are more likely to have smaller drawdowns than worse governed companies during periods of market stress. We therefore suggest that investors should consider good corporate governanceas a contributor to outperformance.

Brooke, P., Docherty, P., Psaros, J., Seamer, M. (2015). Internal Governance Characteristics, Time-Varying Agency Costs and Stock Prices. Forthcoming
Carhart, M. (1997). On persistence in mutual fund performance. Journal of Finance. 52, 57-82.


No. of independent directors
Board Chair Independence
Board Meetings per annum
Independent Directors with tenure < 10ys
Proportion of Female Directors

Audit Committee Exists
No. of independent directors on audit committee
Independence of Audit Committee Chair
Number of Audit Committee Meetings per annum
Audit Committee Size
No. of Audit Committee members with financial expertise

Remuneration Committee Exists
No. of independent directors on Remuneration Committee
Remuneration Committee Chair
Remuneration Committee Size 

Nomination Committee Exists
No. of independent directors on Nomination Committee
Nomination Committee Chair Independence
Nomination Committee Size

Non-audit Fees Collected by External Auditor

Risk Management Committee Exists
Restrictive Share Trading policy
Existence of Code of Conduct
Adequate General Corporate Governance Disclosure

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Gary Adamson

Gary Adamson

Chief Executive Officer – Platypus Asset Management