Governance is probably the easiest part of environmental, social and governance (ESG) for investors to understand—and underestimate. This series has described ESG methodology, and how it adds a lens for assessing investment risk. This concluding article explores governance scores—the measure of how a company is managed, and the importance in protecting value.
Corporate governance—the structure, processes, and people guiding a company’s high-level decisions—has clear relevance for investors. Having a good board of directors and strong executive leadership might seem like obvious considerations, but governance scores are especially useful because they capture risks not explicitly contained in traditional financial statements.
Key governance metrics include board composition, executive compensation, oversight, transparency, stakeholder engagement, and anti-fraud protections. For instance, research has shown that companies with diverse and independent boards typically generate higher profits.1 Likewise, companies that base executive compensation on value creation, and include appropriate long-term incentives, generally outperform their industry peers, according to Alex Edmans in his book, Grow the Pie: How Great Companies Deliver Both Purpose and Profit.
A company that scores poorly on governance metrics is much riskier. Mismanagement can be costly. At a minimum, it can result in missed opportunities. At its worst, it can destroy shareholder value and even have broad negative impacts for all stakeholders.
The 2017 Equifax data breach serves as a glaring example of the high cost of poor governance. As one of the three major U.S. credit bureaus, Equifax has a vast amount of personal information that it uses to score our creditworthiness for consumer loan applications. This credit reporting agency likely has your date of birth, social security number, marital status, a record of every address you have ever had, every car you have owned, court appearances, student loans, payment history for every credit card or loan you have ever held, and so on.
In 2016, MSCI Inc., one of the leading ESG ratings agencies, identified that Equifax had severely inadequate measures in place to protect against and respond to cybersecurity attacks. MSCI gave Equifax a rating of “0” on privacy and data security and removed the stock from its ESG Leaders Index. How did Equifax—a company in the business of assessing risk—respond to receiving a “complete and utter failure” score? The management and board of directors took no action.
The following year, Equifax’s information security department detected its security systems had been breached.2 Data of over 143 million consumers had been exposed, yet the company delayed disclosing this massive breach to the public for over a month. When the news broke on September 7, 2017, Equifax’ stock price plunged from $141/share to $93/share the following day. With 122,000,000 shares of stock outstanding, this breach resulted in a collective loss for shareholders of nearly $6 billion dollars. The stock price took two years to recover.
Consider how the outcome might have been different if management and the board had been engaged and actively addressed the privacy and data security issues that MSCI identified. Equifax’s low score on one governance metric turned out to be indicative of a bigger governance problem. The company’s lack of response affected many stakeholders: the exposed consumers, thousands of shareholders, and over 2,000 laid-off Equifax employees, to name a few. So much value and so many people could have been protected.
As investors, when we screen out companies with poor scores in governance, we stand to benefit from boards that are engaged, work on the behalf of shareholders, and take responsibility to protect the value of the firm they oversee. Applying governance scores also helps us by directing our investment dollars to well-managed companies that are best positioned to continue their growth, profits, and returns to shareholders.
Wrapping up this series on ESG, it’s worth noting that governance ultimately encompasses the two other ESG areas, Environmental and Social, discussed earlier, as a company’s performance on those metrics often depends on the decisions of its board and executive leadership. Integrating ESG scores into a traditional financial analysis helps us identify some of the financially strongest, best-managed companies to include in investment portfolios. Reach out to your advisor if you would like to discuss our wide variety of customizable ESG options.
1 “The Business Imperative of Diversity,” Boston Consulting Group. Tsusaka, M., Krentz, M., and Reeves, M. 2019, June 20.
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