New York – “The virulent debate over bankers’ pay ignores bigger problems—especially governance.” This is the header for an article in The Economist this week titled “Sound and Fury.” It argues that while executive’s six-zero bonuses are indeed infuriating to a society struggling in a fierce economic crisis, the more substantive issue of the governance structure that enables such payments has taken a back seat.
Fortunately, some have looked beyond the bonus “sound and fury” into deeper governance issues. GovernanceMetrics International (GMI), a governance research and ratings firm, has kept its eye on the bigger picture of corporate governance, thoroughly screening the space. In fact, an independent study issued last January analyzes GMI’s ratings and provides empirical support to the correlation between corporate governance and company performance.
The report addresses a key question: do additional sources of information relating to the governance of corporations have any relevance for investor decision making and therefore, does this information have the potential to increase shareholder welfare? Ultimately,the report concludes:
“This initial study has demonstrated that GMI ratings have historically had a significant influence upon future returns and that investors could have used them to earn economically significant excess returns from implementing simple investment strategies involving the holding of a portfolio that is say, long on GMI highly rated firms and short on low rated firms”
The report’s methodology goes beyond statistical analysis and includes simulation techniques. In order to determine whether the GMI ratings could actually be used in an investment setting, besides using traditional statistics, the authors created three simulated portfolios based on GMI’s scores (high, medium, low). These methodologies led the authors to affirm:
“We observed significantly lower raw and relative returns for the low-GMI portfolios than for either the high or medium GMI based portfolios. These results suggest that GMI ratings have been of significant economic importance to investors by providing them with a potentially simple and low cost method by which to make investment decisions.”
The study was restricted to US firms. However, Howard Sherman, GMI’s CEO, said that various studies internal and external to GMI show consistent results on the correlation between corporate governance and company performance across the globe. Mr. Sherman said that one of the key issues highlighted in these studies is the correlation between governance and the cost of capital. This is relevant to measure how the markets price corporate governance, which can be a helpful analytical tool to investors.
The study was conducted by Kevin Spellman, CFA, Director at Hawk Center for Applied Security Analysis at the Wisconsin School of Business, and Dr. Robert Watson, Professor of Financial Management at Instituto de Empresa Business School in Madrid. The two scholars conducted the study independently, without receiving monetary incentives from the GMI.