U.S. investors have been slower than their European counterparts to embrace research focused on a public company’s environmental, social and governance (ESG) profile. U.S. investors tend to be skeptical whether ESG factors make a difference in a stock’s performance. A recent academic study suggests that governance factors do influence stock performance.
In a recent study that will be published by The Journal of Financial Economics, Lucian Bebchuk, Alma Cohen, and Charles Wang examined the reaction of stock prices to earnings announcements and found that prior to 2001 the earnings announcement of companies with positive governance characteristics were more likely than those of poor-governance companies to surprise the market positively. Since 2001, the difference between ‘good-governance’ firms and ‘poor-governance’ firms is reflected in the relative stock prices, suggesting to the study’s authors that market participants are now paying more attention to governance factors.
We see this trend reflected in the investment research community. Fundamental analysis is more likely to evaluate the governance characteristics of a publicly traded company. At the same time, forensic research providers such as Assay, Veritas and Vision Research seek out the accounting tricks associated with poor governance, which their clients translate into short sales of ‘poor-governance’ companies which attempt to manipulate their accounting policies.
In addition, research firms focused on environmental, social and governance factors (ESG research) explicitly examine governance factors. Firms like GMI Ratings, Riskmetrics and EIRIS evaluate board structure, management compensation, and other governance factors. Firms like Management CV go further, assessing management quality.
In a survey we conducted in 2011, governance was the most valued component of ESG research with 61% of asset managers using ESG research finding governance factors “very valuable”.
In the forthcoming study, Bebchuk, Cohen and Wang found that a strategy of buying stocks with good governance stocks and shorting poor governance stocks generated excess returns from 1990 to 2001, but not subsequently. The authors focused primarily on board structure and takeover provisions: staggered boards, limits to shareholder bylaw amendments, supermajority requirements, poison pills and golden parachutes.
The findings suggest that market participants began paying more attention to governance factors in the last decade, and that these factors are now reflected in stock prices. At first glance, this result suggests ESG skeptics, having missed the boat in generating alpha, are now vindicated. However, the study focused on only a small subset of governance factors which research providers now assess.
While board structure and takeover provisions may now be reflected in stock prices, other governance factors may not. As study author Lucian Bebchuk put it: “Are there any ways left for investors to make money from governance? Yes. Some governance arrangements outside the governance indexes might not be priced yet, and investors could look for them. Our findings indicate that markets might require significant time to recognize fully, and incorporate into prices, the significance of certain governance arrangements.” Innovative approaches to evaluating governance have generated alpha in the past, and can do so in the future.