Avoid Stocks Hit With Corporate Governance Issues

Indian equity investors have had a rough ride over the past 18 months. During most times, the pain in the market has been due to economic slowdown, earnings downgrade, global meltdown, and various other financial aspects impacting the performance of the listed companies. This time around, what has caused negative impact is the lack of corporate governance in several of the listed companies. Investors were caught unprepared by such lack of corporate governance standards and practices by some of their favourite stocks. There was no way that investors at large would have predicted this issue of corporate governance emerging amidst the economic slowdown. 

Therefore, it is high time equity investors start recognising the importance of corporate governance and its relevance to sustainable equity returns. Often it is seen that corporate governance is not on the radar of investors while analysing stocks. With numerous reputed companies throwing negative surprises on the governance issues in the past couple of years, corporate governance has been a topic that can no more be sidelined. Says Amol Dandwate, a long-term equity investor: “All these years I was focusing on numbers and profitability to select stocks. After the recent corporate governance debacles, I am now going to read annual reports more thoroughly and try to estimate the corporate governance standards and principles of the chosen company. It is a must in my view.”

Understanding Corporate Governance Corporate governance in simple terms is a combination of rules, processes or laws by which businesses are operated, regulated and controlled. It includes the internal and external factors that affect the interests of a company’s stakeholders, including shareholders, customers, suppliers, government regulators and the management. Hence, the boards of directors are responsible for creating the framework for corporate governance that best suits the business conduct with its objectives. 

Investors in order to identify companies that adopt stringent corporate governance norms can definitely look at the following aspects of any listed company: performance measurement, disclosure practices, executive compensation decisions, dividend policies, procedures for reconciling conflicts of interest and explicit or implicit contracts between the company and shareholders. Investors should also be aware about the corporate governance principles that include the following key elements:

• All shareholders should be treated equally and fairly, implying that the shareholders are aware of their rights and how to exercise them. 

• Legal, contractual and social obligations to non-shareholder stakeholders must be upheld which includes communicating information to employees, investors, vendors and members of the community.

• The board of directors must maintain a commitment to ensure accountability, fairness, diversity and transparency within corporate governance by possessing adequate skills necessary to review management practices.

• Organisations must define a code of conduct for board members and executives, appointing new individuals only if they meet that standard. 

• All corporate governance policies and procedures must be transparent and disclosed to relevant stakeholders. 

The Importance of Awareness 

Investors can use this reference list of corporate governance principles to scrutinise companies on governance, wherever possible. Even if it is not easy to do so, being aware of these principles will surely go a long way in distinguishing quality companies from poor quality companies in terms of governance. As shareholders are the owners of the company, they must keep a check on the decisions and business operations of the company. 

The easiest way for an investor to look out for trouble in a company is by closely following any presence of related party transactions, siphoning of funds, loans to subsidiaries and lack of transparency in disclosure documents by the promoters. 

Mismanagement in cash flows exposes promoters to high risk in the stock market. This is the most common indicator of issues in corporate governance. Usually as the cash flows in a company go astray, promoters and top management officials are likely to resort to tricks like pledging of shares to raise funds, messing with the accounts to please bankers and big investors, diluting stake to raise funds, trying to divert in unrelated businesses, building relationships with market operators so as to manipulate their own stock, etc. Investors must look out for such irregularities progressing in a company. Executives tend to enjoy lavish compensations and hence a company must have effective claw-back provisions to safeguard the interest of investors. 

Conclusion 

Any well-run company is assumed to be adopting high corporate governance standards. Investors do not have an inclination to focus on the corporate governance standards and principles adopted by various listed entities. As a result, it comes as a shocker for most investors including the experts when a corporate governance issue threatens to destroy the business completely. 

Corporate governance ideally should guarantee exceptional transparency between the company management and its shareholders. Those companies that adopt transparency will always trade at a premium and those susceptible for issues related to corporate governance will struggle to get a premium in any market conditions, in fact may trade at a hefty discount to its peers. 

Corporate governance should be viewed as a central foundation of responsible and value-oriented management, efficient collaboration between the board of management and the supervisory board of management, transparent disclosures, and appropriate risk management. Investors are well-advised to not touch any companies that are facing scrutiny on corporate governance issues, not even when such stocks are available at 50 per cent cheaper rates than your purchase price. 

The temptation will always be there to buy cheap these listed stocks; however, it is strongly recommended to not do so.

Expert Quote

Azim Premji Chairman, WIPRO

"The real threat to business is from within, from poor ethical standards and lack of integrity that can do incalculable harm."

Albert Camus Author

"A man without ethics is a wild beast loosed upon this world"

Adi Godrej Chairman, Godrej Group

"Corporate governance should be done more through principles than rules."

Mervyn King Chairman, King Report

"Good corporate governance is about intellectual honesty and not just sticking to rules and regulations. Capital flowed towards companies that practiced this type of good governance."

Dr. Richard W. Leblanc Professor at University of York

"Corporate governance is the control of management in the best interests of the company, including accountability to shareholders who elect directors and auditors and vote on say on pay. How a company is governed influences rights and relationships among organisational stakeholders, and ultimately how an organisation is managed, and whether it succeeds or fails. Companies do not fail; boards do."

Jeffrey Sonnenfeld Professor at Yale University

"The highest performing companies have extremely contentious boards that regard dissent as an obligation and that treat no subject as nondiscussable."