Dr. P.V. Viswanath
Making Sense of the Risks Posed by Governance Issues
By HERB GREENBERG
Options backdating, sky-high salaries, conflicted boards of directors notwithstanding: Should corporate governance really matter when it comes to picking stocks? "It depends on what time frame you are looking at," says Gavin Anderson, chairman and co-founder of GovernanceMetrics International, a New York research firm that grades 4,000 companies on governance issues. "If you had a poorly governed oil company during the last 12 months, chances are that the stock has done well, regardless."
Likewise, Mr. Anderson says, if you owned Enron, WorldCom, Adelphia or even Global Crossing in 2001, "you would have been pretty happy looking at the future prospects for those stocks. But a look at the corporate-governance attributes would have told you that there was another kind of risk associated with them. The governance risk was their eventual undoing."
Like competition, currency swings and the price of oil, Mr. Anderson says governance "is just one risk" for investors to consider. As the rising number of governance-related issues shows, it is an important one, especially with institutional investors who seem to be using them increasingly as rallying cries either to flee or fight.
Mr. Anderson's firm grades firms based on dozens of measures in three broad areas. "Think of it like a Seurat painting," he says, referring to the French impressionist famous for such pointillist paintings as "Sunday in the Park." "One dot [or data point] means little. Twenty dots or pieces of information might provide a hint at the subject of the painting, but a lot of dots reveals a picture."
A review tends to start with such structural things as voting rights, director independence "and the sort of standards most people think of when they think of governance." Finally, the company's culture gets a once-over. "You can have a company that on paper has all the structural issues right but has a culture in which everybody is pushing to make earnings estimates. They will take shortcuts to do it."
Using those metrics, Mr. Anderson says the "poster child of poor governance" has been Apollo Group, which operates the University of Phoenix, which has received low grades ever since it was first rated by GovernanceMetrics in 2002. Issues include the company's use of a dual-class of stock, and low marks for not filing a proxy statement, though that isn't required for a company like Apollo, whose shares are controlled by a single person -- in this case founder and acting Executive Chairman John Sperling.
Apollo's vice president of public affairs, Terri Bishop, says that while there is no evidence that closely controlled companies have "any better or any worse records on issues arising from control," Apollo has spent the past year revamping its governance practices. "In addition," she says, "there is no statistically valid evidence, of which we are aware, that any of these 'governance' scores [such as GovernanceMetrics] can predict long-term financial performance."
Mr. Anderson counters that there tends to be a strong correlation between poor governance and underperformance, with Apollo as a prime example. In 2004, the company was stung by a report by the Education Department that zeroed in on questionable recruiting practices. Without admitting guilt, it paid a $9.8 million fine. More recently, Apollo has been among those companies snared by the stock-options backdating trap. After peaking at nearly $100 in the spring of 2004, the stock is trading at around $49. In comments following backdating-related earnings restatements, President Brian Mueller said Apollo believes it has "significantly strengthened" governance and internal controls.
The relationship between questionable governance and performance was studied by researchers led by Harvard professor Paul Gompers. Published in 2003 in the Quarterly Journal of Economics, its tracking of 1,500 companies found that buying those with good governance and selling those with poor governance throughout the 1990s would have produced returns that beat the market by 8.5% a year.
No surprise, then, that companies like Colgate-Palmolive, PepsiCo and Kimberly Clark, whose stocks have been solid performers, also have received the best possible grades year after year from Mr. Anderson's firm.
"Well governed companies face the same kind of market and competitor risks as everybody else," he says, "but the chance of an implosion caused by an ineffective board or management is way less." No argument here.