ESG factors and investors — Much analysis has attempted to find an empirical link between ESG factors and investment returns. By contrast, the focus of our research is the significance of ESG factors for equity valuations.
“G” at the country level — We examine the significance of governance for country equity valuations using both “top-down” (governance at the national level) and “bottom up” (governance at the corporate level) metrics.
“G” matters — Our analysis reaffirms our conviction that systematically analyzing governance factors gives insight into regional valuations.
Macro metrics outweigh micro? The perception of good governance at the corporate level seems to be negated by the perception of poor governance at the national level.
Four macro measures that seem to matter most — A multiple regression shows that four macro measures of governance are correlated with country equity valuations. They are: (i) The World Economic Forum’s Corporate Governance score; (ii) The World Bank’s Ease of Doing Business Index; (iii) Transparency International’s Corruption Perceptions Index; (iv) The World Bank’s Worldwide Governance Indicators.
A composite national governance score — We take a weighted average of the four macro governance measures to derive a composite national governance score.
Gauging Governance Globally
Much analysis has attempted to find an empirical link between Environmental, Social & Governance (ESG) factors and investment returns. By contrast, the focus of our research has been the significance of ESG factors for equity valuations. When we introduced the Cornerstone Capital Regional Strategy model in the April 2014 edition of The Cornerstone Journal of Sustainable Finance & Banking we wrote that:
- We start with the assumption that only two things ultimately determine the fair value of equities: earnings and P/E. In the short term, other factors may play a role — e.g., sentiment (“fear” or “greed”), politics (including geopolitical issues), macroeconomic variables (e.g., Central Bank tightening or easing) etc. — but, in the long run, we believe it all comes down to earnings and the valuation of those earnings. A number of factors drive valuation multiples at any point in time, including perceptions of corporate governance.
We went on to rank the world’s major economies and regions utilizing a number of factors, including governance. We derived national governance scores by using two widely-cited surveys:
- The joint World Bank and International Finance Corporation “Doing Business 2014” report, which ranked 189 countries globally in terms of “ease of doing business.”
- Transparency International’s “Corruption Perceptions Index 2013,” which ranked 177 countries in terms of perceptions of public-sector corruption.
As we discuss in detail below, we have utilized a number of governance metrics to derive an improved national governance score — see Figure 1.
ESG Factors at the Country Level
In an analysis of sovereign credit risk, the United Nations Principles for Responsible Investment (PRI) noted that:
- Environmental factors showed the weakest correlations with sovereign bond performance in studies carried out by AXA Investment…Its research showed correlations between returns and governance and social ratings, but showed a weaker link to environmental issues.
In particular, the PRI pointed out that [italics added].:
- Corruption, a key indicator of governance failings, proved to be one of the most important factors of the euro-zone debt crisis. Tax avoidance and false financial statements on a massive scale undermine nations’ credit strength and mislead investors…Academic and investor research show that corruption and sovereign debt performance are clearly correlated [italics added].
- Moving to social factors, we see that a highly educated, IT-literate society paired with a repressive political system can increase the risk of political regime change. Egypt during the Arab Spring movement is a case in point. By looking at social and political factors, investors can build up a picture of a country, and better gauge the risks of investment.
Another PRI report that focused specifically on ESG factors and equity valuation noted that:
- The importance of considering both national and corporate governance has increased in recent times. It has become more apparent as investors have sought to profit from growth in developing and emerging markets where lack of transparency and underdeveloped legal structures exist. The financial crisis that has impacted economies since 2008 is widely considered to be caused by lack of appropriate governance at both company and country levels.
The PRI highlighted the significance of governance failings by contrasting the perceived attractiveness to investors of two different countries:
- The effects of corruption on economic activity and growth can be significant, making a strong case for giving it a higher weight in analysis: If India could reduce its corruption to Singapore’s level, the effect on attracting foreign investment would be the same as reducing its marginal corporate tax rate by 22 percent
In this report, we examine the significance of perceptions of national and corporate governance on equity valuations at the country level. In subsequent reports, we will study the correlations of social and environmental factors with equity valuations, which may well be more significant than the aforementioned PRI analysis on sovereign credit risk suggests.
Defining Corporate Governance
According to one definition, corporate governance “represents the relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations.” By this definition, corporate governance has both strategic and ethical implications:
- Simply put, bad corporate governance leads to bad strategy formulation and implementation.
- Among ethical issues associated with corporate governance are: (i) how to align the interests of top managers and shareholders; (ii) the proper level and function of executive compensation; (iii) who monitors the top management team and how that monitoring occurs; and (iv) inclusion of shareholders and non-shareholder stakeholders.
So, for example, the OECD Principles of Corporate Governance (currently under review and last revised in 2004) have five components:
- The rights of shareholders — The corporate governance framework should protect and facilitate the exercise of shareholders’ rights.
- The equitable treatment of shareholders — The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders.
- The role of stakeholders — The corporate governance framework should recognize the rights of stakeholders established by law or through mutual agreements and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.
- Disclosure and transparency — The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company.
- The responsibilities of the board — The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders.
However, as stated in the Preamble of the OECD report:
- The Principles are non-binding and do not aim at detailed prescriptions for national legislation. Rather, they seek to identify objectives and suggest various means for achieving them. Their purpose is to serve as a reference point. They can be used by policy makers as they examine and develop the legal and regulatory frameworks for corporate governance that reflect their own economic, social, legal and cultural circumstances, and by market participants as they develop their own practices.
Governance at the National Level
As noted, we introduced the Cornerstone Capital regional strategy model in the April 2014 edition of The Cornerstone Journal of Sustainable Finance & Banking and derived national governance scores by utilizing two widely-cited surveys: The World Bank “Doing Business 2014” report and Transparency International’s “Corruption Perceptions Index 2013.”
Subsequent to the publication of that report, we obtained a time series of the two surveys, which enabled us to perform further analysis. Figure 2 shows that, for the period 2007 – 2014, there was a positive relationship between a country’s P/E and its Ease of Doing Business rank. (Note that we have only plotted the data for the 33 countries with the largest weights in the MSCI All Country World Index, with their percentile rank being relative to the 189 countries in the “Doing Business 2014” report. We adopt a similar approach in subsequent figures.)
Similarly, Figure 3 shows that, for the period 2007 – 2013, there was a positive relationship between a country’s P/E and its Corruption Perceptions rank.
In other words, countries that offer relative ease in doing business or are perceived to have low public sector corruption are “rewarded” by investors in the form of relatively high P/Es.
A multiple regression reveals that the combination of the “Ease of Doing Business” and “Corruption Perceptions Index” percentiles produces a higher R squared (0.11) than the individual series (both with an R-squared of 0.10).
Governance at the Corporate Level
In addition, we recently gained access to GMI Ratings’ ESG ratings. GMI has been providing an independently calculated score of the quality of corporate governance at the company level in most of the world’s major economies for several years. The output is a score from 1 – 100, with 100 being the best.
There are four components of the GMI corporate governance rating:
- The Board Rating, which is scored primarily on the basis of the board’s independence from management, and on various measures of board experience and effectiveness.
- CEO and Other Executive Pay Practices Rating, which is scored primarily on both levels of pay, relative to peers, as well as specific features of the pay program design.
- Ownership & Control Rating, which is scored based on a company’s ownership and control structure.
- Accounting Rating, which takes into account corporate transparency and the reliability of reported financials.
We use GMI’s mean corporate governance score of the companies in a particular country as a “bottom-up” proxy for that country’s overall corporate governance. Figure 4 plots country P/Es against the mean corporate governance score of a given country’s companies for the period 2008 – 2014.
Clearly, there is no relationship between a country’s P/E and its mean company corporate governance score — indeed the R-squared of the two data series in Figure 4 is 0.00.
So, for example, GMI time series data reveal that, although governance at the corporate level in Russia has been ranked as better than corporate governance in South Korea in most years (with Korea’s family‑controlled chaebols being one potential factor here), Korea has consistently traded at a higher P/E multiple than Russia. Although Russian companies are rated in the middle of the pack in terms of the quality of their management, Russia is perceived to be a difficult country in which to do business, reflecting issues such as enforceable contractual and property rights. The perception of good governance at the corporate level seems to be negated by the perception of poor governance at the national level.
More Macro Metrics
Another data set we analyzed is The World Bank’s Worldwide Governance Indicators, which measures the traditions and institutions by which authority in a country is exercised. These indicators report annually on six broad dimensions of governance for 215 countries.
- Voice and Accountability: This indicator captures perceptions of the extent to which a country’s citizens are able to participate in selecting their government, as well as freedom of expression, freedom of association, and a free media.
- Political Stability and Absence of Violence: This indicator measures perceptions of the likelihood that the government will be destabilized or overthrown by unconstitutional or violent means, including politically-motivated violence and terrorism.
- Government Effectiveness: This indicator captures perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government’s commitment to such policies.
- Regulatory Quality: This indicator captures perceptions of the ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development.
- Rule of Law: This indicator captures perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence.
- Control of Corruption: This indicator measures corruption among public officials.
Figure 5 illustrates that the R-squared of The World Bank’s Worldwide Governance Indicators and country P/Es is a relatively low 0.07. However, it could well be that, although they are correlated with many countries’ P/Es, the World Bank’s Worldwide Governance Indicators follow a bell curve distribution, which results in a relatively low aggregate R-squared:
- A country that ranks poorly for “government effectiveness,” “regulatory quality” and “rule of law” (e.g., Russia) is awarded a relatively low P/E.
- But a highly regulated country (e.g., Italy) that ranks relatively well for “government effectiveness,” “regulatory quality” and “rule of law” is also awarded a relatively low P/E because of perceptions of a bureaucracy that impedes ease of doing business.
Separately, the World Economic Forum (WEF) Corporate Governance score is the average of seven specific scores for 148 countries that are based on a WEF Executive Opinion Survey. This annual survey captures the opinions of over 13,000 business leaders in the 148 economies on specific issues within their respective countries. The components of the WEF Corporate Governance score are:
- Ethical behavior of firms: How would you compare the corporate ethics (ethical behavior in interactions with public officials, politicians, and other enterprises) of firms in your country with those of other countries in the world? [1 = among the worst in the world; 7 = among the best in the world]
- Strength of auditing and reporting standards: In your country, how would you assess financial auditing and reporting standards regarding company financial performance? [1 = extremely weak; 7 = extremely strong]
- Efficacy of corporate boards: How would you characterize corporate governance by investors and boards of directors in your country? [1 = management has little accountability to investors and boards; 7 = investors and boards exert strong supervision of management decisions]
- Protection of minority shareholders’ interests: In your country, to what extent are the interests of minority shareholders protected by the legal system? [1 = not protected at all; 7 = fully protected]
- Reliance on professional management: In your country, who holds senior management positions? [1 = usually relatives or friends without regard to merit; 7 = mostly professional managers chosen for merit and qualifications]
- Willingness to delegate: In your country, how do you assess the willingness to delegate authority to subordinates? [1 = low – top management controls all important decisions; 7 = high – authority is mostly delegated to business unit heads and other lower-level managers]
- Extent of incentive-based compensation: To what extent is management compensation in your country based on performance rather than fixed salaries? [1 = not at all—based on fixed salaries; 7 = heavily—based on performance using bonuses or equity compensation]
Note that there is an overlap between some of these factors and the five components of the OECD Principles of Corporate Governance — Figure 6.
Figure 7 illustrates that the R-squared of the WEF Corporate Governance score and country P/Es is the highest yet at 0.13. It’s possible that surveying the opinions of thousands of executives within various countries gives amore accurate portrayal of national governance.
That said, none of the WEF Corporate Governance factors explicitly take into account perceptions of (i) ease of doing business, (ii) public sector corruption, or (iii) the effectiveness of the institutions by which authority in a country is exercised:
- Ease of Doing Business: As noted above, the perception that Russia is a difficult country in which to do business seems to negate the fact that Russian companies are rated in the middle of the pack in terms of the quality of their management.
- Corruption: The PRI highlighted that if India could reduce its corruption to Singapore’s level, the effect on attracting foreign investment would be the same as reducing its marginal corporate tax rate by 22 percent.
- Government Effectiveness: The PRI also pointed out that, by looking at political factors, investors can build up a picture of a country and better gauge the risks of investment.
A multiple regression reveals that the combination of (i)The World Economic Forum’s Corporate Governance score,(ii) The World Bank’s Ease of Doing Business Index, (iii) Transparency International’s Corruption Perceptions Index, and (iv) The World Bank’s Worldwide Governance Indicators produces the highest R-squared yet: 0.16.
A Weighted National Governance Score
In our regional equity strategy model, valuation and earnings are equal weight, with national governance representing 15-20% of the valuation weight i.e., an overall national governance weighting in the model of about 10%. A 10% weight for a factor (i.e., national governance) generating an R-squared of 0.16 with country equity valuations seems intuitively correct.
Figure 8 illustrates that we take a weighted average of the four governance measures to derive a composite national governance score. (Statistical analysis reveals, not surprisingly, a high degree of correlation among the four variables. In addition, countries’ percentile ranks are relatively stable in the time period covered, with average standard deviations ranging from 1% for the Worldwide Governance Indicator to 5% for the WEF Corporate Governance score.)
The WEF Corporate Governance rank gets the heaviest weight given its relatively strong correlation with country P/Es. Despite its low R-squared, we include The World Bank’s Worldwide Governance Indicators because a statistical analysis reveals that a four-variable model is more statistically significant than a three variable model (i.e., one that excludes the World Bank Worldwide Governance indicators).
Michael Geraghty is the Global Markets Strategist at Cornerstone Capital and formerly the founder of Informed Investor, LLC a consultancy specializing in thought leadership that produces bespoke research reports for institutional investors. Michael has over three decades of experience in the financial services industry including working as an investment strategist at UBS and Citi.
Arthur Copstein made an important contribution to the statistical analysis in this report.