Zeal ESG Insight: Governance – The cornerstone of ESG

Would you take a guess on which one of the ESG elements professional investors value the most?

Before revealing the answer, there is a story we would like to share with you. It began with a visit to a mid-sized manufacturing company in Southeast Asia many years ago. Little did we know that the moment we set foot in the premise, it would be its lobby that had us flabbergasted.

The atrium was tall and wide, while the honeydew green marble slabs covering the floor were exquisitely juxtaposed with white marble, each tile waxed so finely that they reflected vaguely the marble wall behind the concierge counter. That wall could not have been the work of an amateur interior designer – every streak and vein of the metamorphic rock was an artwork of its own, with each of the backlit marble tile carefully mounted, leaving a small gap between them so that the soft lighting seeping out of the wall would accentuate the intricate patterns of the stones further.

The concierge counter in gold polish was equally magnificent. It’s around ten-feet-wide, with the front facing the main entrance designed with wave effects. Indeed, it sounded ostentatious, but, together with an orchid arrangement sitting on the counter, nothing looked out of place.

Adding an extra touch of luxury was the backlit ceiling: lights were diffused from the top, illuminating the entire lobby without overwhelming the eyes. In the center of it hung a tasteful chandelier, glistening softly and conveying the elegance of a six-star hotel.

The splendor of the lobby certainly made an impression on us, to say the least – it resembled more of a luxury hotel than a manufacturing company.

But first, back to the question about which one of the ESG elements carries the heaviest weight. In a 2017 poll by the CFA Institute, 67% of investors would integrate corporate governance (G) into the investment decision process, more than those who would consider environmental and social factors[1]. Naturally, stock prices are highly subject to the quality of corporate governance.

Many components make up what we now broadly call corporate governance, but in essence the following two criteria should be met: is capital being put to good use, and are minority shareholders being treated as fairly as those holding larger stakes.

In the example above about the manufacturer, should it really be splurging on fancy décor? Whose interests did those marble tiles serve? Had it been a private bank, it probably wouldn’t hurt to fuss over furnishing pieces and decorative lighting. They could well command confidence from clients, which would ultimately be good for business. But the customer base in question here is that of manufacturers, who would more likely fret over product quality and costs than whether the lobby floor has marble in it. In other words, what they would generate for the company’s investors was anything but tangible returns.

Now that we have looked at what responsible corporate finance means, we think that, in investors’ analysis of how well companies are upholding governance standards, they could also pay attention to whether bigger shareholders are cognizant of the interests of smaller ones. For example:

1. Should corporates be distributing dividends? We don’t think failing to do so reflects poor governance, rather, the crux of the issue lies more in the “why”. If business performance is robust with substantial potential for further growth, the decision to not distribute dividends may be justified, or encouraged even, provided that profits are being reinvested. Ultimately, such moves will support share prices.

If instead, the profits end up being hoarded or squandered in speculative stocks, without any plans to be reinvested, the lack of dividends will reflect poorly on the corporates’ governance quality. It shows an insufficient focus on creating value for minority shareholders. As such, we think analysts should exercise more caution towards valuing these companies.

2. Are corporates hiring reputable accounting firms to handle their financial records? It could be a red flag for analysts if turnover of auditors is high, or if there’s an apparent predilection for smaller accounting firms.

3. Are they entangled in convoluted business ties with their parent companies? The more complicated these dealings are, the easier their boards could potentially manipulate the financial records.

4. How are corporates’ shares classified? The Hong Kong Stock Exchange has relaxed the rules on weighted voting rights in a bid to attract Chinese tech companies to go public in the city, giving some companies’ senior management personnel disproportionate voting rights than allotted by the shares they hold. This could put minority shareholders at a disadvantage, so we think analysts should take due note of how share classes are structured as well.

[1] Source: CFA Institute, as of Dec 2017


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