What’s Good Governance?

Investing in good businesses seems self-evident, but how do you determine which companies fit the bill?

Corporate governance can be one way to find out. It looks at how well a company mitigates risk, provides oversight and holds its managers and employees accountable.

It’s one of the three pillars of sustainable investing (environmental, social and governance or ESG), and it’s also used by fund managers who don’t identify as sustainable investors.

Good governance seeks to maximize value and mitigate risks

Some portfolio managers, like those at Oakmark, believe good governance can help maximize a company’s long-term value. Others use governance to try to mitigate risks. A CFA Institute survey1found that 63% of portfolio managers and research analysts relied on environmental, social and governance (ESG) criteria to help them manage risks.

Equifax is one example of how ESG ratings can help identify a company’s risks. In September 2017 the colossal credit reporting agency reported one of the worst security breaches in history, putting the personal information of potentially 140 million people at risk. The data breach hurt its investors as well as its customers —Equifax’s stock price plummeted over 30% in the six trading days following disclosure of the breach. Its bond ratings also sank and its CEO stepped down.

Investors who screen companies’ environmental, social and governance (ESG) practices may have been able to sidestep these problems. Equifax had low ESG ratings from MSCI and Sustainalytics, two leading ESG-rating firms. In fact, a year before the 2017 data breach, MSCI gave Equifax their lowest possible rating, citing governance concerns. “Equifax shows no evidence of data breach plans or regular audits of its information securities policies and systems,” MSCI reported.

What good governance looks like

Good governance is sometimes used as a proxy for good management. Well-governed companies tend to have strong oversight and a system of checks and balances that aim to help them avoid the kinds of problems that Equifax faces, including costly mistakes, lawsuits or regulatory problems that could hurt their bottom line.

Well-governed companies usually have an independent board of directors who work to keep management in check and look out for the rights of shareholders and customers. These companies also seek to address key issues, such as executive compensation and cyber security, and they’re transparent about their accounting and financial statements as well as their political spending.

Apple and Google are examples of good governance: both have independent boards of directors who are elected annually, and they have separate CEO and chairman roles. Google is working to address pay inequality, while Apple seeks to improve diversity in its workforce.

As an investor, you don’t have to reward mismanaged or poorly governed companies with your investment dollars. Instead, you can choose to own companies whose values manifest in a more sustainable way. We can help: the FundX Sustainable Impact Fund (SRIFX) is a way for you to own a portfolio of diversified stock funds that have strong environmental, social and governance (ESG) ratings as well as strong recent returns.

Publication Date: Autumn 2017