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Holly LaFon
Holly LaFon
Articles (9419)  | Author's Website |

Causeway Capital Study: Corporate Governance, ESG and Stock Returns Around the World

From investor Sarah Ketterer's firm

January 08, 2019 | About:

EXECUTIVE SUMMARY OF CAUSEWAY RESEARCH ON

“CORPORATE GOVERNANCE, ESG, AND STOCK RETURNS AROUND THE WORLD”

QUESTION:

Is there a relation between firms’ ESG performance and their stock return performance?

Firms’ performance on Environmental, Social, and Governance (“ESG”) issues has been gathering increasing attention from various parties, including customers, employees, public interest groups, and government regulators. Firms, in turn, have responded to this scrutiny by undertaking internal initiatives to improve performance on ESG issues, conducting non-deal management roadshows with investors to showcase their ESG practices, and publicly reporting on their ESG efforts in their annual reports. Against this backdrop, investors have been asking whether ESG performance predicts stock returns.

METHODOLOGY:

We constructed new corporate governance and ESG metrics, and examined whether they predicted stock returns in a global investable universe

A key challenge in examining the return predictability of ESG is how to measure ESG. Drawing on academic literature, we constructed a new corporate governance (“G”) metric based on the observation that the governance problem globally differs from that in the U.S. in three important ways. First, ownership structure tends to be more concentrated globally, with control being exercised by a founder, family, or state. Controlling shareholders can divert value from minority investors in many ways, and potentially vitiate traditional governance mechanisms such as boards of directors. Second, shareholder value maximization is not a universally acknowledged firm objective, and firms with more of a “stakeholder orientation” systematically subject shareholder interests to competition against the interests of a broader set of stakeholders. Third, it is difficult to assess firm-level governance in isolation from the country-level institutional setting that envelops it. Weak country-level institutions increase the risk of shareholder loss. We constructed a new governance metric that sought to systematically incorporate these governance factors alongside traditional governance factors.

We further constructed new environmental (“E”) and social (“S”) metrics by evaluating firms’ performance on material E and S issues. Material issues are those that are expected to impact financial performance. For example, fuel management is likely a material environmental issue for healthcare distributors who have a large fleet of distribution vehicles, but not for healthcare providers who are not heavy fuel consumers. We constructed material E and S metrics industry-by-industry, since material E and S issues likely vary by industry as in the foregoing example.

The new ESG score combined the new governance score, and material environmental and social scores, described above.

FINDINGS:

There is significant evidence that better governance and ESG performance were associated with better future stock return performance globally

We found significant evidence that firms with better governance had higher future stock returns in a global investable universe consisting of large, mid, and small cap firms from 42 countries.

Stripping out confounding differences in style characteristics, time, and sector, firms in the top governance quartile outperformed those in the bottom quartile by a statistically significant 31 basis points monthly, on average, over the 2009-2017 period for which we had governance data. This performance differential had an annualized information ratio of 0.75.

Firms in the top ESG quartile outperformed those in the bottom quartile by an average 32 basis points monthly over the 2013-2017 period for which we had ESG data. This performance differential had an annualized information ratio of 0.87.

We conducted a battery of robustness tests, and concluded that firms’ governance and ESG performance have the potential to predict their return performance if governance and ESG are measured correctly.

1. Introduction

Firms’ performance on Environmental, Social, and Governance (hereafter, “ESG”) issues has garnered increasing attention from various parties, including customers, employees, public interest groups, and government regulators. Firms, in turn, are increasingly ESG-aware, undertaking internal initiatives to improve performance on ESG issues, conducting non-deal management roadshows with investors to showcase their ESG practices, and publicly reporting on their ESG efforts in their annual reports. Against this backdrop, investors have been scanning for potential rewards and risk. Is there a relation between firms’ stock return performance and their ESG performance? A key challenge in examining the return predictability of ESG is how to measure ESG. In this paper we draw on prior academic literature to construct a new measure of ESG, and test its return predictability in a global investable universe.

We begin with the “G” in “ESG” by constructing a new governance score, based on the observation that the governance problem internationally is different from that in the U.S. in three ways. First, there

is significant variation in ownership structure globally (La Porta et al., 1999; Bebchuk and Weisbach, 2010). The U.S./U.K. context is largely characterized by dispersed share ownership, whereas a common ownership structure internationally is concentrated ownership with a controlling shareholder such as a founder, family, or state. The presence of a controlling shareholder changes the governance problem for shareholders, as conflicts of interest with managers are superseded by conflicts of interest with the controlling shareholder who can divert value from minority shareholders in a variety of ways (Bertrand

et al., 2002; Johnson et al., 2000; Jiang et al., 2010). In this case, traditional governance metrics such as board of director characteristics are unlikely to be informative about the strength of corporate governance if the board of directors is captured by the controlling shareholder.

Second, it is generally accepted in the U.S./U.K. setting that the purpose of the firm is to maximize shareholder value. This conception of the firm is not universally acknowledged across countries. Rather, in many countries the interests of shareholders are weighed against those of employees, community groups, and other stakeholders. The competing objectives of stakeholders likely render governance mechanisms developed in the U.S./U.K. setting less effective in other countries. For example, an independent board is unlikely to accord primacy to shareholder interests if half the board consists of employee representatives as is required for (supervisory boards of) large German companies (OECD, 2017)1.

Read more here.

About the author:

Holly LaFon
I'm a financial journalist with a Master of Science in journalism from Medill at Northwestern University.

Visit Holly LaFon's Website


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