Corporate governance in PSUs is negligible, while the prime motive of family run business is to maintain control and not produce profits for shareholders. So for increased returns on your investment, pick companies with the most corporate oversight and the best governance.
Over the centuries judges in common law learned something about human nature. They realised that agents might not be particularly honest when acting on behalf of their principals. To remedy this problem, they created the highest duty under the law, a fiduciary duty, and assigned it to agents. This duty is now borne by all sorts of agents including trustees, employees, partners, and corporate officers. Wisdom of this judge-made law is confirmed by game theory. In game theory an agent’s best move is to cheat the principal.
For investors, the most important aspect of this concept is corporate governance. The basic idea of good corporate governance is to develop methods where the true owners of a corporation, its shareholders, have some sort of say over the agents running the corporation, the officers and directors.
Some of the basic principals include that executives and their pay should be accountable to shareholders. Companies should be transparent. Shareholders should exercise their stewardship over the companies they own by participating in all votes. Finally, investors should be more concerned about the long-term outlook for the company, in contrast to employees who know that their tenure may be limited.
Depending on the country, some of these concepts are either enshrined in law, regulations or sometimes listing contracts. Their importance is correlated with the distance between the owners and the officers. In small companies they are not needed because they owners are the officers. They are absolutely necessary though for widely held listed companies.
In the largest markets, the rights of the shareholders are often not exercised by them. These days they are often outsourced to large proxy advisors, who have become very powerful. Large fund managers are also the arbitrators of shareholder rights. This may concentrate power away from the final owners, but well-informed opposition to management might not be such a bad idea.
Even in the large well-developed markets, elites, not shareholders, call the shots. In France, corporate policy is often dictated by a combination of well-connected industrial families, state investment agencies, large unions, and last but not least the industry minister. Being an alumni of one of the three elite “Grand Ecoles”, whose networks Harvard alums can only envy, usually connect this web of government, union and corporate officers. Fortunately the power of this elite is breaking down. The reason is that foreigners, who insist on higher standards, now own half of the shares of the biggest French firms listed on the CAC-40.
Italy has had the same issues. There are no Grand Ecoles in Italy, but there is Mediobanca. Mediobanca is an investment bank at the center of a web of cross-shareholdings, shareholder pacts and nested stakes, that allow control despite ownership of relatively small shareholdings. Mediobanca is in theory selling many of its stakes in other companies, but old habits die-hard.
Italy may have problems, but it doesn’t compare to Japan. In Japan nearly 600 of the 1,400 listed firms still do not have any outside directors. In contrast China, South Korea and India, not paragons of corporate governance, all require them. Only 0.2% of Japanese listed companies had majority independent boards. In the US the number is 90%, 50% in the UK and 30% in Singapore.
As part of Prime Minister Abe’s third arrow reform efforts, there is a proposal to change the rules. The proposal includes guidance for appointment of independent directors. The provision is voluntary, but refusal requires explanation. The powerful Keidanren business lobby is opposing the provision. It has been successful in blocking all such proposals before.
Still Japan is far ahead of other Asian markets in one respect. It has the largest percentage of firms with diverse owners. Only 28% of Asian firms fall in this category and the vast majority are listed in Japan. Most firms in Asia are either state owned (40%) or family run (27%). Neither type of firm is known for allowing shareholders a major say in a company’s operations.
The probability for reform of corporate governance of state owned firms is negligible. For government officials, their largest asset is their potential for corruption and patronage. The largest listed Chinese and Indian firms each employ between a quarter and a half million people.
Family firms are equally difficult to change. Their prime directive is for the family to maintain control, not produce profits for shareholders. These firms are often excellent examples of crony capitalism. Large state owned banks are the source for cheap capital for both family and state owned firms. Seven of the ten largest firms in India have been tainted with corruption scandals. The ten most indebted firms account for 13% of the banking system’s bad loans.
So who cares? Why would investors or policy makers want to encourage good corporate governance anyway? The simple reason is money. Good corporate governance makes companies attractive to investors and makes them more profitable. The firms in the TOPIX 500 index had an average return on equity in 2012 of 7%, compared with over 15% for American and European companies. State run firms in Asia with their terrible corporate governance have lost a trillion dollars in value since 2007. Their aggregate PE ratio is half of private firms.
In developed markets, recent research has shown that the best governed companies did not out perform their peers, but the 10%-20% of firms with the worst corporate governance definitely underperformed.
So the conclusion is simple. If you want the best management team who will do the most to increase your investment, pick companies with the most corporate oversight and the best governance.