Aug 27, 2017
Corporate governance is the application of best management practices, compliance with laws and regulations and adherence to ethical standards for effective management and distribution of wealth and discharge of social responsibility for sustainable development of stakeholders. Good corporate governance is essential for the vibrancy and efficiency of any financial market. Over the years, we have seen vast financial losses, both globally and locally, partly attributable to poor corporate governance structures and oversight.
This focus note aims to first highlight the need for good and sound corporate governance, and point out examples of firms where poor corporate governance has led to investor losses. We then aim to conclude by demonstrating that proper corporate governance structures do have a correlation to stock market performance, but requires the input of all market participants and stakeholders, drawing lessons from the US market, where proper corporate governance has led to the recovery from the global financial crisis in 2008, and vibrancy of the financial market.
Following the global financial crisis in 2008, more emphasis has been placed on good corporate governance and consequently, the redefinition of corporate value has become increasingly imperative. The financial crisis of 2008 led to the review of global principles regarding corporate governance after it was determined that poor governance contributed largely to institutional failures in the crisis. Bringing this home, we are all too familiar with the recent bank failures and operational crisis in firms such as:
Taking the United States as an example, corporate governance is strong given that it is embraced as an industrywide practice. The following are the stakeholders involved in enforcing corporate governance:
The regulation around corporate governance in the US has been so strong post-2008, that there is a clear correlation between stock market returns and corporate governance. Previously, investing in companies with great corporate governance was considered a niche market, but post 2008, with tighter regulations around corporate governance, picking any stock from the market is almost a guarantee that they have the right governance structures in place. The chart below of, the MSCI KLD 400 Social Index, a market cap weighted index of 400 U.S. securities that provides exposure to companies with outstanding governance ratings, against the S&P 500, clearly indicate that the market and the social index deliver generally similar returns over the years. Since both indices are market cap weighted, and deliver similar returns, it is an indication that the largest companies by market cap in US, are also the ones that rank highest in terms of corporate governance.
However, in markets where corporate governance structures have not been as tightly enforced, stocks with great corporate governance structures outperform the market. In Turkey, comparing the BIST Corporate Governance Index (a market cap weighted index comprising of 50 of the highest-ranking companies as per their corporate governance ratings) and the BIST 100 Index, the BIST Corporate Governance Index has outperformed the BIST 100 Index, having grown by a CAGR of 18.8% and 17.6% since 2009, respectively.
The correlation between corporate governance and stock performance can also be observed in the Nairobi Securities Exchange (NSE). The recently released Cytonn Corporate Governance Ranking Report 2017, (CGR), highlighted the strong correlation between corporate governance and returns on stocks of the listed entities. The top 25 companies in the Cytonn CGR delivered an absolute return of approximately 37.8% over the last 5-years compared to the bottom 25 companies, which delivered an absolute return of (5.1%) per annum over the last 5-years. The chart below illustrates this:
From the above examples, it is clear that corporate governance has a direct relationship with stock markets returns. However, for the Kenyan case, it is imperative that corporate governance be emphasised to a level where an investor does not necessarily have to dig deep to gauge whether a company has put in place the right corporate governance structures. This can be achieved by both companies and regulators taking an initiative in educating both the corporate world and the public on the importance and impact of corporate governance on returns and sustainability for the future. Assessing the corporate governance regulation in the Kenyan market, we have to applaud the Kenyan listed entities in their mission to firm up to sound corporate governance practices. We cannot also fail to recognise the support from increased regulation from various bodies and organizations responsible for corporate governance oversight, with (i) the CMA publishing the Code of Governance Practices, and (ii) the Government of Kenya forming Mwongozo, an independent body tasked with management, governance and oversight of state corporations, which is essential for stability of the companies and the general market. However, despite a general improvement in terms of market participants embracing global best practices in terms of corporate governance, there still lacks a significant level of goodwill in adopting said practices.
Sound corporate governance structures are essential to well-functioning and vibrant financial markets. However, structures do not mean anything if there lacks goodwill and participation from all stakeholders. It is therefore imperative that all participants ensure that they are adhering to the corporate governance structures set out by the various regulators.