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The Compounding Effect of Corporate Governance
Great businesses don’t always generate great stock returns. And poor corporate governance can explain a lot of such instances.
A positive side of the existence of activist investors is that the companies start implementing good practices proactively.
Bad Capital Allocation Destroys Value
There are companies that are trading at discounts to their “real” value regardless of all the positive things they have or project – low financial leverage, defensible tech, growing cash flows. However, market investors don’t believe the management is doing a good job at capital allocation via reinvesting profits, as evidenced by past failures.
Another reason is that the company is doing a poor job talking to investors about their use of funds. It’s one skill of the Board that is routinely overlooked and it’s the first to be picked up.
It shouldn’t come as a surprise that poor investment decisions are made in attempts to boost stock price and appear more innovative than the company really is.
It’s also fair to say that the lower ROE the company has – the higher the negative impact on its stock price is. Getting the ROE below the hurdle rate effectively destroys shareholder value.
So improving capital allocation (at least making it less hectic) and corporate governance should have a positive compounding effect on the firm’s performance.
The Importance of Corporate Governance
Corp gov practices and policies, together with exec compensation, materially impact the performance and the value of the corporation.
The ability to communicate to the CEO, the exec team and the Board gives sizeable investors more assurance and comfort.
But a row of poor investment decisions (while initially being tolerated) and the inability / unwillingness to change course eventually takes toll on the share price and leads to uncomfortable conversations with the management.
Good governance means that the conversations with the management take place before the capital allocation even, and hence are much more friendly. Avoiding snap decisions (made for various reasons, many of which are meant for the CEO to prove their worth with the Board, i.e. completely unpractical) is a nice outcome (among others) of giving the Board a true voice.
Mistakes are tolerated on the way up, but they don’t go away, but rather compound and accumulate. This leads to bad governance debt that can sink the firm (and the Directors, for that matter).
Many “high growth” or “high quality” companies have an Achilles heel of substandard corporate governance, which can bring down said companies (e.g. Uber, WeWork).
One can have really bad governance with even the best Directors – just by mismanaging the Board dynamics, ignoring strong signals and not asking the right questions.
Good governance is easy to spot in the hindsight (by looking at a long stretch of increasing stock price performance), but in itself it can’t be estimated in dollar terms and never make it to the P&L.
One way to look at the quality of the governance is looking at stakeholders: employees (low churn [MK: but: a) good luck figuring it out from the outside; and b) low churn is also a function of good hiring]) or shareholders who hold on to their shares longer.
Unsuccessful bets are better tolerated for companies with a history of good governance; such companies also seem to weather crises better due to the better capital allocation rules.