Exploring the G in ESG: The Relationship Between Good Corporate Governance and Stock Performance – Part 2

Year-to-date, Facebook (FB) was down 7.13% as of April 12, 2018, compared to its 53% total return in 2017. What started as a data breach issue has expanded to encompass management structure, procedures, and safeguard concerns—issues that are all related to corporate governance. Market participants have a tendency to only care about corporate governance when things go wrong, despite empirical evidence that companies with strong governance tend to perform better than those with weak governance.

We have been exploring the “G” component of ESG, and many tech companies in general do not score favorably on the governance front. In a previous blog, we provided a breakdown of the various elements or dimensions that are part of the S&P Dow Jones Indices’ governance score. In this follow-up blog, we explore the return information contained in the governance component and how investors can manage risk by avoiding companies with low governance scores.

To test whether ESG scores, G in particular, correspond to future stock performance, we formed hypothetical, annually rebalanced quintile portfolios, and we ranked them in descending order by scores and tracked their forward 12-month performance. The underlying universe was the RobecoSAM coverage universe, which comprises 400 global companies starting from December 2000 and increasing to over 4,000 stocks in 2017. The quintile portfolios were formed on an annual basis as of December 31 of every year, and returns are in USD.

In regard to the governance score, looking at the period from inception in 2001 to present, there was little distinction in performance between companies in the top three quintiles. However, there was a clear distinction between these quintiles and the bottom quintile (see Exhibit 1). Securities with the lowest governance scores, on average, underperformed (7.84%) those that ranked higher.

The spread between the top and bottom quintile was greatest for the governance criteria, representing almost double the spread for the total ESG score (0.90%).

The asymmetrical return profile suggests that companies that rank well below average on good governance characteristics are particularly prone to mismanagement and risk the ability to capitalize on business opportunities over time. Management strategy and ability, whether superior or compromised, will manifest over time and therefore, economic dimension-scored portfolios should be viewed over longer time horizons as the time element is necessary in revealing whether the strategy is working or not.

As discussed in Part 1, the EDS is comprised of more than just traditional governance criterion and includes business strategy, risk management, and tax strategy—elements that are long term and strategic in nature. The inception data in Exhibit 2 provides a 17-year timeframe in which to gauge the performance of quintile portfolios. The bottom quintile returned 7.84% annualized compared to 9.51% for the first quintile, 10.02% for the second quintile, and 9.58% for the third quintile.

The underperformance of securities with the lowest governance scores is even more readily apparent when viewed over rolling periods. To demonstrate, we calculated annualized rolling one-year, three-year, and five-year returns, and we reported the averages. On average, across all three calculation periods, the Q5 portfolio, which comprises companies with the lowest governance scores, underperformed the Q1 portfolio by 1.8%-2.0% (see Exhibit 3). The results indicate that market participants may be economically better off avoiding securities that rank in the bottom quintile of the governance universe.

In the next blog, we will continue the discussion on ESG scores and stock performance, however with a focus on the “E” and “S” scores.

Sources:

Gompers, Ishii, and Metrick (2003) and Bebchuk, Cohen, and Ferrell (2009)

The posts on this blog are opinions, not advice. Please read our disclaimers.

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