Better Governance = Better Performance?

Terms like corporate governance and good governance have gained popularity
over the past 10 years, both in the business world and in financial markets.
While spreading the practices of good corporate governance is a priority for
policymakers, smart investors will certainly ask: does good corporate
governance lead to better performance on the stock market? Based on research
in Thailand, the short answer is: yes. Better corporate governance is
associated with better stock market performance among companies trading on
the Stock Exchange of Thailand.

In this brief report, I will: Define corporate governance, Give examples of bad
and good governance in corporate practice, Present the results of research on
the impact of good governance on the financial performance of companies
listed on the SET.

Background
In its broadest sense, corporate governance is the system by which companies
are managed and controlled. In practice, it boils down to finding an effective
and fair balance between the rights and responsibilities of the main players: the
managers of the firm, the shareholders, the Board of Directors, creditors,
employees and other stakeholders. In its most basic form, a corporate
governance problem arises when shareholders disagree with the actions taken
by the managers in charge of the firm. A good example is the merger between
HP and Compaq in 2002. The merger was proposed by the CEO in charge of
Hewlett-Packard, Carly Fiorina, but strongly opposed by Walter Hewlett, a
large shareholder and son of the founder of the company. The HP-Compaq
merger caused great conflict between the top managers of HP, who vigorously
defended the merger, and an opposing group of shareholders led by Walter
Hewlett which owned 18% of HP’s outstanding shares. Eventually, HP
organized a vote among all its shareholders about the merger and 51%
supported it.

Bad governance
In practice shareholders typically don’t get to use their votes to directly
influence the strategy of the company, as in the HP merger case. Most of the
time, shareholders only use their votes to appoint directors to the firm’s Board
of Directors and to approve the compensation of top executives. Apart from
these special cases, the interests of the shareholders are supposed to be
represented and protected by the Board of Directors, which has the authority to
hire and fire the managers in charge of the firm on behalf of the shareholders.
However, the consensus around the world these days is that supervision of top
management by the Board of Directors is often ineffective. The lack of
management oversight by corporate Boards is illustrated by a long list of
corporate scandals such as Anderson Consulting, Enron, WorldCom and
Parmalat.

Corporate governance problems can also arise when shareholders disagree

among themselves about how the firm should be managed. This is especially
common in disputes between controlling shareholders and minority
shareholders. A controlling shareholder typically holds such a large number of
shares – e.g. 20% or more of the shares with voting rights – that he or she can
influence the management of the firm. Minority shareholders, on the other
hand, hold only a small fraction of the company’s shares and have very little
influence. For example, many listed firms on SET are controlled by the
founding family, with family members often holding senior management
positions, such as CEO and CFO. In most cases, the founding family works
hard to increase the long-term value of the firm and all shareholders are happy.
However, in some cases conflicts of interest arise; for example, due to related
party transactions between the listed firm and other companies controlled by
the same family. Other examples of bad corporate governance are when the
manager-owner is caught “cooking the books”, usually to hide huge losses from
minority shareholders, or trading shares to exploit inside information about the
company.

Good governance initiatives

So, based on a string of corporate scandals around the world we can recognize
bad governance when we see it. But how can we recognize good corporate
governance? And once we recognize it, how can we stimulate and promote it?
At this point, enter governments and stock market regulators, who have stepped
in and taken the initiative. In most countries an official “Code of Best
Practices” has been introduced, exactly describing what good corporate
governance is and how companies can implement it. For example, in 1998 the
SET issued a code of best practices for Board members of listed companies,
followed in 2002 by 15 principles of good corporate governance for listed
companies.

Good corporate governance codes usually emphasize that a public company

should provide accurate and timely information to all stakeholders and make it
easy for shareholders to use their voting rights. Further, good governance
codes also try to strengthen the Board of Directors’ role as an independent body
supervising management.

For example, in Thailand the stock market regulators -- SEC and SET --require
listed companies to appoint at least three independent directors, who are not
related to major shareholders or the managers of the firm. Further, the SEC
requires the Board of each listed firm to establish an audit committee. This
committee is responsible for inspecting the company’s financial affairs and
monitoring whether decisions made by the Board are carried out by top
management. The good corporate governance principles of SET also
recommend firms to appoint an independent Chairman of the Board, but firms
are not required to follow this advice

Voluntary means irrelevant?

Some measures to improve good governance are required by law or imposed

by stock market regulators, such as the establishment of an audit committee.
However, in most countries, the majority of good corporate governance
recommendations are voluntary: firms can choose to implement them, or not. A
suspicious mind may wonder how corporate governance initiatives can be
effective if firms themselves are allowed to pick which recommendations they
wish to implement and which ones they will ignore. Research in a number of
developed markets, including Portugal, the Netherlands, Japan and Germany,
has indeed found evidence that voluntary good corporate governance
initiatives are ineffective. More precisely, the research found that the stock
market value of companies in these countries does not depend on whether firms
implement good governance practices or not. If investors are unwilling to pay
a premium to own shares in supposedly well-governed companies, then the
practical relevance of a good governance initiative is questionable.

Why do investors seem to care little about these voluntary good governance
initiatives? In developed markets, shareholders who feel that management is
abusing its power or mismanaging the firm, have a number of options. They
can organize themselves and start a vocal protest, just as Walter Hewlett did.
Further, in cases of suspected fraud, they can sue the company in court. Finally,
poorly managed companies can also be bought and taken over by competing
firms, with the failing managers usually ending up out of work. Relatively
weak voluntary corporate governance initiatives might not add a lot of value
when these alternative mechanisms are available for shareholders.

Emerging markets are different

In emerging markets, however, the story might be different as these alternative

means of enforcing shareholder rights are less developed. First, in emerging
stock markets trading is still dominated by individual investors, rather than
pension funds and other large investors. Individuals with small shareholdings
usually have limited knowledge about the company, and are not well organized.
They are unable to exert much influence on the company.

Second, hostile takeovers are very uncommon in emerging markets. This is due
to the presence of large controlling shareholders, as well as laws preventing
foreigners from buying local companies.

Third, an ineffective legal system often makes it difficult to successfully

prosecute and convict managers who abuse the company for their own benefit.
Thus, some of the key means by which corporate oversight is maintained in
developed markets is lacking in many emerging markets.

The most natural and effective way to ensure proper management of a firm in
an emerging market context may actually be concentration of ownership:
powerful large shareholders who monitor the management of the firm closely
or even get involved in management themselves. So, there are good reasons for
the large shareholdings held by founding families, companies, banks and
governments that we observe in Thailand and other emerging markets countries
around the world.

Even so, one problem remains: how to make sure that minority shareholders
are treated fairly by the large controlling shareholders? The minority
shareholders cannot be ignored; without their help the shares of the company
would not be traded, and share prices would end up very low. Therefore, good
governance codes usually include various policies designed to ensure the
protection of minority shareholders.

But the question still remains, when firms in emerging markets voluntarily
implement good governance principles, does it make any difference for
investors? Or, stated differently, does good governance lead to better
performance on the stock market?

Better Governance = Better Performance?

Recent research by the author on the impact of the good governance code
introduced by the Stock Exchange of Thailand in 2002 indicates that good
governance does matter. This can be seen from the following main results:

• Firms that followed most of the 15 good governance principles introduced by

SET in 2002 had a higher stock market value in the period 2003-2005
compared to firms that did not implement them.
• The stock return of the top 20% “good governance” companies in the period
2003-2005 was 19% per year better than the stock return of the bottom 20%
companies (see Figure 1).
• The bottom 20% companies had much lower accounting performance, as
measured by the Return on Equity (ROE). Their ROE was only 9.3% versus
15.2% for the top 20% companies.

• Finally, lack of good governance procedures seems to have the strongest

impact. The bottom 20% of firms based on implementation of good
governance underperformed the SET index by more than 16% per year.

Looking back to the period 2003-2005, we can conclude that Thai investors
could have benefited from avoiding companies that did not implement good
governance principles. The SET requires companies to disclose annually how
they implement the principles in their annual registration statements (Form 56-
1) and annual reports. So, information about the corporate governance of
listed Thai companies is publicly available, for example on the SET website.
Investors can either use this information for their own advantage, or choose to
ignore it at their own risk.

Figure 1: Stock Return of the Top 20% and Bottom 20% of Firms
based on Implementation of Good Corporate Governance Principles
Bottom 20%
firms based on
governance
Top 20%
firms based on
governance
SET
Index
Portfolio value: 30-Jun-03
100.0
100.0
100.0
Portfolio value: 31-Dec-05
117.4
176.5
169.4
Annual portfolio return
6.6%
25.5%
23.5%

References
Roy Kouwenberg (2006), “Does Voluntary Corporate Governance Code
Adoption Increase Firm Value in Emerging Markets? Evidence from
Thailand”,Research paper, Mahidol University, College of Management.
1
For more detailed results, see Kouwenberg (2006). The research considered a sample of 320
listed Thai firms. The CG Center of SET kindly provided data about the implementation of the 15
good governance principles by these firms for the accounting year 2002, measured by a score on
scale from 0 to 100. The research analyzed the relation between average firm value in the period
2003-2005 (measured by Tobin’s Q) and the governance score for the year 2002, while
controlling for other factors that might affect firm value (industry effects, firm size, ownership
concentration, profitability and sales growth). The results show that a one standard deviation
increase in the governance score in 2002 (about 13 points) is related to a 10% increase in average
firm value in the period 2003-2005. The relation is statistically significant and robust to various
changes in the model.
The research paper, Kouwenberg (2006), reports a slightly lower estimate of the difference (16%)
because it uses logarithmic returns. Here, in Table 1, we use yearly compounded returns as they
are easier to interpret for investors. Note that the difference in returns might be caused other
factors, not related to corporate governance. For example, an alternative explanation might be
that the companies in the bottom 20% governance portfolio are less risky and investors are
willing to accept a lower return for this reason. Further evidence shows that risk can explain a
part of the difference in returns, but not all of it. See Kouwenberg (2006) for more details. The
statistical evidence on the exact factor driving the return difference, e.g. governance or risk, is
still inconclusive. However, the author of this article is of the opinion that the difference in
returns between the bottom 20% and top 20% portfolios is so large (19% per year), that investors
should be aware of it, regardless of the underlying driving factor.

Address: Mahidol University, College of Management, 69 Vipawadee Rangsit Rd., 10400, Bangkok,
Thailand. Email: roy.k@cmmu.net. The author is indebted to the Corporate Governance Center of the
Stock Exchange of Thailand for providing data on the corporate governance of Thai listed companies and
Tjeert Keijzer for helping to collect financial data. Special thanks to Suraphon Buphakosum of the CG
Center for his help.