Investment Insights

Corporate governance: Thinking fast and slow

Corporate Governance (CG) is important to investors, but it is more complex than first appearances would have you believe. With contemporary CG measures running the risk of oversimplifying a topic that is too complex to be captured in a single number, we introduce an indicators-based perspective of CG.

10/07/2019

Marc Hassler

Marc Hassler

Sustainable Investment Analyst

Jessica Ground

Jessica Ground

Global Head of Stewardship

Daniel Kahneman’s book “Thinking Fast and Slow” is essential reading for anyone who invests. It shows, by breaking down the thinking behind decision making, where we are prone to mistakes in our judgement. Most of our everyday thinking is based on System 1, which comprises our intuition, gut-reactions based on first impressions, and easy to access information.

System 2 is the more analytical critical thinking used for reflection, problem-solving, and analysis. This is the thinking that should kick in when System 1 does not offer answers, where we observe things outside our expectations, or where we are making mistakes.

If we survey the corporate governance (CG) landscape today we can see plenty examples of System 1 thinking: long lists of governance boxes to tick, codes to comply with and “quick” governance scores. Yet we also see plenty of evidence that this approach does not work, from the returns generated by technology companies with unconventional governance structures to the failure of companies such as Toshiba, which had all the right committees and 25% independent directors, a model of governance in Japan.

Governance is important to investors, but it is more complex than first appearances would have you believe. For example the number of governance inputs that are easily observable is high. Current practice then focuses on these, working under the assumption the most important aspect of governance is constructing the right framework. This System 1 approach suffers from assuming that correlation is the same as causation. However good governance should not be seen as an end in itself, but rather as something that if well executed, leads to the best possible result of long-term sustainable returns. We have turned our focus to identifying indicators of strong governance practice that deliver these kinds of financial results; an activity that we would argue needs System 2 thinking.

With contemporary CG measures running the risk of oversimplifying a topic that is too complex to be captured in a single number, we introduce an indicators-based perspective of CG and examine how it relates to financial performance. We started by identifying what desirable indicators of good CG would look like. Appendix 1 on page 11 provides a brief summary of the process. We find that taking distinct perspectives of CG in the form of business oversight, strategic oversight and shareholder alignment appear to be more meaningful compared to an approach that simplifies these perspectives into a single dimension. However, our analysis suggests that CG is dependent on context and a singular plug-and-play approach when implementing CG into investment decisions should be handled with caution. While it is hardly possible to fully capture all facets of CG in such a systematic approach, our model serves as an empirical framework providing a starting point for company-specific analyses in a more meaningful fashion than the typical fast thinking System 1 perspective.

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