Corporate governance: Thinking fast and slow
Good corporate governance (CG) matters.
Yet the consensus amongst academics and professional practitioners about what ‘good governance’ actually looks like is mixed.
The UK is often seen as a leader in corporate governance. However, that did not stop Carillion, a major listed company, going into liquidation in 2017 following some serious CG failures.
Similarly, it has not meant that the UK has outperformed other developed markets. Indeed it has lagged the US whose corporate governance code is conspicuous by its absence.
Too much System 1 thinking
We believe that part of the problem is that current CG assessment techniques focus too heavily on what Daniel Kahneman, author of Thinking Fast and Slow, described as ‘System 1 thinking’ which comprises our intuition, gut-reactions based on first impressions, and easy to access information.
The prevalence of System 1 thinking in CG measurement is clear in the abundance of long lists of governance boxes to tick, codes to comply with and ‘quick’ governance scores.
We see plenty of evidence that this System 1 approach does not work, from the returns generated by US technology companies with unconventional governance structures to the issues experienced by companies such as Toshiba, which had all the right committees, 25% independent directors and had been viewed as a model of good governance in Japan.
Our System 2 assessment framework
As fundamental investors, we firmly believe assessing governance is worthwhile and is a factor that can support performance.
But determining a framework to assess this in an evidence-based and relevant manner is more complex than conventional scores and codes would have you believe.
The time has come for some slower thinking.
We believe the CG landscape needs more of Kahneman’s ‘System 2 thinking’ and not an exclusive focus on easy to access information.
System 2 thinking is the more critical thinking used for reflection, problem-solving, and analysis.
Using this thinking has enabled the development of a framework for assessing good CG that differs from the approach that more traditional measures take.
Essentially, more conventional methods focus on the inputs of CG, rather than their desired outcomes.
The starting base for the methodology of most governance scores is a local corporate governance code or an international norms-based structure, which is used as a measuring stick against which to assess companies’ governance abilities.
We believe in an approach identifying the desirable outcomes of good CG and have distilled them down to business oversight (financial transparency and lack of controversies), strategic oversight (effective capital allocation) and shareholder alignment (protection of minority rights).
We have then sought to identify indicators for these outcomes that have a positive effect on financial performance.
Our indicators captured factors that are not recognised by traditional governance scores such as the likelihood of earnings manipulations or bankruptcy.
The rise of unconventional data has assisted with this.
For example, quite often, we successfully follow strong managers and directors from company to company, and vice versa.
The help of our Data Insights Unit has been instrumental in enabling us to measure the strength, expertise and track records of companies’ respective boards.
Our extensive research also indicated that independent, diverse, unitary, and smaller boards are associated with better business and strategic oversight. We have long been advocates of all of these things as our ESG policy and engagement approach has shown.
Our research did throw up some surprises.
Neither the presence of an audit committee nor its independence featured as reliable indicators of good CG.
However, we are still advocates of independent audit committees.
We found that of greater importance was how the board treated minority shareholders and the CEO being aligned with shareholders with shareholdings and the right remuneration plans.
A more meaningful approach
Taking distinct perspectives of CG in the form of business and strategic oversight, as well as shareholder alignment, appear to be more meaningful as opposed to an approach that simplifies these perspectives down to the lowest denominator.
Our framework is all about combining the immediate System 1 process of simply considering traditional governance inputs as the basis for assessing CG, with the slower thinking System 2 method associated with identifying the desirable, but less easily quantifiable, outcomes of good CG.
Rather than focusing on the easiest option of linear box-ticking it is best to think both fast and slow when it comes to identifying best CG practice.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
This article first appeared in Financial News.
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