Coopting Good Governance

Professor Lucian Bebchuk and his co-authors at the Harvard Law School have produced an interesting paper concluding that while there may have been some excess returns to investing in a "good governance" portfolio in 1991-1999, no such excess return existed 2004-2008, just when the "good governance" investment thesis should have been paying off maximally.

Why? In a sense, "good governance" has been co-opted as a term. A good analogy is the term "organic" in the food business. The term was coined for small farmers using sensible land-use, water and pesticide practices and selling their products in farmers' markets to a narrow market segment. Now, that term has been co-opted by corporations of every size, and the consumer's Good Housekeeping Seal (remember that?) is certification by some body that no one knows about. We have organic Oreos (Paul Newman), organic coffee (Starbucks, Caribous) and organic vinegar. Quite often, in the case of chicken, the real practices used to meet the seal of approval are completely antithetical to the real meaning of the original label.

So it is with good governance. Enter businesses that label governance, like ISS, and public companies have learned how to game the system to get their seal of approval. But, it is almost impossible for an equity investor to truly know how well a portfolio company is governed without having tape transcripts of board meetings over a period of time. Since we get Fed transcripts five years later, we can forget this notion.

As academic research has pointed out, most corporate performance can be explained by the interaction of cyclical factors, random events, and intra-industry shifts in short-term market share.

Now that proxies are full of full of uninformative and non-measurable disclosures about processes, the focus on good governance and on aligning management's interest with those of stakeholders is abating. In fact, the article shows that publications in academic and NBER journals on governance peaked a few years ago.

Investors should continue more than ever to ferret out how a portfolio company is being run on a long-term basis but it can't be done by looking at proxies and governance ratings, as these have been stripped of meaningful value.