Do "Bad" Companies Make Bad Investments?

Wouldn't you like to know if you own the next Enron? That's exactly what ratings agencies like GMI Ratings attempt to predict by judging companies based on several governance measures, like excessive compensation or poorly constructed boards. And through using these factors, it selects a handful of companies that "stakeholders should review with concern." But should stakeholders care about these ratings?

Put another way, just how important are the supposedly negative factors affecting a company's stock price?

Concerning companies
GMI Ratings has nine companies on its risk list that date to last October, with five more recent picks. Let's look at the performance of those first nine after they were singled out:

Source: GMI Ratings, Yahoo! Finance.

Over the same period, the S&P 500 gained about 10.6%. So, four out of the nine companies beat the market, while five lost to the market -- about as good as flipping a coin. From this, one could say that the environmental, social, governance, and accounting standards that GMI Ratings looks for have no influence on the value of a company.

But maybe this timeframe, since October, is too short of a time for these companies to fall apart. Let's look at an earlier study that addressed this question.

Even less evidence
In a study published by the Journal of Financial Economics in 2010, Northwestern University looked at three ratings agencies: GMI, ISS, and The Corporate Library, which merged with GMI following the study. By studying these ratings, along with stock returns, operating performance, market value, lawsuits, and accounting troubles, the researchers came to a conclusion:

We find that these governance ratings have either limited or no success in predicting firm performance or other outcomes of interest to shareholders. Moreover, even when there is a statistical association with future outcomes, the substantive economic effect is small. In contrast, we find somewhat stronger predictive evidence for the governance rating produced by Audit Integrity, AGR, which uses information in financial statements, rather than focusing on observable corporate governance mechanisms, such as board structure.

In short, these ratings mattered very little for stock performance. So does that mean investors can ignore environmental, social, or governance issues?

Of course not!
Investors should care about these issues. Companies that value sustainability have been proven to outperform others. Additionally, ask yourself as an investor:

• If you want a say in the companies that you own through a legitimate shareholder structure?
• If you want a company to pay more out as dividends, or more to executive compensation?
• If you want a company to uphold moral and ethical standards?

The problem with these ratings is that it is difficult to measure the vast number of varied companies with the same criteria. While investors should keep an eye on the firms that "fail" the criteria, judge for yourself whether it is a fair assessment given the firm's industry, structure, age, strengths, competitors, and past. While it would be great for a simple rating to provide all this information upfront to compare across possible investments, it is clear that such a rating has yet to be popularized.

For some great long-term investments that investors shouldn't have to worry about failing any governance ratings, check out our free report: "3 Stocks That Will Help You Retire Rich".