Is good governance good enough? Not according to several Stanford University researchers, who found that the four big companies that issue corporate governance ratings had a pretty dismal record of predicting performance, risk, or undesirable events such as earnings restatements and shareholder lawsuits.
One result of the scandals that ruined investors in Enron and WorldCom was the Sarbanes-Oxley Act. "Corporate governance" became the mantra of those interested in cleaning up Wall Street, but for the researchers, the "one size fits all" policy of standardized ratings falls far short of the goal.
It's certainly not surprising that this study comes out now, when ratings of all types are coming under scrutiny. Whether it's Moody's (NYSE:MCO) and Standard & Poor's being too slow to identify risky businesses, or Morningstar (NASDAQ:MORN) being accused of pressuring analysts to lower the star ratings of financial stocks like Citigroup (NYSE:C), the assumptions underlying the rankings are being called into question.
Define good governance
The researchers point out that even among the raters, there's little consensus about what's good governance and what's not. Risk Metrics, which owns the influential proxy firm Institutional Shareholder Services, says Anheuser-Busch (NYSE:BUD) ranks better than three-quarters of the other companies in the S&P 500, while grading it better than 91% of its peers in the food, beverage, and tobacco sector. Corporate Library, on the other hand, gave the brew master an "F" last year.
Relying on shorthand methods to gauge an investment's worth is bound to disappoint. If someone is using some grade, star rating, or quotient to make investment decisions, they likely will be disappointed in their portfolio. Similar to using only a P/E ratio to determine a company's value, good governance ratings are but one piece of a larger puzzle.
Motley Fool CAPS, our ratings based on the collective intelligence of 110,000 members, regularly advises against relying on star ratings to make investment decisions; rather, it advises using them as a launching pad for further research. Still, initial research and subsequent follow-up has found that higher-rated companies in CAPS tend to perform better than lower-rated ones. But here, we're rating an investment's prospects, not its governance quotient.
Good enough?
It's no secret, either, that corporate insiders want to protect their power base and could easily use the results of the study to strengthen their hold -- to the detriment of shareholders. While these attributes might not predict anything, well-defined shareholders' rights, high levels of transparency, a strong and independent board of directors, and pay scales that only reward CEOs for strong performance should be more widespread.
Moreover, according to a report by World Bank Group, investors are willing to pay a premium for good governance. Deutsche Bank (NYSE:DB) found that businesses with strong or improving corporate governance practices outperformed those with poor or deteriorating practices by about 19% over a two-year period, while a Harvard-Wharton study found that U.S.-based companies with better governance practices had faster sales growth and were more profitable than their peers.
The Stanford study is important because it underscores that investors shouldn't rely on any one data point for their decisions. Yet, even if a good governance measure won't clue you in to whether a company will restate its earnings or be subject to an SEC investigation, that doesn't mean it isn't still a valuable practice.
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