Does Good Governance Make Great Stocks?

Stock investing takes guts. When you buy stocks, investors entrust a company's management with their money, counting on leaders to do right by common shareholders. Ideally, the market should reward good governance and punish shady behavior. Institutional investors respect this relationship, and so should you.

How will I know (if management really loves me)?
Astute in her questioning of whether certain men had genuine concern for her emotional well-being, Whitney Houston was on the right track. And you are too, if corporate governance scandals like Enron, Parmalat, and Adelphia give you the willies. You'd scrutinize a potential mutual fund manager before investing, so why not look into the leadership practices of the individual companies in which you want to invest?

There's a lot of widely accepted evidence that good corporate governance pays off. If you're still skeptical, consider these points:

• Back in 2001, some folks from Harvard and the University of Pennsylvania did a study on 1,500 U.S.-based companies. They came up with a strategy in which you bought companies with strong shareowner rights protections, and sold short companies with weak protections. Such a strategy yielded additional returns of 8.5 percentage points per year over the market's average return.
• More recently, to determine the reasons for the improved performance of more democratic companies, Institutional Shareholder Services and Georgia State University produced a joint study aimed at dissecting the findings of said Harvard publication. That study found that the best-governed companies achieved higher average returns on equity by 23.8%.
• The CFA Institute, which traces its existence back to Benjamin Graham's words when he proposed a rating system for financial analysts, believes that the evidence adamantly supports the direct link between good corporate governance practices and higher valuations for businesses.

If you're able to suspend disbelief long enough to accept that governance is tied to performance, you're probably wondering how to gauge a company's governance quality without having a brain aneurysm. It can be done a few ways.

Rating governance
The most convenient assessment of a company's corporate governance quality is probably obtained via the Corporate Governance Quotient (CGQ) data from Institutional Shareholder Services, a RiskMetrics Group subsidiary. Those subscriptions aren't free, but you can get some information on Yahoo! Finance and other free news sources. Also, ISS makes its top 10 governance quotient rankings for several indexes available online.

But the ratings don't always make much intuitive sense. For instance, General Motors is currently ranked second in the Russell 3000, despite its trip into bankruptcy protection. ISS also gave Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) low marks for its lack of board independence and once campaigned for Coca-Cola's (NYSE:KO) removal of Warren Buffett from its board.

So, good governance obviously doesn't guarantee success, and success doesn't guarantee a good governance rating. Furthermore, great companies sometimes won't fit the ISS mold. The metric clearly has some validity, though, and while you'll need more than the CGQ data to make an intelligent investment decision, owning shares of healthy companies with strong shareholder protections has clear advantages. Institutional investors and the corporations themselves listen to the ratings agencies, so it won't hurt you to do the same.

After running a screen for companies with improving growth prospects, I've listed a few with above-average CGQ scores here:

Sources: Yahoo! Finance.

As you can see, some of these well-governed companies have been doing better than others in the recent market environment.

Elephant in the room
Arguably, there are just as many excuses for retail investors to dismiss corporate governance ratings as there are reasons to support their importance with regard to firm valuation. The data is expensive, and the alternative -- digging through stacks of proxies and old footnote disclosures -- is hardly appealing.

But seeking out good governance and strong shareholder rights could mean the difference between your portfolio returns soaring like the U.S.S. Enterprise versus sinking like the Titanic. For buy-and-hold investors, you have to count on owning a stock for a long time, so by seeking out the very best stewardship, you'll improve your chances of sailing to glory.

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