Can This Factor Improve Your Returns?

The words "corporate governance" make many investors' eyes glaze over. Sure, you can grab some attention by talking about overpaid CEOs. But when you start discussing classified boards, director independence, or majority vs. plurality voting, many folks begin to snooze. If your own eyelids are getting heavy, here's one great reason to stay awake: Sound corporate governance could give you better returns.

More problems = more risk
The Corporate Library, an organization that tracks corporate governance issues, recently released a report correlating good governance and solid investment returns.

The organization's study showed outperformance in three hypothetical portfolios of companies with good corporate governance ratings, benchmarked to the Russell 1000 over the 2003-2010 timeframe. Even more interestingly, the best outperformer of the three used the strictest governance screens, outperforming by an annualized 275 basis points.

The Corporate Library's report acknowledged that previous research comparing investment performance and governance factors yielded mixed results. However, the current study they conducted based its categories on the amount of governance problems at companies, as opposed to focusing on "best practices." In other words, if you're looking for long-term outperformance, you might want to avoid stocks with poor governance ratings.

Shareholders gain traction
The most recent proxy season yielded mixed results in governance improvements, but it also produced plenty of evidence that corporate governance fans and fed-up shareholders are gaining traction.

Target (NYSE: TGT) shareholders recently approved a proposal to declassify its board of directors, meaning that all board members will be elected on an annual basis. In a similar high-profile vote, Massey Energy (NYSE: MEE) shareholders pressured the company to agree to annual elections and implement majority voting.

Compensation questions have also been dragged into the spotlight. After Abercrombie & Fitch (NYSE: ANF) revealed an outrageous component to CEO Mike Jeffries' compensation package, shareholders last week defeated the company's incentive plan. One member of the company's compensation committee just barely managed to get reelected. The defeat is considered a clear signal that shareholders are none too pleased with the teen retailer's management pay policies.

Shareholders further voiced their "say on pay" at Occidental Petroleum (NYSE: OXY), Motorola (NYSE: MOT), and KeyCorp (NYSE: KEY), voting down all three companies' compensation policies this year.

Separating the best from the rest
Companies plagued by self-centered, short-sighted managers could easily foreshadow lousy investment results to come. If a company's been stuck with complacent, entrenched board members for what seems like eons; if it pays its top brass astronomically, despite clearly lackluster performance; or if it shows other shareholder-unfriendly behavior, investors should definitely start calculating the long-term risk to their investment returns.

Good corporate governance policies are just another way to identify well-run businesses, which might in turn become top-performing investments. Unfortunately, far too many corporate managers have resisted adopting common-sense, shareholder-friendly principles. In the future, shareholders should pressure their companies' top brass to adopt better corporate governance practices. That's the best way leaders can prove they're in it for the long haul, and for all their stakeholders -- not just in it for themselves.

Check back at Fool.com every Wednesday and Friday for Alyce Lomax's columns on corporate governance.