Strong governance, an aid to low-risk outperformance: investing in trust and profitability
Recent examples of corporate fraud have highlighted the importance to investors of the Governance criteria in ESG, in terms of reducing risk when investing in equities.
Since 2015, European companies with a strong track record of Corporate Governance (relating to transparency and shareholder rights) have collectively outperformed the STOXX Europe Index consistently, particularly when allied to an above-average level of profitability.
We believe that investors wishing to invest in companies with excellent ESG credentials should focus on companies with strong Governance, since this aspect of ESG is often neglected in favour of the more visible Environmental and Social criteria.
Marrying strong Corporate Governance with high profitability is an attractive long-term defensive equity strategy and a good alternative to sovereign and corporate bonds. Prospective returns from stocks with a combination of strong Governance and high profitability remain very attractive when compared with sovereign bond yields that are frequently negative, and with corporate bond yields that are currently as low as 0.5% for Euro BBB credit.
While equity exposure to companies with strong Corporate Governance and high profitability is our preference, this theme also applies to corporate bonds, as over time, stronger governance should be reflected in improved credit ratings..
Trust takes time to build, a moment to lose and forever to repair
This mantra is becoming ever more relevant to listed companies, in the area of investor relations.
Governance in ESG incorporates a range of concepts including:
- Code of conduct
- Legal issues
- Board independence
- Shareholder rights
- Supply chain management
Strong Governance can improve returns at lower risk
Contained within these concepts is a wide array of potential risks to a company’s profitability and even long-term viability, which may result in heightened risks. We believe that investors are unlikely to be compensated for these Governance-related risks.
Since 2015, a basket of European stocks demonstrating strong Corporate Governance characteristics have outperformed the benchmark STOXX Europe Index by 17%, underlining how strong Corporate Governance can be a powerful motor for stock performance over time.
Higher profitability is also a driver of higher returns
This is true for companies with sustainably above-average returns on capital employed (ROCE); since 2015, a basket of European high-ROCE stocks has outperformed the STOXX Europe Index by 33%.
Indeed, this underlines the investment attractions of highly profitable companies that typically have sustainable economic moats (such as strong brands or superior distribution networks) built into their business models, helping to protect companies and their products and services from competition.
Academic research has consistently demonstrated the superior risk-adjusted returns to investors from highly profitable companies with these economic moats. Investing in highly profitable companies demonstrating strong Corporate Governance is an attractive defensive equity strategy. This strategy should, in our view, continue to deliver attractive risk-adjusted returns to investors in 2021.
ESG fund inflows to boost Governance
European companies, as a group, have been leading the global movement towards strengthening their ESG credentials. We see that the tsunami of fund flows into ESG equity funds is very likely to continue into 2021, which will drive more investment in companies with a strong and improving Corporate Governance track record.