Commentary
Note:
This is the third of a three part series on ESG—environmental, social, and governance—investing. Two previous columns addressed the environmental and social elements of ESG investing. Here, we discusses the last element, corporate governance. In this third discussion of ESG investing, we see how governance—as with “social”—arises not from what it was intended to be but from what it has been debased to become by progressive activists who manage investments for municipal pension funds, some Wall Street fund managers, and in the firms that market this otherwise benign—and common sense —investment strategy.
Readers will remember in our discussion of social investing that we discussed how the “S” investment standard promulgated by S&P Global and the Boston Consulting Group operated with “a closer nexus to bottom-line financial results, to advise ... clients about social investing risks,” to address issues such as “labor relations, supply chain vulnerabilities, and political as well as geopolitical matters in key markets and in jurisdictions where suppliers are located.”
It was thus intended with “G,” governance, at least originally.
Protecting Shareholders’ Interests
Sound governance of an enterprise was meant to consider how boards—and particularly boards with executive directors—stewarded the interests of shareholders over their own, as well as how well the enterprise was governed generally.In 2003 paper titled, “
Corporate Governance and Equity Prices,“ by Paul A. Gompers, Joy L. Ishii, and Andrew Metrick (note the last names of the authors), for example, the authors analyzed stock returns in the context of 24 governance rules that had been outlined by the Investor Relations Research Center (the ”
IRRC provisions“ ). These were compiled into what has since been called the ”GIM Index“ (named after the authors). They found that companies, in what the authors called a ”democracy“ portfolio which had strong shareholder rights, had significantly better returns than those in a ”dictatorship“ portfolio, wherein shareholder rights were weak. But the paper could not prove a direct ”cause and effect” relationship between the governance rules and the valuations (as measured by
Tobin’s Q); that came later.
In a 2004 paper titled, “
What Matters in Corporate Governance,“ by Lucian Bebchuk, Alma Cohen, and Allen Ferrell, it was determined that the democratic or dictatorial corporate governance came about from share values, not vice versa. The authors concluded that companies that are less well-managed, or in low-growth industries, tend to be more prone to takeover attempts and, therefore, tend to adopt more defensive (i.e., ”dictatorship") governance rules.
But sound board governance goes so much further than leaving board control open to challenge by shareholders.
The Dogma of ESG Investing
It’s assumed that board members possess the minimum competencies in finance, law, and management as well as the personal character necessary for responsible stewardship. Investors should, of course, ensure that such people are in place or run grave risks if they are not. For example, the financial pages are replete with CEO wrongdoing that crashed or damaged share values of companies through executive incompetence, indiscretions, inattention, or outright corruption that put some of them
behind bars. Board members are also occasionally
named.
But neither being incompetent nor indiscreet is generally a crime; hence, the need for competent and unassailable directors, good legal and regulatory counsel, and board rules that, to the greatest extent possible, have objective standards, such as debt ratios; compensation standards; rules for mergers, acquisitions, and split-ups; personal behavior; and the like.
There is nothing about these governance elements in ESG investing that most investors would find objectionable.
But with the rise of what now purports to be ESG, “good corporate governance” has come to include subjective dogma. Widespread, unquestioning, dogmatic embrace of social and political causes fashionable among America’s chattering classes, such as
encouraging children to dress in drag,
Black Lives Matter, and other causes are now the “norm” in corporate board rooms. Banal mantras such as “Diversity is our strength,” which are demonstrably false—and yet accepted as “truth”—are
de rigueur among “proper” corporate board members. And they affect corporate decision making.
But, as
Stuart Kirk wrote in the Financial Times on Sept. 2, these elements of “G”—as well as their “E” and “S” counterparts—are “outputs,” in contrast to what he calls “inputs”—the factors traditional analysts have used for years to evaluate a prospective investment.
Every analyst evaluates whether a prospective investment has ESG risks and whether or not management has those risks in hand. “Inputs” like critical infrastructure, such as road, bridges, and a reliable power supply; compliance with local laws; supply chain resilience; and a board of the type I’ve described above, are all weighed by every
buy-side analyst before they put their fund’s money down.
But those with little understanding of how ESG should work—people like elected managers of public employee pension funds and some politically oriented fund managers—bring to their investment analysis a political or social agenda. They have made investment analysis an adjunct to their own subjective and usually progressive agenda by conflating ESG investing with
ethical investing,
sustainable investing, or
socially responsible investing. The criteria for those types of investments are things like the company’s carbon footprint; a myriad of social issues, from gun control to trans-fats; and board diversity—that is, outputs.
Kirk’s suggestion is to split ESG into an “input” and “output” analysis, so that the outputs of ethical, sustainable, and social responsible investing will be clearly delineated as investment objectives to avoid their encroachment on a more traditional, objective, apolitical, wealth-building investment analysis.
That’s certainly one alternative.
The other is for funds that wish to pursue ethical investing, sustainable investing, or socially responsible investing to simply label themselves and their agenda and not muddy the waters by imposing their ideology or their dogma on fund managers or the investments they make. There is a market for such investments, and there are plenty of investors who wish to vote their environment, political, and social objectives with their dollars.
The market should be permitted to reward or punish such investors by allowing them to know full well the objectives that fund managers are pursuing—and the rest of us who wish no part of them, too.
