Governance refers to how well a company is managed and to the oversight of its management. Without such good governance, there is no assurance that management will promote innovation, preserve intangible assets, reinvest profits or allocate capital wisely.
Though somewhat counterintuitive, we see governance as more important for the high-quality companies we focus on than for other companies. This is partly because management has more degrees of freedom when overseeing strong cash flow and intangible assets. Three main risks can arise from poor governance: short-termism, capital misallocation and excessive risk-taking.
Management teams may prioritize short-term measures over longer-term success. This may be an excessive fixation on quarterly results, revenue growth or this year’s earnings per share. The end result is destruction of long-term compounding power. The problem is even worse if the short-termism is encouraged by poorly structured incentive schemes.
Managing a business for the long term confers huge advantages. Companies with a short-term perspective lose touch with their stakeholders and are not sustainable. Eventually, their return-generating potential becomes curtailed. Witness the lack of innovation that led to the demise of Polaroid, Blockbuster, Kodak, Nokia or Blackberry. Consider the challenges facing a company that finds itself shadowed by the dark cloak of a major internet retailer and struggles to become digitally relevant.
For high-quality companies, earnings can be easy to “massage.” For instance, consumer staples companies tend to have large advertising budgets. Management can trim these costs to inflate short-term profits, but failure to promote the business comes at a cost of the franchise later.
A further threat comes in the allocation of capital. Investing capital at low returns, either through paying too much for acquisitions or expanding into lower return businesses can undermine the overall quality of the business and impair its ability to compound over time. For high-quality, high-return companies, the high levels of free cash flow give rise to temptations for misallocation.
Finally, poor governance may lead to excessive risk-taking. High-quality companies have more to lose in this regard, simply because the greater value of the franchise means there is more at stake. For example, misconduct in environmental and social issues – two ESG pillars – could be more likely if a company is not grounded in the third pillar, governance.
We think our focus on governance has led to a portfolio of companies whose management have relatively long-term perspectives, are judicious risk managers and allocate capital better than the market as a whole. Global Sustain, the latest addition to our global equity product suite, benefits from this longstanding emphasis on governance.