|Corporate Governance Myths in Brazil - II|
This month’s Governance section presents the second and last part of the article, Corporate Governance Myths in Brazil. It aims to point out some statements which seem to have become unquestionable truths, but do not hold up to a more structured and methodologically correct analysis. In the first part, we presented the following myths: 1) Bovespa’s Corporate Governance Index (IGC) as a proof of the value of governance; 2) tag along; 3) the entrepreneur who has to be the controlling shareholder; and 4) the need for poison pills. This time we will cover another three:
THE MYTH OF THE INFORMATION ON THE PROSPECTUS – When questioned about certain governance practices, such as, for example, the systematic hiring of services from companies that belong to relatives of the controlling shareholder, many company representatives try to justify such actions by saying that this information was already contained “in the prospectus”. In other words, it is argued that since the practice is written out on “page X” of the prospectus, it is transparent and, therefore, plainly compatible with good governance. Nothing could be farther from the truth.
Firstly, the final purpose of good governance is to have all decisions made with the goal of maximizing the business’s long term value. So, with the example at hand, if the company pays an excessive amount for services from other companies belonging to the controlling shareholder, the fact of having made these transactions publicly available in a prospectus does not transform them into a good governance practice. Secondly, transparency is only one of the pillars of good governance. It must be followed by equity and accountability. As for equity, it is the obligation to treat all shareholders equally, which is obviously not the case in the situation above. As for accountability, there is the need for management to highlight to current and potential investors all material aspects of the business, facilitating (and not hindering) a correct understanding about the company in order to improve investment decision making. It is the distinction between volume of information and transparency.
THE MYTH OF GREATER EXPECTED RETURNS FROM STOCKS OF COMPANIES WITH BETTER GOVERNANCE – Almost every practitioner takes it for granted that companies with better governance should systematically achieve better stock returns for their shareholders. Unfortunately such a simplistic approach goes against logic and theory. From the point of view of the investor, corporate governance basically represents a risk factor, a chance of loss or expropriation of the capital invested. This risk factor is reduced as companies adopt better governance practices, since there is then a smaller chance of unpleasant surprises due to better internal controls, more active and independent boards, greater transparency, etc.
Since one of the basic principles in finance is that risk and expected returns should walk side by side, why should we wait for a greater return from such companies? Furthermore, since the expected stock return is used as a measure of the cost of equity capital, this would mean a higher cost of capital for companies with better governance practices, something simply illogical.
So, better governance should lead to smaller expected stocks returns and, therefore, to a larger relative value for such companies, due to greater investor confidence. What happens – and what probably confuses market practitioners – is that governance improvements should lead to a reduction in the perceived risk, translating into a discrete positive effect in share prices and, therefore, greater returns during the improvement period. In other words, it is the improvement in corporate governance practices that should lead to better returns, by reducing the level of business risks.
So, a curious fact happens: when we look back, we often observe a superior return of the stocks of companies which, currently, have better governance practices. Such returns are the result of the improvements obtained in the period. However, when we look forward, we shouldn’t necessarily expect greater returns again. Finally, there is another complicating factor for this analysis: it is probable that improvements in a governance model lead not only to risk reduction, but also to better business decisions by top management, as a result of better decision processes. As a consequence, such companies with better governance would tend to increase the frequency of positive surprises in the future (such as announcing good investment decisions, good leadership succession processes, etc.) which would lead to greater returns on such occasions.
How to solve such a complex matter? Again, we must look at the risk adjusted returns of companies with superior levels of governance, instead of nominal returns. In sum, companies with better governance practices should show greater risk adjusted returns over time, which, occasionally (and counter-intuitively), would be fully compatible with smaller nominal returns than those registered by other companies.
THE MYTH OF SUSTAINABILITY – Without question this is the most controversial myth. Nobody questions the importance of discussing the sustainability of the planet, bearing in mind the survival of future generations. However, here we have the question of business sustainability, a very widespread, and not to mention vague, concept. In the last few years, many have started to preach sustainability (or long-term survival) as the new objective of companies, even including corporate governance in a great subject called “sustainability”. This vision is incorrect.
In the first place, there is no concrete evidence that a well produced documentary and a few books by consultants on the importance of the planet’s climatic changes were enough to alter human nature, which seeks to maximize personal well-being. So, people continue creating companies or investing in securities with the basic purpose of reaping the greatest possible returns (it is possible that there are exceptions, but we cannot work with behaviors outside the standards). As a result, companies’ main role is still the same - to maximize cash flows over time - and managers’ purpose is still to maximize their careers, which inevitably leads to conflicts of interest. Since a greater firm value tends to be reached when the time frame of theses cash flows is longest, then we have the connecting point of sustainability and long-term cash flow growth.
Therefore, the theme of sustainability may be presented through two well known (and old) prisms: risk management and opportunities. As a tool for risk management, it reinforces the need for companies to make a more correct understanding of the environment, in order to avoid public embarrassment and legal action. Companies must carefully manage their goodwill risks, environmental liabilities, government corruption and labor issues due to slave or child labor, among other things. For opportunities, it is the idea that a “green strategy” can create value and become part of the company’s competitive advantage (naturally moving towards the traditional corporate objective function, erroneously called “financial”). This may occur in several ways:
a) reducing waste and the operational costs of the business (e.g. reducing energy consumption and using recyclable bags at supermarkets); b) exploiting a market niche with a demand for products with an environmentally correct label; and c) exploiting niche investors more willing to buy shares in companies with the sustainability label, as has been shown by the increase in socially responsible investment funds. In January this year, the magazine The Economist summarized the sustainability theme in a tough, though (fortunately or unfortunately) correct manner: “this survey concludes that, done badly, it is often just a fig leaf and can be positively harmful. Done well, though, it is not some separate activity that companies do on the side: it is just good business”.
In sum, the myths described in the two parts of this report are the result of the non-observance of basic concepts such as: measuring risk adjusted returns, evaluating the private benefits of control, the separation between ownership and management, the distinction between volume of information and transparency, the relation between incurred risk and expected return, and companies’ objective function. Such concepts should be strengthened in business schools and market entities, aiming at reducing the dissemination of these and other corporate governance myths in Brazil.