The G in ESG: last but not least

Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

We’ve looked before at how Environmental and Social factors can have a significant bearing on investors’ portfolios, both now and increasingly over the years to come. It’ll come as no surprise, then, that it’s the same story when it comes to corporate Governance, the final part of Environmental, Social and Governance (ESG) investing.

Let’s be honest, Governance is the last part of ESG investing that you think about, isn’t it? The ‘G’ word conjures up images of regulation and board meetings that don’t tend to attract investors’ attention.

Scratch the surface, however, and ‘G’ may be the most important of the three for your investments in the long run. Good corporate governance is a vital component of companies’ lasting success, and as such it’s something investors should expect to see from all their holdings. Businesses that are well governed can typically point to strong management guiding their decision-making and a long-term focus. Simply put, they are usually better companies than those with poor standards of governance.

Buffett’s take

Before we get into how well governed companies make for sensible investments, let’s be clear over what we’re talking about. ‘G’ is all about the governance factors that influence how a company makes decisions, how its board of directors is established and functions, how it relates to shareholders, how it manages risk, and so on.

Sometimes it can be difficult to distinguish ‘Governance’ from ‘Social’ factors that affect a company’s culture, such as the level of minority representation at board level. In truth, the two often overlap - it’s no coincidence that good companies can point to both strong governance and high levels of social responsibility.

To get an idea of the importance of good governance, we can turn to none other than Warren Buffett.

Buffett has for many years written an annual letter to shareholders in his company, Berkshire Hathaway. In this year’s letter, he chose to highlight some important areas of corporate governance and the composition of company boardrooms. He addresses the dearth of women in the boardroom, criticises the number of directors who fail to challenge chief executives and their inflated salaries, and outlines how governance still has a long way to go to ensuring companies act more responsibly.

It’s a good letter to read to get a sense of how corporate governance functions behind the scenes but it’s also revealing to see the value that the world’s most famous investor, who himself has served as director of 21 publicly owned companies, places on good governance. When the ‘Sage of Omaha’ speaks, investors tend to listen.

The investors’ view

That’s all well and good for the world’s most famous investor, but you may be wondering what any of this has to do with you and me as private investors.

Fundamentally, it’s all about making sure the companies we invest in are ones we trust with our capital. I said before how companies that are building for a greener future or can boast strong social standards tend to make for good investments - the environment is likely to rise as one of the key investing themes of the future, and companies that care about society tend to avoid scandal and benefit from strong management.

It’s no different with corporate governance. Companies are increasingly scrutinised for their governance credentials, and the consequences for sub-standard practices are growing in severity.

The recent Wirecard scandal tells us what can happen when a company neglects proper governance standards. The company, once the most valuable financial services company on the German-listed DAX exchange, has now collapsed into insolvency following revelations of a €1.9bn (£1.7bn) hole in its accounts and the arrest of its chief executive on suspicion of inflating the company’s finances.

Fidelity analysts had given Wirecard a rock-bottom ESG rating months before the scandal broke. It was clear that it had a problem corporate culture, its management of ethical risks was inadequate and its boardroom governance sub-standard. Now questions are being asked of Germany’s financial watchdog, BaFin, and its auditor, EY, over how things ever managed to get this far.

Not every poorly governed company is going to be the next Wirecard, but what’s clear is that investors shouldn’t be exposed to the risk that theirs could be. Good corporate governance should be a prerequisite of any strong investment, so that poorly run companies don’t have a chance of making it into anyone’s portfolio.

Like environmental and social factors, good governance is good for everyone - companies and investors alike.

More on ESG investing

Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. The Investment Manager’s focus on securities of companies which maintain strong environmental, social and governance (“ESG”) credentials may result in a return that at times compares unfavourably to similar products without such focus. No representation nor warranty is made with respect to the fairness, accuracy or completeness of such credentials. The status of a security’s ESG credentials can change over time. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

Topics covered

Active investing; ESG investments; Investing ideas