Corporate governance considerations occupy center-stage in today’s fundamental analysis. An analyst needs to know/inquire about a company’s ownership and voting structure, composition of its board of directors, relationships between its execution compensation and company performance, its major shareholders, robustness of shareholders’ rights, and management of long-term risks.
Ownership and voting structure
When voting rights are decoupled from economic ownership, an analyst needs to study its implications. It is most commonly the case when a dual structure exists, in which there are two classes of common shares, one held typically by insiders carrying disproportionately higher voting rights, and the other carrying no or low voting rights. Another mechanism is when both classes of shares carry equal voting rights, but one is entitled to elect a majority of directors. Proponents of dual-class structure say that it promotes stability while opponents argue that it creates conflicts of interest. Since it is impossible to dismantle a dual-class structure, an investor/analyst needs to study the motivations of controlling shareholders, generational dynamics, succession planning, relationship between management and shareholders, etc. It may also impact valuation because such shares may trade at a discount.
Composition of board of directors
Analysts must assess independence, tenure, experience, and diversity of the board of directors. When there are too many related party transactions, independence may be impaired. When the tenure is quite long, it may add experience but may also create diversity and adaptability problems.
Remuneration and company performance
While availability and quality of executive compensation disclosure is not uniform, an analyst needs to check its composition, i.e. base salary vs cash bonus vs equity-based incentive compensation and assess whether the contingent compensation is linked with factors which actually drive the company’s performance. Potential considerations include:
- Little aligned between executive compensation and shareholder rights.
- Little variation in compensation over time despite variation in operating/financial performance.
- Excessive payout in comparison with comparable companies with comparable performance.
- Whether the plan is linked with some strategic event (not necessarily bad, but an analyst needs to assess whether it is aligned with the company’s objectives).
- Plan based on incentive from an earlier period (for example compensation based on revenue growth when the company has already exited the high growth phase).
Investors in the company
Examining the composition of a company’s investor base may help an analyst uncover cross-shareholders, affiliated shareholders and activist shareholders. Both cross-shareholders and affiliated shareholders may shield a company from the effect of takeover attempt and voting by outside shareholders respectively. Activist investors may result in a rapid change in investor composition of a company because their actions garner interest by other investors. However, analysis of investor composition must be taken in the context of the market because in some markets concentrated cross-holding of affiliated shareholders may be considered necessary for long-term stability of the company.
Strength of shareholders rights
An analyst needs to assess whether shareholders’ rights as contained the company’s charter and bylaws are strong, average or weak when compared to other companies following the same corporate governance frameworks. It is because many corporate governance frameworks, particularly in the developed markets, allow a company to either comply with some rules of publicly disclose the reason in case of non-compliance.
Managing long-term risks
An analyst needs to consider how a company manages various long-term issues such as environmental risks, human capital, transparency, etc. It is because improper management of such risks can adversely affect a company’s value. If a company has a persistent pattern of fines, accidents, regulatory actions, etc.