Governance is important for understanding the leadership and direction of a company. This series has described ESG methodology, and how it adds a lens for assessing investment risk. This concluding article explores governance scores—the measure of how a company is managed. I encourage you to read the other two articles – one on the ‘E’ in ESG and the other on the ‘S’ for a full look at ESG investing.
The “G” in ESG aims to measure the impact of a company’s leadership. Corporate governance — the structure, processes, and people guiding a company’s high-level decisions — has clear relevance for investors. A corporation’s board of directors and executive leadership team will steer the longevity of a business. Governance scores can be especially useful because they capture risks not explicitly contained in traditional financial statements.
How is a company’s governance measured?
Key governance metrics include board composition, executive compensation, oversight, transparency, stakeholder engagement, and anti-fraud protections. Stock prices can move rather rapidly in the short-term when changes in executive leadership are made public. One may consider the long-term impact of having effective leadership running a business. For instance, research has shown that companies with diverse and independent boards typically generate higher profits.1 Additionally, executive compensation can make up a significant portion of a company’s expenditures. During this article we will explore how these factors may impact a company’s ESG score.
Executive compensation
Executive compensation is on the rise. In fact, when looking at the underlying companies in the S&P 500, on average, a chief executive made over $16 million in 2022.2 CEOs are making more than 300 times the amount of a typical worker. For comparison, in the mid-1960s, CEOs were making about 20 times more than the average worker.3 With such a hefty expense on a company’s balance sheet, analysts must ask the question, “Is this compensation reasonable for the value they’re providing?”.
Companies that base executive compensation on value creation, and include appropriate long-term incentives, can outperform their industry peers. In an extensive study done by the Harvard Business Review, some of the largest public companies are not only using peer-reviewed compensation formulations for determining value-driven compensation, but are also including environmental, social, or governance goals.4
Reputation and business ethics
In identifying possible governance risks a company faces, analysts can also evaluate controversy and the willingness to disclose certain activities. In response to shareholder demands, companies are disclosing not only executive compensation plans but contributions to political campaigns as well. With the increasing desire to align your investments with your values, an investor may decide to invest elsewhere if their political support or lobbying practices are misaligned.
Brand value, social media following, and response to controversary would all be factors a ratings agency considers in the “G” score. Corporate behavior can be important when evaluating risks that a company may face given it’s standing on certain social issues. Investors are interested in a company’s response to controversy and their success in retaining public opinion and paying consumers.
For example, consider Anheuser-Busch shares, better known for one of America’s popular alcoholic drinks — Bud Light. They experienced big backlash amongst consumers in 2023 when the company attempted to take a stance in culture wars. Fox Business recently reported that U.S. sales continue to suffer a year after the controversy.5
Consider Starbucks as another example, this time in evaluation of their business ethics and response to employees request to unionize. Since first launching in 2021, the Service Employees International Union endured may hours of litigation to finally be accepted by Starbucks in 2024.6 Starbucks’ prior year stock price is down 28% at time of writing. ESG analysis attempts to correlate Starbucks’ response to the performance of their stock.
E, S, and G work together
As investors, when we screen companies with poor scores in governance, we stand to benefit from boards that are engaged, work on the behalf of shareholders, and take responsibility to protect the value of the firm they oversee. Applying governance scores also helps by directing our investment dollars to well-managed companies that are best positioned to continue their growth, profits, and returns to shareholders.
Wrapping up this series on ESG, it’s worth noting that governance ultimately encompasses the two other ESG areas, Environmental and Social, discussed earlier, as a company’s performance on those metrics often depends on the decisions of its board and executive leadership. Integrating ESG scores into a traditional financial analysis helps us identify some of the financially strongest, best-managed companies to include in investment portfolios. Reach out to your advisor if you would like to discuss our wide variety of customizable ESG options.
1. “The Business Imperative of Diversity,” Boston Consulting Group. Tsusaka, M., Krentz, M., and Reeves, M. 2019, June 20.
2.“CEO pay averaged $16.7 million last year at S&P 500 companies, a decline” Reuters, Ross Kerber, August 3, 2023. https://www.reuters.com/business/ceo-pay-averaged-167-million-last-year-sp-500-companies-decline-2023-08-03/#:~:text=Aug%203%20(Reuters)%20%2D%20S%26P,fell%20with%20poor%20stock%20returns.
3.“CEO pay slightly declined in 2022” Economic Policy Institute, Josh Bivens, September 21, 2023. https://www.epi.org/publication/ceo-pay-in-2022/#:~:text=Cumulatively%2C%20however%2C%20from%201978%E2%80%93,much%20as%20a%20typical%20worker.
4.“Compensation Packages That Actually Drive Performance” The Harvard Business Review, Boris Groysberg, Sarah Abbott, Michael R. Marino, and Metin Aksoy, February 2021. https://hbr.org/2021/01/compensation-packages-that-actually-drive-performance
5. “Bud Light sales still suffering in US a year after controversy” Fox Business, Breck Dumas, May 8, 2024. https://www.foxbusiness.com/lifestyle/bud-light-sales-suffering-us-year-controversy
6.“Starbucks and Unions: What Congress Should Know” U.S. Chamber of Commerce, Glenn Spencer Senior Vice President, Employment Policy Division, U.S. Chamber of Commerce, March 4, 2024. https://www.uschamber.com/employment-law/unions/starbucks-and-the-nlrb
