The higher the quality of a company, the more important its governance, says William Lock of Morgan Stanley.
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.
Short-termism
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.
Capital misallocation
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.
Excessive risk-taking
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.
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RISK CONSIDERATIONS
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and that the value of Portfolio shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. In general, equities securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, market and liquidity risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Stocks of small- and medium- capitalization companies entail special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. Nondiversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Illiquid securities may be more difficult to sell and value than public traded securities (liquidity risk).
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