BDTI and METRICAL collaborate on researching the linkage between CG practices sand value creation. We have recently released our updated analysis as of April 2018 for the roughly 1,800 publicly traded companies with market capitalization exceeding about JPY10 billion.
In this analysis, by examining board practices (CG guidelines, practices, and composition of the Board of Directors) and specific actions (real actions by a company) separately, we try to identify statistically significant correlations with financial performance measures (ROE, ROA, Tobin ‘s q) for each of these respectively – i.e, for, board practices and action respectively.
We have observed a certain degree of improvement in board practices since the introduction of the Corporate Governance Code. However, assuming that one of the key goals of the corporation is value creation, in order to improve the effectiveness of engagement and stewardship it is very important to regularly analyze the way in which such improvement (and specifically, which improvements) appears to lead to value creation.
We can summarize the results of our recent analysis as follows:
(1) There is a significantly positive correlation between the following board practice factors and the respective value creation yardsticks shown below:
- Incentive (compensation) plan adoption and ROE (actual)
- Nomination committee adoption and Tobin’s q
- Percentage of independent outside directors and Tobin’s q
In this analysis, we could not detect significant positive correlation with other board practice criteria whose improvement is thought to lead to value creation. Probably, as ROE and ROA measure only a single year’s performance, this is to be expected. But notably, Tobin ‘s q (the stock price premium) shows a positive correlation with the existence of a nomination committee and with the percentage of independent outside directors (INEDs).
(2) In the analysis of action and value creation, we detected significantly positive correlation between specific actions and value creation in many criteria.
- There are significantly positive correlations between ROE, ROA and Tobin’s q, and actions such as cross-holding shares/sales (lower level viewed assigned a higher value), cancellation of treasury stock (more cancellation assigned a higher value), robust growth strategy, and the absence of takeover defenses.
- On the other hand, there are significantly negative correlations between ROE, ROA and Tobin’s q, and actions such as the cash/sales ratio (lower level assigned a higher value), large ownership by a parent company or a founder’s family (lower level assigned a higher value).
The analysis shows that actual corporate actions such as reduction of cross-holding shares, cancellation of treasury stocks, and robust growth policy directly contribute to value creation. In addition, subsidiaries of listed companies and family-run company are more likely to generate higher profitability. Consequently, greater amounts of excess cash are often accumulated on the balance sheets of these companies and their share prices tend to trade at a premium.
(3) Analyzing the correlation between board practices and actions, there are significantly positive correlations for a number of criteria.
- Nomination Committee adoption showed significantly positive correlation with lower levels of cross-shareholdings, cancellation of treasury stock, the absence of takeover defenses, and robust shareholder meetings/IR practices.
- Compensation Committee adoption showed significantly positive correlation with cancellation of treasury stock, absence of takeover defenses, and robust shareholders meeting/IR practices.
- Diversity on the board showed significantly positive correlation with dividend policy, lower levels of cross-shareholdings, cancellation of treasury stock, absence of takeover defenses, robust growth strategy, robust shareholders meeting/IR practices.
- Incentive plan adoption confirmed significantly positive correlation with dividend policy, less share issuance (dilution), cancellation of treasury stocks, and robust shareholders meeting/IR practices.
- The percentage of independent outside directors showed significantly positive correlation with lower levels of cross-shareholdings, cancellation of treasury stock, robust growth strategy, the absence of takeover defenses, and robust shareholders meeting/IR practices.
Based on these findings, we can hypothesize that improving CG practices and composition of the Board of Directors has a certain positive effect on actual corporate actions. If continuous improvement of board practices leads to value creation indirectly, the CG Code has played a significant role.
Finally, we analyzed companies by dividing them into groups depending on the percentage of independent outside directors (INEDs) on the board. As in earlier years, his suggested that companies tend to fall into three rough categories.
(1) Companies with boards having greater than than 50% INED participation showed (on average ) significantly superior value creation criteria and METRICAL CG scores.
These companies are very likely to continue promoting both board practices and related actions. They will strive to improve the company even more because they will have confidence in their financial performance.
(2) Groups with 10%-15% and less than 5% INED participation also include some companies with superior performance in terms of value creation criteria, although of course METRICAL CG scores are low for these groups.
As mentioned earlier, companies that already have high profitability and are family-held companies or subsidiaries of listed companies are less likely to be interested in improvement of CG practice, especially only for the sake of “appearances”. But they may benefit from the presence of a large, active shareholder.
(3) Many other companies, many of them firms with lower profitability and diversified shareholders, are trying to look good in terms of governance practices, which they are enhancing without taking truly decisive improvement such as appointing INEDs that make up 50% or more of the board.
Based on our analysis, unsurprisingly, it can be expected that improving board practice will contribute to value creation as and when it results in actions. Even if the positive impact would not immediately be reflected in criteria such as ROE and ROA which only measure a single year of performance, this linkage with value creation can be expected for the medium term. (Valuation of the share price may be reflected earlier.)
With respect to the details of our analysis of the percentage of INEDs as a proxy for improvement of board practice, we would note that the number of companies with more than 50% INED composition is only 103 companies out of 1,793 companies. numerically, lagging far behind other board practice criteria. So there are still many companies that may (or may not) choose to take this step.
In order to encourage further improvement, the CG Code needs to play a significant role. We strongly hope that CG Code will be reviewed and improved periodically, as the Code can also accelerate certain action criteria (cross-shareholdings, cancellation of treasury stock, robust growth strategy, no takeover defense, etc.) which affect value creation directly.
Lastly, we would like to take this opportunity express our thanks you for the cooperation and other advice of BDTI related this analysis.
Akihiko Matsumoto, CFA
Executive Director, Metrical Inc.