What Correlates with Superior Corporate Performance? (Summary of Research)

BDTI and METRICAL conducted joint research regarding the governance structure/practices and related corporate actions that correlate with superior firm performance in Japan, and reported on the preliminary results at seminars hosted by BDTI on March 16th and by Goldman Sachs on April 4th. Our research is still underway, but the preliminary results are intriguing and provide useful guidance for the next stage of analysis.

BDTI and METRICAL believe that corporate governance is not functioning effectively unless it leads to superior strategy, fine-tuning of capital allocation and capital structure, and other value-creating corporate actions. Therefore, in our research we have sought to identify the apparent linkages and correlations between board practice, key corporate actions, and value creation.

In Phase 1 of our analysis, we studied the TOPIX100 Index composite (large 100 companies) to see whether scores we assessed for each company’s nomination policy, training policy, compensation policy, board evaluation policy, and the percentage of independent directors significantly correlate with ROA and ROE. The coefficient table below shows that in this group of firms, there appears to be either no correlation, or a statistically significant negative correlation, between the scores and ROA and ROE.

TOPIX100 Companies Nomination Policy Training Policy Comp. Policy Board Evaluation % INEDs
ROA (e) Correlation
Significance X X X X
ROE (e) Correlation
Significance X X X X
ROE (actual) Correlation
Significance X X X
ROA (actual) Correlation
Significance X X X X
(Note)  ◯: 95%confidence level, △: 90%confidence level

We would hypothesize that at this early stage in the post-CG Code evolution of corporate governance in Japan, companies with poor performance are attempting to “look good” in front of investors by adopting practices deemed to be preferable, precisely because their financial performance is not good. At the same time, however, the analysis did show correlation at the 90% confidence level between lower levels of cross-shareholdings and superior performance.

Admittedly, this group of companies comprises many of the companies which have traditionally been slower moving in the area of corporate governance improvement, and many of the scores were clustered at the low end, where there was not much difference between them. In addition, at many of these firms, the presence of multiple independent directors are a new phenomenon.  In this sense, the results were not that surprising.

For this reason, in Phase 2 of our analysis we expanded our analysis universe to a dataset of 494 companies that are either included in the TOPIX100 and/or the JP400 Index, or are considered candidates for inclusion in the JPX400 Index. We also added Tobin’s q as a performance indicator. As shown in the correlation table below for these 494 companies, scores for nominations committee, compensation committee, executive incentive plan, and the percentage of independent directors (INEDs) still showed significantly negative correlation with all three performance measures:

Incentive Plan % INEDs
ROE (actual) Correlation
Significance X
ROA (actual) Correlation
Significance X
Tobin’s q Correlation
Significance X
(Note)  ◯: 95%confidence level, △: 90%confidence level

Again, we would hypothesize that companies with poor performance are attempting to “look good” in front of investors on the governance practice front, for that very reason. Not surprisingly, low stockholdings/sales ratio, share cancellations, robust growth strategy, and the presence of a large shareholder all correlated significantly with our measures of superior performance. METRICAL’s CG score also correlated with superior performance. 

494 Companies Stock Holding/Sales Equity Issue   Share Cancellation Growth Strategy Cash Holding/Sales Parent/Large Ownership
ROE (actual)
ROA (actual)
Tobin’s q
(Note) Stockholding/sales is lower, score is higher. Equity issuance is less, score is higher.
Cash holdings/sales is lower, score is higher. Parent/large ownership is smaller, score is higher.

We then stratified the group of 494 firms into subgroups depending on the percent of independent directors.  At most companies, independent directors make up less than 40% of the board, and multiple outside directors are a new phenomenon at many of these firms. At only 26 companies do independent directors make up a majority of the board of directors. However, for this subgroup of firms, average Tobin’s q, ROA and ROE are outstandingly high if we exclude Toshiba, which only appointed a high percentage of INEDs after its accounting scandal.* Average performance is also relatively high (though not as high as for the 26 firms) for the subgroup of companies that have a very low level of independent directors.
 This out-performance would be even more conspicuous if we were to exclude two financial services companies which skew the results, which is the case for most of the large financial institutions. The skewing impact is much greater in this case because the number of firms in this sub-group is so much smaller than most of the other sub-groups.

% of INEDs # of Cos Stock Holding Score Tobin’s q ROA ROE METRICAL CG Score
>60% 9 5.1 2.00 6.8% 14.2% 7.6
>55<=60% * 14 6.1 2.37 5.4% 9.6% 6.9
>50<=55% 3 2.3 1.41 2.7% 9.2% 6.5
>45<=50% 23 6.7 1.50 3.3% 6.5% 6.8
>40<=45% 17 5.2 1.36 4.4% 11.0% 6.8
>35<=40% 40 5.0 1.33 4.1% 8.2% 6.7
>30<=35% 45 4.5 1.57 4.6% 9.7% 6.5
>25<=30% 60 5.8 1.86 5.6% 12.1% 6.4
>20<=25% 88 5.7 1.54 5.0% 10.6% 5.8
>15<=20% 117 5.2 1.52 4.8% 10.8% 5.9
>10<=15% 51 5.9 1.87 6.0% 11.2% 5.5
>5<=10% 22 5.9 1.56 5.6% 11.1% 5.3
<=5% 5 8.6 1.78 8.6% 12.1% 5.1
All 494 5.5 1.62 5.0% 10.5% 6.1
 TSE1  2,008    1.31         3.9%  7.9%
* >55<=60%
if exclude TOSHIBA
6.0 2.5 6.4% 15.4% 7.1

As can be seen from this analysis, the further improvement of corporate governance in Japan remains at a rudimentary initial stage, and even at supposedly “superior” companies, at many firms the recent reforms are not yet translating into appropriate capital allocation, robust strategy, and other value-creating corporate actions.

When we examine these and other features of the 494 companies that have large market capitalization and relatively higher profitability among all listed companies in TSE, it appears they can be divided into three groups:

  1. A small number of companies that are actively implementing effective corporate governance based on appointing a large number of independent directors, and (in almost all cases) fully utilizing them in nominations and compensation committees which are 100% composed of INEDs.  At these companies, we believe one can have higher confidence that superior profitability and performance will continue;
  2. Founder-led companies, family companies, or de facto subsidiaries of a larger company,  which generate superior financial returns while seeming to care little (probably, not needing to care) about formal corporate governance structure, replete disclosure of a robust growth strategy, optimal capital structure, or diversity, and
  3. A large number of companies for which less than 50% of the board is composed of independent directors, and which in many cases appear to have implemented new governance practices on a somewhat cosmetic basis, as can be seen from the fact that INEDs only make up 60-70% of the membership of key committees even if such committees exist.  Within the entire 494-firm group of “out-performers”, on average these firms are under-performing.

BDTI and METRICAL will now move forward to conduct the next phase of research, in which we hope to expand the universe to include all TSE-1st Section companies, and further identify the factors that are most correlated with superior performance. Moving to the full TSE1 universe should yield more robust results that can guide companies as they deploy practices intended to improve profitability and growth, and can inform investors as to how to best focus their engagement and proxy voting activities.

Parties interested in our research may contact us at the following addresses:

Aki Matsumoto of METRICAL

Nicholas Benes

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