Be curious about companies

Since the Satyam scam, the focus on corporate governance has increased manifold. Investors should keep a close watch on a company’s activities to ensure safety of their money.

On January 7, 2009, Satyam Computer Services’ Chairman Ramalinga Raju informed shareholders that he had “cooked” the company’s books for years. Raju’s statement opened a can of worms that had investors and fund managers questioning the veracity of several companies’ numbers who had dubious dealings in the past.

There were several calls for improving corporate governance of listed entities. In fact, the market regulator, the Securities and Exchange Board of India (Sebi), introduced peer review, whereby another auditor would scrutinise a company’s financial documents with their existing auditor.

Irrespective of the debate, corporate governance is one of the key areas that investors should look at before putting their money in stocks. Some companies, such as HDFC and Infosys, get better valuations because of transparency. If you look at most of the corporate bankruptcies globally in the last two decades, you will find that a majority of the businesses failed not because of market conditions, but due to lack of corporate governance.

While financial results, earnings per share (EPS) and operating margins show the quantitative characteristics of a company, the qualitative ones are judged by corporate governance and ethical behaviour. All these combined have a bearing on the stock prices of a company.

Simply put, corporate governance is a system of checks and balances between a company’s board, its management and investors. The system strives to create shareholder value. And scandals like Enron, Worldcom and Satyam are painful reminders that companies, which do not follow ethical values, are likely to hurt both employees and investors.

Studies have proved that good corporate governance not only increased investors’ confidence, but also brought down the cost of capital for the company. A company that is transparent has standardised accounting practices, free flow of information and clear policies. They even find it easier to sail through bad times and secure support of stakeholders in times of difficulty.

Let’s look at some of the practices companies with better corporate governance follow and how one should interpret their actions as an investor.

INTERNAL
Board-level governance: Independence of the Board and professionalism are key to corporate governance. The Board is required to discharge its fiduciary obligations. Look for companies that have proper committees to decide on remuneration, audit, nomination, investor grievances and so on.

Auditors: Auditors should keep proper checks and balances on company affairs. In case of any wrongdoing, they should report to the Board and shareholders. In case of Satyam, its auditor Pricewaterhouse faced a lot of flak.

Investor servicing: Companies with good governance adopt greater transparency in their reporting. They provide proper disclosures to their shareholders and are prompt in resolving investor grievances. Many companies’ governance is reduced to a narrative in a paragraph in the annual report or directors’ reports. This should not be the case. Corporate governance should be part of the Board’s responsibility towards shareholders.

Shareholder participation: Institutional investors have the means to play an active role in ensuring that the management doesn't go off-track. The institutional investors can demand the required changes at companies they have invested in.

For instance, just a couple of weeks before Raju admitted to fudging Satyam’s books, institutional investors blocked his proposal to buy a majority stake in his family owned Maytas Infrastructure by using the cash in the company’s balance sheet.

Forming minority shareholders' groups can also be a positive step. There are several activist minority shareholders abroad, who constantly keep a check on the company’s plans. Individual or retail shareholders should use these groups to communicate with institutional shareholders for taking up their concerns with the company's management. They can always question a company’s governance at the annual general meetings.

EXTERNAL
Rating: Rating agencies, such as CRISIL and ICRA rate companies on the basis of corporate governance. Ratings enable the stakeholders to know how much importance the company attaches to corporate governance.

Self-regulatory bodies: Industry should be encouraged to form self-regulatory bodies to look at improving governance at industry level. This can be by way of standardised disclosures, fair practices, customer care initiatives and so on. This is seen in case of banks (Indian Bankers’ Association) and automobile companies (Automobile Association of India).

While these pointers are mostly associated with good governance, there are some clear signals about misgovernance. For instance, stay away from companies which have been accused of under or over reporting of revenues and profits, misrepresentation of facts, insider trading, oppression of minority shareholders, non-payment of dividend and interest to lenders/depositors. Sometimes, companies are even debarred from raising capital from the financial markets because of the above traits. Investors need to keep an eye on such developments to separate the good from the bad.