The rapid falls in equity markets earlier in the year spurred numerous reports about the outperformance of ESG funds through this weaker period. To me this reflected the durability and attraction of well governed businesses, as well as the continuing share of responsible investment within overall capital flows. Undoubtedly the data was helped by the disastrous performance of the traditional Energy complex as the oil price fell, a segment avoided by funds with even the faintest tinge of green. Yet even excluding this impact the trend of outperformance by companies with a strong, responsible culture should not have been a surprise.
A recent report from Grant Thornton showed the very strong positive correlation between performance and good governance. The research covered the constituents of the FTSE 350 ex-investment trusts over a 10 year period, and the results are compelling. One of the most notable elements was the exceedingly high correlation between a strong corporate governance score and cash flow generation. Again, to my thinking this was unsurprising, and explains why most long term investors take so much notice of the character and behaviour of management teams. The correlation is high because the former is an important driver of the latter. Management teams not only set the procedural policies of a firm but also set the tenor of the organisation. Culture truly does begin at the top and permeates throughout the business.
While all of this is, I believe, widely accepted it does nevertheless clash slightly with another observation. As an investor I have long been drawn to companies with significant family ownership. My experiences here have generally been very positive with my longer term approach typically aligning well with that of the majority owner. Many of these companies score highly in terms of strategy, internal investment in both plant and people, as well as flexibility and creativity. However, it is not uncommon to find less than best practice in some areas of corporate governance. For example, in my experience it is not uncommon to find a weaker than average showing in important elements such as the ratio of women on boards, and the true independence and influence of non-execs. In addition, family led companies may also be less inclined to consider wider societal issues if they impact their own bottom line. The academic literature is somewhat mixed here but in 2015 Rees & Rodionova concluded that “when it comes to investments that foster social good but do not guarantee financial returns, families tend to act as financial wealth maximizers and tend to hinder such expenditures.”
If this is right, how do we square this particular circle? If strong and demonstrable corporate governance is a key factor in longer term performance and family run businesses do not necessarily excel here, why do they still outperform? I think the answer is simply that they have the best interests of the company at heart. In order for a business to go on delivering over many years it needs investment and guidance. Family owners know this all too well, but they care less about proving it to the outside world. The capital market’s focus on good governance is to prevent poor behaviour which is ultimately costly for shareholders. A career CEO joining a new business could be more concerned about feathering his or her own nest for the next few years than steering the company into the next decade. External scrutiny is therefore a powerful force to limit this behaviour. Non-execs have a crucial role to play here by holding management’s focus across all stakeholders and steering an alignment of interests.
What to do? Ultimately if a family remains in control of a firm it is very difficult for minority shareholders to force change in these areas, but they can apply pressure. Obviously as more and more equity capital resides in the hands of ESG savvy investors the companies which score poorly in these areas will likely face declining investor interest and their share prices will suffer. This passive trend is certainly helpful but is also slow moving. This is where dialogue is so important. Even minority shareholders can bring about change if their views are clear and backed by evidence. Sometimes the best performing family companies sometimes need a nudge in the right direction. Bringing together the benefits of robust governance with the typical family focus on longevity of future cash flows is a powerful combination for the longer term investor.