When large firms falter on governance, what can investors do?
Penny stocks are bad. Small and mid-cap stocks are high risk, high return proposition. That leaves blue-chip companies as the haven for bulk of the investors. What happens when these stocks lose value on the bourses since the companies get mired in governance issues? Investors in Sun Pharma, ICICI Bank, IL&FS group companies, Yes Bank and Fortis Healthcare will identify with this predicament.
Incidentally, investors can do little when large companies falter on their governance. However, before the actual faltering occurs, leading indicators of failing governance standards do manifest. Shareholders should track such indicators and stay away or exit the stock in time. Exit of the CFO or company secretary, resignation of independent directors or auditors and regulatory inspection or settlement are some obvious events that have to be scrutinised.
Some governance issues can also tend to be industry-wide. For instance, almost all large pharma companies have received some adverse observations from the USFDA inspection of their facilities showing lack of observance of governance standards in manufacturing. “An example of leading indicator of failing governance is unwarranted or excessive PR around individual leaders as opposed to PR for the business or corporate entity,” said Milind Sarwate, an independent director on several boards. “Hero worship hides bad governance, but eventually leads to disaster as checks and balances start failing”. He modified a famous Jack Welch quote to say that when all in a company stay busy in applauding the promoter or CEO, they invariably lose sight of governance. “Investors dont need to overpay for a company simply because it is good on corporate governance – and dont have to dump the stock of a company facing bad governance if it has been priced into the stock value,” said Nilesh Shah of Kotak Mahindra AMC. Historically, stocks of MNCs have commanded a premium over stocks of their local peers – predominantly due to presumption of better governance and reporting standard.
Shahs advice to investors is to monitor how things are changing after the governance issue is in public – is the promoter or management willing to change and how much of bad governance is priced in? Shah said that maximum value gets created when Valia becomes Valmiki – a rogue that became a saint. “But it doesnt happen automatically. It requires the investors relentlessly pushing the companys management towards the desired standard of governance”.
Experts believe there is a silver lining to the governance issues faced by large reputed companies in contrast to small companies. “Management quality, leverage position, working capital stress and valuation comfort are the four criteria that investors need to check in stocks” said G Chokkalingam of Equinomics Research. A governance issue combining with problem in any of these parameters implies a disaster – especially in case of small & midcaps. “When blue chip stocks with strong business fundamentals face governance issues, the tendency to recover losses in the aftermath is relatively high in the absence of issues in case of the basic parameters,” he said.