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How to gauge corporate governance?

Apr 3, 2012

Sound corporate governance system is a key to protecting shareholder's interests. Conflict of interest may arise between management and shareholders as many times managers try to maximize their self-interests at the expense of minority shareholders. This is known as a principal-agent problem. A strong corporate governance system is a one that aligns the interests of managers and shareholders. And this is a difficult task considering that managers are:-

  • Just agents, hence the intention is to extract benefits for themselves

  • They know more about the business than minority shareholders and thus can use price sensitive information for their own advantage
Thus, companies with strong corporate governance systems have always commanded premium valuations. But how can an investor really gauge the effectiveness of a corporate governance system in any organization? In this article, we highlight one such measure that is assumed to be of some help to the investors in this regard. And it is:-

Composition of the board: The board of any company comprises of certain number of independent directors. These directors are neither employees of the company nor do they have any material interest in the business of the company. Higher independent board composition is beneficial to minority stakeholders as decision making at top management becomes independent in nature and without managerial hubris. This is because it is believed that the decisions of independent directors are unbiased as they are not related to the company.

But here we present the board composition of few noteworthy companies that contradicts this general perception. Please note that we have excluded government enterprises as public sector undertaking (PSU) boards are dormant in nature. This is because decision making in PSUs is at the mercy of government with minimal inputs from the board of directors.

Board Composition of select companies*
Company Name Total number
of directors
No of independent
directors
% of independent
directors in board
Bharti Airtel 16 8 50%
Reliance Industries Ltd 13 7 54%
Bajaj Auto 16 9 56%
Hindustan Construction Company Ltd 10 7 70%
AIA Engineering Ltd 8 6 75%
HDFC Bank 10 6 60%
Hindustan Unilever Ltd 9 4 44%
* As on 31st March 2011
Source: Company Annual Reports, Ace Equity

The above table might reveal that Hindustan Construction Company (HCC) and AIA Engineering have best practices on corporate governance. While it is true for AIA Engineering, higher independent board composition is not a thumb rule for best practices on corporate governance. If that was the case then HCC's debt might not have been referred to corporate debt restructuring (CDR) cell (Independent board should have opposed continual raising of funds through debt). At the same time lower independent board composition does not mean that company is managed ineffectively. Hindustan Unilever Limited (HUL) has the lowest ratio of independent directors but hardly can one comment on the ethical practices followed by the company.

Thus, while it is believed that higher independent board composition is a sound corporate governance practice, it is of little help due to its contradictory results. That's because the independent directors (though independent) are mere puppets of the top management and cannot influence the ultimate decision making.

Thus, we believe that corporate governance section that appears in the annual report is meaningless and a mere lip service. In order to gauge the true corporate governance practices one needs to understand the intentions and actions of the top management which are qualitative in nature. However, past actions like averseness to debt and not adopting "a growth at all cost approach" gives us some direction in that regards.

Jinesh Joshi

Jinesh Joshi (Research Analyst) holds a masters degree in Finance and has over 8 years of experience in tracking equities. He has a keen affinity for number-crunching and is often sought after for his valuable insights on financial modeling and valuations. He has a keen eye for spotting emerging growth opportunities across sectors and market caps. Jinesh contributes to our Megatrend investing service The India Letter.

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