Introduction to Fundamental Analysis
Qualitative analysis: Corporate Governance.
If you are also a fan of SUITS, you will be familiar with the power and impact that corporate governance has on a company. Can you recall what happened with the investors and competition every time they switched/removed/added partners to the law firm in the series? Let’s talk about it.
Peter Lynch, an American investor, mutual fund manager, and philanthropist, once said: ‘Look for a company that an idiot cna run, because he will at some point’. As harsh as it may sound, he’s most likely right.
If you wonder what the term entails, are all those processes, rules, and practices that are set to run a company and balance the interests of the main stakeholders:
- shareholders
- management
- customers
- suppliers
- financiers
- government
- community
There are many factors that involve bad governance, but supporting illegal activities will simply kill the company. Remember Volkswagen scandal in 2015? Well, that’s just one example.
Some issues related to corporate governance include not choosing the right auditors, which leads to non-compliant financial results; bad executive compensation packages, which do not incentivize the corporate officers enough; poor board structures, which make it difficult for shareholders to outperform the inneficient incumbents.
In those companies where the owners and managers are separated without shareholders controlling in between, the principal-agent issue emerges:
- The upper management becomes the agent, which has more information and different interests than the shareholders, which are the principals.
The issue comes when the decisions made by the board benefit the management and no one else. An example provided by Hendricks et al. includes ramping up production to reach production targets to receive large bonuses without really maximizing production.
Is there then a solution?
Yes, there is. It is important to prevent it in the first place by setting up processes, policies, laws, customs, and institutions that regulate the company’s control.
Another smart point is insider ownership, which means that the management will also own shares, hence, it will suffer if it performs badly.
Trnasparent rules and processes are necessary to align everyone’s incentives and interests. Nevertheless, we see other trends like corporate citizenship emerging, which includes being aware of the environment, behave ethically, and carry out good corporate governance practices.
Rounding up qualitative analysis.
- Analysing the company and industry provides you with a good understanding.
- The changes in the environment affect the company’s value.
- Qualitative analysis tells you where the company’s position is relative to its competitors.
- To make a valuation on the company, quantitative analysis is needed. Check out the next post!
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Bibliography:
Hendriks, P., Heeringa, M., Koenraadt, J., Rikken, I., Paganini, A., Grigolini, A., Vlaming, E., Dijkstra, S., Piech, S., Kalinin, P., Quint, S., Faddegon, A. (2020) B&R Investment Guide. Second Edition August 2020. B&R Beurs, 25–27.
