Investment and Corporate Governance

Investment and Corporate Governance

Sam Choon Yin (2003)

            In general, investments are said to have taken place when one forgoes his current consumption for more consumption power later in his life. Investments can be intangible like investing in education and health. They can be tangible as well. Tangible investments are categorized into two types; physical investment and financial investment. The former includes investments in building, real estate and equipments while examples of the latter include investments in shares, bonds, derivative instruments, insurance and savings in financial institutions. This essay focuses on financial investments.

There are several reasons why people invest. One possibility is that investors have excess capital. Possibly, more likely in the working stage of a person’s life, an individual may find that he has more money than what he wishes to spend say on a monthly basis. The excess capital may be invested to grow to larger amounts in the future. This essentially brings me to the second reason why people invest. Greed! In a materialistic world, money talks. To gain reputation, power and prestige, people invest their money to buy them hope to reach higher standards of living in the near future. The other reason is security. Depositing one’s money in commercial banks or investing in house, car and life insurances helps to protect the individuals against any mishaps, which could result in lose of ability to earn income. Some individuals may invest as part of their responsibility to the society. Investors can do their part to encourage more ethical acts from corporations. Knowing that individuals in general do not favor companies that harm their workers, environment and the society, corporations are likely to be more careful in their decisions to avoid being perceived as unethical. Otherwise, their reputations would be ruined therefore creating troubles for them to acquire funds. Banks may charge higher interest rates while share prices may be depressed therefore raising difficulty for them to issue new equities in the market. Investments therefore could encourage ethical decisions from the companies (Hancock, 2002).

Because investors have to part with their money, they require some rewards as incentives to do so. The rewards are commonly known as the required rate of returns. Since the investors cannot be for sure that they will obtain the returns, the term ‘expected’ is usually used to replace the word ‘required’. In the case where there is no inflation and other risks associated with investment, investors demand the expected real rate of returns. In many countries, market forces (demand of and supply for funds) determine the real returns. For example, in cases when there is a higher demand for capital, real rate of returns will increase to stimulate more investors to supply funds. Or, in the event where individuals have weaker preference for current consumption, the supply of funds will increase. This essentially reduces the real rate of returns. Firms can obtain funds easier than before.

The real rate of returns however seldom applies. What users and suppliers of funds usually encounter in reality are the nominal rates of returns, which takes into consideration inflation and other risks. Suppliers of funds usually demand more than the real returns in order to compensate them for paying higher prices for the same quantities of goods in the future. This is to at least maintain their standards of living, or real earnings. The users of funds therefore have to offer real returns plus inflation rate to entice investors to part with their capital.

There are other risks involved, although they are more subjective in the sense that they apply differently to different parties. Some of these risks include default risk (not able to get back the intended returns) and liquidity risk (difficult to sell the asset and convert it to cash). Because of these risks, the suppliers of funds (investors) demand higher returns from the users to compensate and attract the former to invest. Larger risks therefore translate to higher expected returns. This makes sense because investors are typically risk averse. To sum up, differences in real and nominal returns are attributed to the presence on inflation and other risks. The gap widens as the risks level increases.

Often, an investor has to consider both the returns and risks of the asset understudied. Returns can be in two forms; income and capital gains. The former refers to dividend payments received. Usually, the corporation’s board of directors determines the amount. Capital gains on the other hand represent the difference between the market price of the asset and purchase price. The returns can be converted to percentage terms by taking the ratio of the sum of income and capital gains to purchase price, and multiplying the ratio by 100. What the income and capital gains provide are essentially the historical ‘known’ returns. The historical returns provide a useful input to determine how future returns will turn out. The historical returns can also be used to compare with the expected returns to see how the corporate performance has deviated from what investors expect. This is essentially the meaning of risk. That is, risk measures the degree in which the actual returns deviate from the expected returns. A common measure of risk is standard deviation.

As Nobel Laureate Harry Markowitz found out, it is not wise for an investor to put ‘all his eggs in one basket’. See Markowitz (1952, 1959). He calls for the holding of a group of assets that are negatively correlated with one another. The portfolio of assets need not necessary contains only shares. Instead, it should contain a group of diverse instruments to reduce unsystematic risk, which is diversifiable. Bonds, fixed deposits or insurance could be included in the portfolio. Even within shares, it is more advisable to hold shares from different sectors of the country’s economy instead of concentrating the portfolio with shares from a single sector. It can be shown mathematically that, with diversification, the standard deviation of the portfolio becomes smaller. The reason is intuitively simple. In the event that a particular company fails, a diversified portfolio will not be severely affected since other assets in the portfolio could help soften the negative impact. The event does not affect the economy across-the-board. Of course, should the shock be economy-wide - like in global recession, unfavorable changes in interest and exchange rates and war - then even with a diversified portfolio, its performance is likely to be badly hit. Diversification in other words helps only in reducing the diversifiable risk (unsystematic risk) but not systematic (or market) risk.

Let us focus on share investment. The strategy of issuing shares to acquire more funds is common. Companies issuing initial public offers (IPOs) are getting more in numbers. In most cases, equity capital gives rise to the separation of owners and managers. The shareholders, as owners, usually do not have the control of companies’ resources and how profits are to be distributed. The power to do so lies in the hands of managers. This is unlike the past where the owners were managers themselves. It was only in the late 19th century, perhaps started off with Standard Oil Trust in the United States, which gave more prominence to a new group – professional managers – in the discussion of corporate management. The professional managers are essentially engaged by shareholders to manage the companies on their behalf. The managers have the responsibility to maximize shareholders value through the decisions they make.

Recall that investors’ returns can come in two forms; income and capital gains. Let’s look at income in the form of dividends. Dividends essentially derive from net profits. Higher net profits translate to greater possibility of receiving higher dividends. It is the duty of managers then to maximize net profits of corporations that they are in charged. The second form of returns comes from capital gains. An investor’ capital gains are higher if he is able to sell his share at a higher price. As the next few paragraphs show, the quality of managers has strong implications to the eventual returns accrued to investors.

It may be useful to know that once a company’s share have been initially issued and bought, the price that people are willing to buy in the secondary market (stock exchange) does not directly go into the business nor does money comes out from the business. But, how the company’s managers perform has an impact on existing shareholders returns. If the managers did not perform well and the market was aware of it, people would not be willing to buy the company’s share. A fall in the demand translates to lower price offered in the secondary market for the company’s share. This poses a problem for an existing shareholder who wishes to sell the shares. He may not be able to find a buyer. Even if he does, the capital gains will turn smaller. It is also possible for him to obtain a capital loss in the process! How about those shareholders who decided to hold on to the shares? Weak managers’ performance also affects them negatively. Profits are likely to be lower. This will affect dividends payment negatively. In addition, the company’s growth potential may be affected since banks are less willing to lend the company money. Even if they do, the interest rates are likely to be on a high side. The company will also face problem issuing new shares. Nobody may be interested to buy them or that the shares will be sold at a discount to face value. Unless the managers do something positive to turn the prospect around, the shareholders will continue to suffer lower returns.

The converse is true. Good managers bring joys to shareholders. A company that provides quality goods, excellent services and consistently good news to the business community benefits its shareholders. How is this so? If investors believe that the company has good prospects, the demand for the company’s share will go up. This translates to higher share price. Existing shareholders who wish to sell their shares in the secondary market could fetch a higher price therefore raising their capital gains. The reason is simple. Avid potential investors will know about high growth potentials of a company. The current share price of the company, to these investors, will be perceived as undervalued when they carry out fundamental analysis on the company. The higher demand for the company’s shares allows existing shareholders to sell their shares at a higher price. Those who decide to hold on to their existing shares will also benefit. Higher profits translate to higher dividends. Moreover, the ability to acquire more funds for investment increases. Banks are more willing to lend to the company at lower interest rates. New issues of shares could fetch higher prices in the market. These events will raise the probability of better corporate performance.

However, the scenario may look more complicated than what the above portrays. The key problem lies in the fact the shareholders (existing and potential) are not able to tell for sure whether the managers are acting on shareholders’ behalf or doing things for their own private benefits. Recall that professional managers are engaged to manage the companies on behalf of shareholders. Although contracts are signed with managers to highlight their responsibilities and duties, the contracts are incomplete. It is technically infeasible to monitor every movement of the managers or define specifically how profits are to be allocated. In reality, managers have the discretionary power to control the company’s resources. Unethical or scrupulous managers may result in the shareholders not obtaining returns that they deserve. This phenomenon is known in the literature as the principal-agent problem. The shareholders represent the principals while managers are the agents. The agents (managers) have incentives to maximize their own objectives which are conflicting with the interest of shareholders. The late Edwin Mansfield and his co-authors in a popular textbook on Managerial Economics noted some examples of the problem. The main ones are included below (Mansfield et al, 2002).

 

1.         Minimizing effort

How much additional effort a manager is willing to put in to make an extra dollar for the owner? Given two choices; one involving less effort than the other, it is likely that the manager would choose the former rather than the latter which yields higher profits. Without any contingent compensation to the manager, the perception he holds is that the ‘owner reaps the profits; not the manager’.

 

2.         Maximizing job security

Managers often believe that bad results are more likely to gain notice than good results. Given a choice to make investment decisions; one with a large probability of high returns but high risk and one with smaller probability of high returns but less risk, it is likely that the manager would go for the second choice. The manager is less willing to opt for the riskier option for fear of losing his or her job. Perhaps a more serious agency problem is the unwillingness of managers to leave their posts even when if they are no longer competent to run the company. This is one of the ways in which the managers can expropriate the shareholders (Shleifer and Vishny, 1996)

 

3.         Enhancing reputation

A manager may do things meant to promote him rather than maximizing profits for shareholders. Mansfield et al (2002) use the example of a CEO with the ambition to hold public office to show himself as a ‘good citizen’ by lowering prices of goods sold below profit-maximizing level. This is done at the expense of shareholders whom he is accountable for. It is also possible for the manager to spend lavishly using company’s resources like spending on luxury travel, furnishing the offices with first-class art works or investing in pet projects. The expenditures are made using the shareholders’ funds rather than distributing the excess cash flows to shareholders in the form of dividends.

 

            The situation may appear more unfair to small shareholders. Also known as minority shareholders, it is more difficult for them to protect their interest since the controlling shareholders can easily outvote their demands. They may not be interested to monitor the performance of managers in the first place. There could be several reasons. First, they may just sell their shares in the secondary market if they dislike how the company is being run. Second, they prefer to be free riders. The minority shareholders may not see the value of monitoring the managers since they have to incur costs for doing so while the benefits are shared by others even those who do not contribute to the creation. It makes more sense, at least from the minority shareholders’ perspective, to be free riders hoping that others would do the monitoring while the minority shareholders reap the benefits. This is true. There are indeed other parties who do the monitoring including regulatory agencies, institutional investors and board of directors.

The principal-agent problem highlights the unethical conduct of managers. The managers are essentially doing things to maximize their own private benefits. This resembles the problem of corruption that is often associated with public sector management. The mechanisms used to tackle the corruption problem can be used to address the principal-agent problem. This issue will not be dealt here. See Sam (2003) for details. The common recommendations in corporate governance literature include designing a well-structured board of directors, enhancing roles of independent directors, signing incentive contracts with managers (like use of stock options plan), easing takeovers and bankruptcy laws and so on. It may useful not note that transparency is often called as a mean to raise accountability of managers. This essentially calls for more information to be released to investors. Some caveats however must be considered. More information may not be useful if it adds to confusion. Information may also be useless if they are not accurate and timely. Recent cases like Enron and WorldCom had exemplified that accounting manipulation was possible. What is important is that the information adds value to investors by conveying messages that are currently not available in the market. Ideally, the information should be provided at low costs and in a timely basis. 

These corporate governance mechanisms are essentially institutional. They provide incentives and disincentives inducements. The institutional mechanisms can work well provided that individuals react to incentives. A necessary condition is that managers are rational individuals. A rationale individual weighs the benefits and costs of each alternative and chooses the one that yields the highest net benefit. This basically describes the thinking process of individuals. The thing to note is that the rationality assumption does not pre-determine the kind of person a manager is. It is not possible for an outsider to do so because such information is hidden and personal. Only the manager perhaps can tell. So, the question of whether the manager is egoistic, altruistic or communitarian is not what we are interested here. Instead, we highlight the fact that a rationale individual reacts to incentives therefore a possible way to influence his decision is through incentives and disincentives inducements. Consider an example. Say a manager has two choices; ‘shirking’ versus ‘non-shirking’. To influence his decision, that is, to choose the latter option, requires decisions to alter the benefits and costs of the two options in such a way that he will end up choosing not to shirk. This would the case if, with the incentives and disincentives inducements, he perceives the choice’s of not shirking to reap higher net benefits than that of shirking. In reality, it is perhaps useful to look into the cultural aspect of human behavior to supplement the institutional mechanisms. Designing a corporate culture that values ethical conduct may be useful. Appealing to moral consciousness to do the right thing may work particularly if it is supported by religious teachings and social norm which supports the communitarian principle of moral.

 

References

1.         Hancock, John (2002) Ethical Money: How to Invest in Sustainable Enterprises and Avoid Polluters and Exploiters. Kogan Pase (Great Britain).

2.         Mansfield, Edwin; Allen, Bruce; Doherty, Neil; and Weigelt, Keith (2002) Managerial Economics: Theory, Applications, and Cases. Fifth edition. W.W. Norton (United States).

3.         Markowitz, Harry (1952) ‘Portfolio Selection’, Journal of Finance 7, no. 1 (March 1952).

4.         Markowitz, Harry (1959) Portfolio Selection – Efficient Diversification of Investments. John Wiley & Sons (New York).

5.         Sam, Choon Yin (2003) Governance in the Public and Private Sectors. Unpublished manuscript.

6.         Shleifer, Andrei and Robert .W. Vishny (1996), ‘A Survey of Corporate Governance’. NBER Working Paper 5554. Also published as ‘A Survey of Corporate Governance’, Journal of Finance, 52, pp. 737-783, 1997.