April 10, 2005
FUNDAMENTALLY: Gauging That Other Company Asset: Its Reputation
By PAUL J. LIM, NY TIMES

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AS regulatory issues keep troubling Wall Street, some investors are beginning to wonder: Are sound business ethics not only a sign of a morally good company, but of a good investment as well?

Jim Huguet certainly thinks so. At the very least, Mr. Huguet, the president of Great Companies L.L.C., a money management firm based in Clearwater, Fla., argues that sticking with companies with sound ethical practices, including transparency, accountability and a shareholder-friendly corporate governance structure, is a good way to avoid land mines in your portfolio.

"This is not about feeling good about doing the right thing," said Mr. Huguet, whose firm oversees $1.3 billion in assets. "It's about returns and protecting those returns."

The list of companies whose shares have been battered amid accusations of wrongdoing is a who's who of widely held stocks. Among the latest victims has been the insurance giant American International Group, whose stock is down 21 percent this year.

A.I.G. is being investigated by regulators over transactions that may have masked the company's financial health. A.I.G.'s longtime chairman and chief executive, Maurice R. Greenberg, was forced to step down as a result of the controversy.

But it's not just A.I.G. The shares of the Marsh & McLennan Companies are off 36 percent over the 12 months; in late January, it agreed to settle a lawsuit by regulators accusing it of cheating customers by rigging prices and steering business to insurers in exchange for incentive payments.

And last fall, regulators in Japan ordered Citigroup to suspend its private banking operations there because of violations of the country's banking laws. Citigroup stock is down 12 percent over the last 12 months. Paying attention to a company's behavior is a strategy to reduce risk. "The lesson here is to treat and research corporate governance issues like any other fundamental," said Andrew Metrick, an associate finance professor at the Wharton School of the University of Pennsylvania.

Moreover, two academic studies conclude that investors appear to attach a good-citizenship premium to companies with solid governance structures and policies.

One of those studies, published by Professor Metrick with Paul A. Gompers and Joy L. Ishii of Harvard in 2003, looked at the corporate governance attributes of roughly 1,500 companies from September 1990 to December 1999. It found that companies with strong shareholder rights provisions tended to exhibit higher profitability and sales growth, among other things.

Companies that scored well on corporate governance issues also had higher Q ratios. This is an iteration of a statistical measure developed by James Tobin, the Nobel laureate economist; in this case it divides the market value of a company by its book value.

Companies with good governance practices were rewarded with higher market values relative to their tangible assets than companies that scored poorly. "There is a premium associated with good governance as far as we measured it," Professor Metrick said.

A more recent study, a working paper released last year by Lawrence D. Brown, an accounting professor at Georgia State University and Marcus L. Caylor, a graduate student at the university, similarly found that investors were paying higher prices for companies with good governance.

The Georgia State research found that some governance practices that are considered shareholder-friendly don't correlate with good fundamentals. For instance, it found that companies that split the roles of chairman and chief executive didn't necessarily generate a greater return on equity.

But even without this correlation, investors are still willing to give higher valuations to companies that are deemed good citizens. Put another way, investors give some companies with good track records the benefit of the doubt. That may explain in part why Warren Buffett's Berkshire Hathaway has lost only about 1 percent of its value this year. A Berkshire Hathaway subsidiary, General Re, was party to a transaction that A.I.G. has said was accounted for improperly.

Berkshire "is a company with a culture of accountability, and that resonates with investors," said Gavin Anderson, chief executive at GovernanceMetrics International, a firm in New York that grades corporations on governance practices. (It does not have an official rating on Berkshire.)

Mr. Anderson's firm recently studied the performance of companies that scored its highest rating: 10 on a scale of 1 to 10. Of 3,220 global companies, only about 1 percent received that score. Shares of those companies generated an average annual total return of 15.6 percent over the five years through Feb. 28. By comparison, the Standard & Poor's 500-stock index lost 1 percent, annualized.

Of course, there is an inherent difficulty in trying to beat the market by choosing companies based on good corporate governance. Governance is just one issue; there are other fundamentals to consider, like earnings growth and profit margins. It's also hard to know that a company that is considered ethical today will seem so in the future.

And it's important to distinguish between ethical business practices and social responsibility issues. Cases in point are so-called sin stocks, like shares of tobacco, gambling and alcohol companies, which have been on a tear over the last five years while the overall market has been flat.

Individual investors face another problem: they generally don't have access to private sector research, like reports from such firms as GovernanceMetrics, whose most basic data package costs $7,500 a year.

But at the very least, investors should look for past improper behavior in companies in which they're about to invest, Mr. Anderson said. A quick way, he said, is to run a search of a company's litigation and regulatory infringement history, much of which is available through public databases and the Securities and Exchange Commission.

"What we're looking for when we search for this type of information is a pattern," he said. "I would submit to you that if a company has a pattern of constantly being sued for improper business practices, that suggests its culture allows this type of behavior."

And that's precisely the type of company that should make an investor wary.

Paul J. Lim is a financial writer at

U.S. News & World Report. E-mail:

fund@nytimes.com.