Most professional fundamental investors wouldn’t dream of simply taking the opinion of a sell-side analyst at face value before investing in a company. Should not the same concept hold true for Environmental, Social, and Governance (ESG) investing, particularly if the framework is being used to uncover insights or otherwise identify value that’s largely overlooked by conventional wisdom?

Consider the "G" within an ESG framework—all those things pertaining to corporate governance and how a company advances on its business objectives while making decisions that balance its approach among all stakeholders. This covers an array of issues, including shareholder rights, the makeup of the board, code of ethics, and a host of other factors.

Numerous studies on governance have shown that companies that lack proper governance characteristics are prone to mismanagement and, in turn, risk their ability to capitalize on business opportunities. Given the importance of corporate governance, why would fundamental investors rely on a third-party ratings firm to determine what's appropriate? You cannot simply take someone else’s word for it.

As an investment team¹  who has utilized a “governance” lens to evaluate risk and opportunity as an integral part of our investment philosophy for more than two decades, we would argue that understanding ownership rights, shareholder structure, board composition/oversight, and board structure are vital before allocating capital towards a new investment. In fact, governance issues are so important that we would encourage investors to take much more than a cursory look at the ‘G’ in ESG. 

Importantly, there’s not a one-size-fits-all approach in measuring what equates to “appropriate governance.” Rather, our experience has revealed that many companies that score highly in the governance factor by third-party ESG ratings firms may be poor investments. Conversely, some third-party ratings that suggest a poor governance score may be missing the point altogether—and thus foregoing intriguing opportunities. 

Consider board structure as one example. Companies that have a staggered (or classified) board of directors—loosely defined as a board structure that elects only a portion of its directors every year, versus an annual election of all board members—typically score poorly on their governance factor by third-party ratings firms. Ratings agencies usually cite the risk of entrenchment of underperforming board members.  

That might be too simplistic. We have identified companies with staggered boards that have a long history of shareholder value creation, thanks to a strict adherence to an economic value-add (EVA) capital allocation philosophy that requires management to demonstrate that every capital expenditure up for board approval will achieve a specified after-tax return on invested capital. In our opinion, having a staggered board of directors may be appropriate—even an advantage—because: (1) it allows new board member to learn the EVA process if they're unfamiliar with its implementation, and (2) it ensures that such an EVA philosophy endures and cannot be easily displaced by an activist shareholder. 

This is but one example, but the key point is that governance matters, and evaluating it requires intellectual flexibility and more nuance than often provided by a third party. Governances need to be part of a professional investor’s due diligence, and it’s too important to outsource.

1 The authors are both members of the Value team at RS Investments, a Victory Capital franchise.