A great article on the Stanford Business School site …
June 2008
STANFORD GRADUATE SCHOOL OF BUSINESS—A study by Stanford law and business faculty members casts strong doubt upon the value and validity of the ratings of governance advisory firms that compile indexes to evaluate the effectiveness of a publicly held company’s governance practices.
Enron, Worldcom, Global Crossing, Sunbeam. The list of major corporations that appeared rock solid—only to founder amid scandal and revelations of accounting manipulation—has grown, and with it so has shareholder concern. In response, a niche industry of corporate watchdog firms has arisen—and prospered.
Governance advisory firms compile indexes that evaluate the effectiveness of a publicly held company’s governance practices. And they claim to be able to predict future performance by performing a detailed analysis encompassing many variables culled from public sources.
Institutional Shareholder Services, or ISS, the best known of the advisory companies, was sold for a reported $45 million in 2001. Five years later, ISS was sold again; this time for $553 million to the RiskMetrics Group. The enormous appreciation in value underscores the importance placed by the investing public on ratings and advisories issued by ISS and its major competitors, including Audit Integrity, Governance Metrics International (GMI), and The Corporate Library (TCL).
But a study by faculty at the Rock Center for Corporate Governance at Stanford questions the value of the ratings of all four firms. “Everyone would agree that corporate governance is a good thing. But can you measure it without even talking to the companies being rated?” asked David Larcker, codirector of the Rock Center and the Business School’s James Irvin Miller Professor of Accounting and one of the authors. “There’s an industry out there that claims you can. But for the most part, we found only a tenuous link between the ratings and future performance of the companies.”
The study was extensive, examining more than 15,000 ratings of 6,827 separate firms from late 2005 to early 2007. (Many of the corporations are rated by more than one of the governance companies.) It looked for correlations among the ratings and five basic performance metrics: restatements of financial results, shareholder lawsuits, return on assets, a measure of stock valuation known as the Q Ratio, and Alpha—a measure of an investment’s stock price performance on a risk-adjusted basis.
In the case of ISS, the results were particularly shocking. There was no significant correlation between its Corporate Governance Quotient (or CGQ) ratings and any of the five metrics. Audit Integrity fared better, showing “a significant, but generally substantively weak” correlation between its ratings and four of the five metrics (the Q ratio was the exception.) The other two governance firms fell in between, with GMI and TCL each showing correlation with two metrics. But in all three cases, the correlations were very small “and did not appear to be useful,” said Larcker.
There have been many academic attempts to develop a rating that would reflect the overall quality of a firm’s governance, as well as numerous studies examining the relation between various corporate governance choices and corporate performance. But the Stanford study appears to be the first objective analysis of the predictive value of the work of the corporate governance firms.
The Rock Center for Corporate Governance is a joint effort of the schools of business and law. The research was conducted jointly by Robert Daines, the Pritzker Professor of Law and Business, who holds a courtesy appointment at the Business School; Ian Gow, a doctoral student at the Business School; and Larcker. It is the first in a series of multidisciplinary studies to be conducted by the Rock Center and theCorporate Governance Research Program. More details can be found at http://www.gsb.stanford.edu/news/research/larker_corpgov.html
