At this time of year, many boards are preparing for their annual review of board effectiveness.  For Canadian public companies, the review may include external benchmarking using the metrics of the annual Board Games ranking in the Globe & Mail.  The Clarkson Centre for Business Ethics and Board Effectiveness, the source of the Board Games analyses, is no doubt busy now collecting the 2018 annual reports, refining the criteria and preparing the analysis to rank the governance of Canada’s largest public companies.

Since its inception 17 years ago, Board Games has served to bring a lot of attention to governance, especially from the over 200 companies and trusts that are the subject of the metrics and rankings.  Each year the Globe & Mail and the Clarkson Centre get complaints from companies that feel the metrics and/or rankings are faulty.  I’m told that most of the conversations begin with something like: “These metrics are wrong and/or unfair and/or misapplied and/or meaningless…..”  but then end with: “Please tell me how we can get a better ranking next year.”  So the rankings draw attention and changes are often made as a result.  In fact, the Globe & Mail reports that in the last 5 years alone, the average score has improved from 69 to 75 and the number of companies scoring 80 or above has increased from 29 to 42.

However, there is an important omission in the metrics that I think is fundamental to good governance – shareholder value.

I teach the course “Oversight of Strategy”, a one-day course run by the Institute of Corporate Directors (ICD).  One of the cases we use is the 2014 Ivey case about Canadian Pacific Railway (CP) in the period 2011 to 2012.  You’ll recall that this is when hedge fund Pershing Square invested in CP and ultimately shook up the board, replaced the CEO and implemented a new strategy that drove the stock price from $60 to $230 per share.  The classroom challenge is to consider how the board could have fallen so short in its oversight of CP’s strategy prior to Pershing Square taking an interest.  Course participants (mostly corporate directors) are always astounded to read that CP ranked 4thout of 253 companies in the 2011 Board Games, while performing so poorly for shareholders in the years leading up to Pershing Square’s intervention.  They ask: “What’s wrong with these metrics?”

The CP case is not isolated. The last Board Games (Globe & Mail, November 26, 2018) featured a comparison of highest and lowest governance scores for 11 industry sectors.  If you look up the long-term total shareholder return performance versus industry for the companies featured[1], you’ll find the following surprising facts:

  • In 6 of these sectors the so-called “worst” outperformed the “best”. Specifically, Rogers, Alimentation, NexGen, Aurora, Tricon and Atco are each identified as governance “worsts” and yet each delivered superior long-term returns to shareholders than its sector’s governance “best”, respectively Telus, Metro, Suncor, Chartwell, Boardwalk and Emera.
  • In 2 others sectors the “worst”, namely Shopify and Canada Goose, have not been in the public markets long enough to show long-term returns, but so far are significantly outperforming their comparators, Descartes and Gildan, respectively.
  • In 2 other sectors, financials and materials, the data is inconclusive.
  • In only one case, Canadian National Railways, is the governance “best” also clearly the best long-term performer for shareholders against comparator Westshore.

As a practicing director and a proponent of good governance, I would have expected the opposite.  That is, good governance should usually result in better outcomes for shareholders, not worse.

Some argue that “good governance” is good for its own sake.  “If we do the right things, then the shareholders will be rewarded in the long run.”  But how do we know these are “the right things”?  The above examples stand in contrast.

A measure of long-term returns to shareholders needs to be incorporated into the benchmarking metrics of good governance.  It is not be hard to do, it enhances the value of the exercise and it provides a better basis for continuous improvement.

The easiest and most impactful way to incorporate long-term shareholder value is to make it a modifier of current Board Game scores.  This can be done by multiplying the current governance score by a shareholder performance index, for example, a ratio of 5-year total returns of the company to the total returns of the industry[2].  If a company performed the same as its industry, this does not affect the governance score.  If a company outperformed for shareholders, its governance score is enhanced proportionately. If a company underperformed for shareholders, its governance score is diminished.

Factoring in long-term shareholder value in such a way brings the shareholder perspective into the scoring. For example, it would have put the score for CP (prior to Pershing Square) where it belonged – at the bottom of its industry – good governance cosmetics should not give any comfort to a board that is overseeing such poor performance.)  It would also correct many of the anomalies in the “best-worst” comparisons in the last report – several of the governance “worst” would move up based on good returns and some that scored “best” would move down.

Incorporating long-term shareholder returns as a good governance metric also partially corrects for Board Games’ harsh governance ranking of companies with dual-class share structures.  Many of these are family-controlled companies that are significantly outperforming their peers in long-term value creation.

Finally, the presence of shareholder value among the metrics serves as a guide to ongoing improvement of the metrics.  That is, when the metrics of good governance get out of alignment with long-term shareholder returns (as they seem to be now in Board Games) it should be cause to ponder: Are the current metrics all correct?  Do we have the weightings right?  Are we missing metrics that could make a difference to good governance?

For example, dual-class structures can be used to protect companies from the short-term interests of the market, (takeovers, in particular), and allow these companies a longer time horizon. Many of them are top performers but are penalized in Board Games.  The major banks are similarly protected from hedge fund influence and takeovers by the widely-held rule, but they are assigned no such penalty.

When you benchmark your board, measure what really matters for good governance.  Governance benchmarking should be more than a game.

 

Ken Smith

Corporate Director

[1]Anyone can do this using public sources; I used trailing total returns to November 2018 month end as provided by Morningstar.ca

[2]Technically, the formula is (1 + company total return %)/(1 + industry total return %), where % is versus base investment 5 years prior.  This is a standard metric for relative total returns.