How to Invest in Well Run Companies and Guard Against Ruinous Losses

Laith Khalaf: When governance failings come to light, they can be ruinous for a company’s share price

Laith Khalaf is head of investment analysis at AJ Bell.

‘G’ is definitely the dullest of the ESG (environment, social, governance) triumvirate.

It is nonetheless a vital aspect that should be a priority for responsible investors, as companies without good governance will normally have other flaws as a result.

In developed markets, a baseline of decent governance tends to be baked into companies, and indeed almost all fund managers will tell you that it’s an important part of their investment process, because to ignore governance is to open yourself up to investment losses.

What is governance and how does it make you money (or avoid losses)?

Governance is essentially the framework that ensure a company has the necessary checks and balances between all its various stakeholders, and ensures that incentives don’t exist that might encourage management or indeed other employees to act against the interests of the business and thereby its shareholders.

Yes, that does make it a particularly dry and procedural part of the corporate sphere, but one which can be rewarding not just from an ethical standpoint, but because it can mean preventing damaging corporate behaviour that has negative implications for investors.

That’s because when governance failings come to light, they can be ruinous for a company’s share price – see the box below.

If you are investing in individual shares, you can research firms to come to your own conclusions on whether they are well run.

If you prefer to invest in funds, you can look for those with a manager who actively seeks exposure to companies that demonstrate commitment to good governance and who keeps an eye on whether they maintain best practice over time.

>>>Which funds focus on good governance? Find tips below

How ignoring governance can lead to disaster

Consider for instance the governance weaknesses at Volkswagen, which led to the emissions scandal, something that cost the company billions in fines and investors billions in value wiped off the share price.

Even today the carmaker has not shed the reputational stain that appeared seven years ago.

The online retailer Boohoo suffered a similar fate when oversight failings led to workers in its Leicester supply chain suffering poor working conditions and underpayment.

Accounting scandals can also be terminal for a business if allowed to flourish by a lack of robust governance, as investors in Patisserie Valerie and the German payments firm Wirecard found to their cost.

Strong governance is not an absolute 100 per cent guarantee that poor behaviour can be evaded, as sometimes this is the result of individuals undermining and hiding from governance processes.

However it does offer a sizeable safety net, and means that when irregularities occur, they are picked up and acted upon, rather than left to fester and worsen.

What funds might you consider for your portfolio?

Stewart Investors Worldwide Sustainability (Ongoing charge: 0.67 per cent)

This is a global fund run by an experienced and well-resourced team that invests in companies across the world that are positioned to contribute to, and benefit from, sustainable development in the countries in which they operate.

A key plank of the investment philosophy is to understand the quality of the management of a company with regards to its integrity and its commitment to high levels of corporate governance.

The fund’s preference for quality companies and a focus on capital preservation may mean that it might lag peers in strongly rising markets, but should offer better protection in falling markets.

Liontrust Sustainable Future Global Growth (Ongoing charge: 0.85 per cent)

Peter Michaelis, the longest serving manager on this global ESG fund, has been running it since before Greta Thunberg was born.

Moral compass:  Companies without good governance will normally have other flaws as a result, warns Khalaf

The fund looks for companies that fit into a matrix of sustainable growth themes, and which make a positive contribution to society, focusing on firms that make the world cleaner, healthier or safer.

A crucial part of the research process is assessing whether company management has put in place appropriate structures, policies and practices for managing its ESG risks and impacts.

Royal London Sustainable Leaders (Ongoing charge: 0.76 per cent)

Fund manager Mike Fox is another long-standing ESG investor, who has been involved in running this offering since 2003.

The investment process is primarily driven by a screening process that scores companies on their ESG credentials. The team then conduct an in depth analysis of the resulting companies, and one of the things they will be looking for is the strength of corporate governance in the firms they are considering investing in.

This is a UK fund so will predominantly invest in UK-listed companies.