Such rich valuations are fully pricing in two lesser-understood soft aspects: 1) An adequate level of corporate governance standards, and 2) Good board quality to guide management on a sustainable growth path.
The independence of the board is perhaps the most discussed subject in this regard. Independence is an essential ex-ante governance mechanism to limit the self-serving behaviours of managers in a diffused shareholding structure. However, the board’s competence also plays a very crucial role in the long-term sustainable growth of a company.
Answers to a couple of basic questions help in understanding the subject better. Why does a company appoint an independent board in the first place? If it is just for regulatory compulsion, then it’s a dead-weight cost to the company and the same should be reflected in the quality and size of its board. The legal definition qualifies any respectable outsider as an independent director. But in reality, the CEOs in India are actively involved in recruiting outsiders as independent directors. Hence, if an independent director’s vintage is shorter than that of CEO in the company that may also sometimes dilute their independence. The true independence of directors lies in their ability to make strategic decisions that are independent of their management. Such ability to act independently comes from the board’s empowerment and capabilities to hire, reward, and replace (if needed) the management.
The other contextual question is what motivates someone to act as an independent director? The pecuniary entitlement under the law is not significant as compared to downside legal risks for these independent directors. Competent candidates may join the board of a large and reputed company for social recognition and other concomitant benefits. However, it is not clear why such candidates would join a less-reputed mid-sized company with higher governance risks. But then, as investors, we sometimes come across surprising instances of competent candidates acting as good stewards on the board of some of these midcap companies. And such surprises are often rewarded handsomely by the market.
At the current juncture, these highly priced mid-cap companies need a large pool of quality candidates with an optimum balance of independence and competence to come forward to join their boards as directors – not to rock the boat, but to support the management in maintaining their premium valuations. In this regard, the recent CII guidelines on independent directors is a very welcome move. Serious market participants study the board closely to differentiate between companies that are doing the right things and companies that want to be seen as doing the right things, which eventually reflect in their respective stock prices.(The writer is the chief investment officer of Aegon Life Insurance)
