By Paul Hodgson – Chief Research Analyst
Like its predecessor firms (The Corporate Library, GovernanceMetrics International, and Audit Integrity), GMI Ratings prides itself on identifying potential problems that stem from poor management practices. The historic correlation between those practices and negative events allows GMI Ratings to predict the likelihood of future events that can result in a loss of value to stakeholders.
Recent predictions based on GMI Ratings analysis include Hewlett Packard, which we have rated a “D” or an “F” in ESG (environmental, social, governance) for as long as I can remember, with a “Very Aggressive” AGR® (accounting and governance risk) rating since at least 2009. Both ratings substantially predated the company’s problems or, indeed, most everyone else’s suspicion that something might have been amiss.
Other accurate predictions include Chinese timber company Sino-Forest, which was accused of accounting fraud; News Corporation, where phone-hacking investigations and the potential for shareholder and other litigation continue to beset the company; and BP, whose environmental record continues to cause enormous economic damage. Each of these companies was rated either a “D” or “F” ESG and/or was labeled with an “Aggressive” or “Very Aggressive” AGR long before the, now well-publicized, problems surfaced.
Being able to identify potential problems makes our services valuable to clients. Since clients can act on GMI Ratings and GMI Analyst reports. And they enable investors to act prior to incurring losses from bankruptcy, enforcement actions, litigation, negative earnings surprises, or other costly damaging governance developments.
Much of our publicity and client communications are designed to allow our clients to protect their investments from serious value destruction, and tend to focus on those companies we currently rate, or have rated, at the highest risk. This research not only demonstrates our prescience, it also validates what we do.
At the same time as proving the value of our ratings, however, the emphasis – in the press and elsewhere – on our negative ratings can give the impression that GMI Ratings is either unrealistically hard in its grading or that we simply rate all companies badly. This is not just unlikely, it does not reflect reality.
A Perfect Distribution
The “F” grades in our system, both in North America and globally, account for a very small proportion – around 5 percent – of the overall sample (well over 5,500) of ESG ratings. They are the ratings we make the most noise about because they represent the highest level of risk. Our clients, whether they be investors concerned about the value of their holdings or D&O insurers pricing a new policy, expect us to alert them to the probability of loss. They also expect us to identify the companies that represent good value, which we determine by their transparent accounting and responsible governance.
The distribution of our ESG and AGR ratings is shown in the graphs at the bottom of this article.
Our AGR ratings, which cover over 18,000 companies globally, are even less skewed towards the negative. As the chart shows, far more companies have either an “Average” or a “Conservative” rating than have “Aggressive” or “Very Aggressive” scores.
Ratings distributions, now and at prior firms, have typically reflected such a pattern. This is because they have been designed to reflect reality. The eventual grades – whether ESG or AGR – reflect the cumulative weightings that we give to the hundreds of data points that are incorporated into our algorithms. These data points represent accounting and governance behavior that has been proven to correlate to negative events, and are weighted accordingly. Not only that, but they were designed with the knowledge that only a very small proportion of companies overall will ever blow up. If we rated all our covered companies badly and only a minor proportion of them blew up, we’d be out of business.
It might be expected that the majority of covered companies which have poor ESG and AGR ratings are well aware of their poor grades. For the same reason, companies that are rated an average or low risk are unlikely to feel the need to validate themselves by finding out why. Yet even those companies that we do consistently rate poorly experience events that cause ratings improvements, even if such behavior is not maintained. For example, predecessor firm The Corporate Library has rated Chesapeake Energy at either a “D” or an “F” since 2002, when it first began publishing its ratings. Yet, even Chesapeake Energy saw an upgrade to a “C” on two occasions in its ratings history, albeit briefly, when compensation practices and/or the situation surrounding related party transactions seemed to be improving in the short-term.
But disasters attract the most attention because they cause the greatest damage. Our clients want to be forewarned of potential litigation risk, potential financial restatements, potential financial loss, scandal, bribery and corruption, and environmental disaster. Our clients also review our analysis of companies that represent lower risk, but the companies with the poorest ratings will always get the most attention. Let’s be honest, if we sent out alerts indicating that The Gap, for example, was rated a “B” with an “Average” AGR, and that there really wasn’t anything to worry about, our clients would very soon stop reading our alerts.
Far from being the unconscious harbingers of doom, this stress on the negative is the result of a strategic decision: stress the “F” ESG ratings and the “Very Aggressive” AGR ratings, and the problems they present to fiduciaries, because that is the most efficient way of acquainting our potential constituency of the value of our analysis. Predicting disaster is our expertise, but while we are wary of endorsing particular companies as exemplars of ESG or accounting practices, we are perfectly well aware that the vast majority of corporations present little risk to shareholders. However, it is with the poorly-rated outliers that our business lies; and the ability of those outliers to destroy value has been clearly demonstrated.