New Frontiers in Extra-Financial Research: A Year in Review

By Lev Janashvili

As usual, the end of the year has brought a new cycle commentary about the mix of risks and opportunities investors might find in the capital markets in 2013. Financial publications are enticing readers with nuggets of thoughtful prophecy shaded by a vague unease about apocalyptic scenarios for Friday, December 21 inspired by the quirks of the ancient Mayan calendar.

Assuming we survive the apocalyptic watershed this Friday, GMI Ratings’ research in the New Year will continue to dissect the risk of routine man-made anomalies stemming from weaknesses in corporate governance and accounting practices. Against the backdrop of the more fashionable focus on highly improbable tail risks, we will continue to study the predictable consequences of bad governance and bogus accounting. Over the past year, we made some important contributions to these areas of study. Here are some highlights.

New Perspectives on The Big Drop

We published extensive research this year on the relationship between the integrity of reported financials, as measured by our AGR® ratings, and the risk of major drops in share prices. The research clearly shows that the relative frequency of the most extreme as well as more moderate share price declines is significantly higher among companies with bottom-decile AGR scores.

Incidence of Major Stock Drops over 10 years

(6-month holding period)

% Stock Decline

Bottom AGR® Decile

Top AGR® Decile

Bottom/Top Multiple

70%

0.26%

0.04%

7.2x

60%

0.51%

0.12%

4.4x

50%

1.00%

0.40%

2.8x

This research led to the prescient placement of Hewlett-Packard on our Black Swan Risk List (BSRL) on November 19, a day before the announcement of a massive write-down related in part to the Autonomy acquisition.

New Applications of Extra-financial Research

We have also started to extend our BSRL research into new areas. Recently, Ophir Gottlieb, our Director of Custom Research, tackled the question: Can AGR Ratings Predict Defaults in the CDS Market? Ophir examined the largest Credit Default Swap (CDS) auctions using a 6-12 month look-back period, and he found that companies in the bottom AGR decile were 11 times more likely to default than companies in the top AGR decile.

Beyond issuer-specific analysis, we started to define new avenues for the applications of extra-financial research to the practical concerns of mainstream institutional investors. We found material variances in the distribution of ESG and forensic accounting (AGR®) risk ratings in major indices compared with the normal (expected) distribution of scores in the same region. This finding shed new light on the implications of an investment manager’s decision to benchmark portfolio performance against a major market index.

Understanding Non-traditional Risk Metrics

This year, we produced a very popular series of reports on ESG and accounting metrics for investment use.   Many mainstream institutions considering ESG research still need credible answers to basic questions such as:

  • On what basis do we determine that a particular risk metric warrants inclusion in ESG ratings?
  • Does board diversity really matter to an investor? Why? Where’s the evidence?
  • How do M&A transactions affect ESG and forensic accounting ratings? Why?
  • What are the most reliable signs of asset inflation?

Moving toward Real-time Event-driven Research

Sophisticated consumers of extra-financial research no longer find comfort in static issuer ratings, “black-box” algorithms and scarce event-driven coverage. ESG and forensic accounting research needs to move toward greater depth, transparency and frequency. That’s why we continue to produce regular/daily research on companies, industry groups, key trends as well as the risk of securities litigation and financial distress.

Mapping Relationships

Earlier this month, we launched Global LeaderBoard (GLB), a data-visualization tool that maps relationships between corporations and corporate board members. GLB was a logical step in the evolution of GMI Ratings’ novel measures of corporate character. GLB helps our clients deepen their analysis of issuer risk by exploring the broader context of board-level relationships and interlocking board memberships that may affect the quality of corporate leadership.

The FT’s Andrew Hill recently covered GLB (Networks and the risk of relying on who you know). Hill wrote: “Networks and networking create business opportunities, ease human relations and lubricate commerce. But a closed web of connections, can be as much a warning of potential weakness as a sign of strength.”

Moving the Dialog Forward

With some of our research and editorial content this year, we helped reframe or rebut some of the misconceptions and misguided priorities that still dominate mainstream perceptions of extra-financial research.

  • In an October 21 op-ed in the FT, GMI Ratings co-founder Bob Monks delivered a long overdue summation to the long-running debate about ESG’s impact on performance. The summary was simple enough to fit into the headline: ESG Research Works. “In fact,” Mr. Monks wrote, “the more the character of capital markets changes, the more relevant non-traditional extra-financial research becomes.”
  • In August, our paper entitled New Frontiers in Risk Modeling provided a response to academic dogmatists who portray extra-financial research as a sacrilegious departure from classical economic theory. Here, we also introduced the concept of routine man-made anomalies to draw a distinction between governance and accounting-related risks and the highly improbable risks called Black Swan events.
  • In an essay last week, GMI Ratings Chief Executive James Kaplan moved the redefinition of Black Swans a step further. He wrote: “In the midst of the avid scrutiny of improbable risks, many investors still ignore the systemic incentives for corporate practices that elevate investment risk as surely as sedentary lifestyles elevate the risk of heart disease. The typical investment manager still relegates forensic accounting to the margins of due diligence. We are still pursuing elusive insights at the expense of observing obvious or easily discernible flaws… Unlike Taleb’s study of the highly improbable, investment analysis based on corporate governance and forensic accounting points to risks with tangible causes and predictable effects. Rewards for poor performance typically result in poor performance. Misleading accounting practices typically result in mispriced risk. It really is that simple.”

In Conclusion

We’re looking forward to 2013, and we welcome feedback and suggestions on how we can better help our readers measure and mitigate risk.