Governance and Transparency
More and more investors – both institutional and retail – are applying environmental, social, and governance (ESG) criteria to their evaluation of the companies they invest in.
Governance, or this case corporate governance, is the system by which businesses are directed and controlled. It involves both the board of directors and management.
Corporate governance covers the areas of environmental awareness, ethical behavior, corporate strategy, and risk management.
What Is Governance and Transparency?
The core principles of corporate governance include accountability, fairness, responsibility, and transparency. Each of these four principles are essential parts of good governance.
Perhaps the most important of these principles is transparency. Shareholders (and even outsiders) should be informed about the company’s activities, what it plans to do in the future and any risks involved in its business strategies.
Transparency means openness, a willingness by the company to provide clear information to shareholders and other stakeholders.
Disclosure of material financial matters concerning the organization’s performance and activities should be timely and accurate. This will ensure that all interested parties have access to clear, factual information which accurately reflects the financial, social and environmental position of the organization.
Transparency ensures that stakeholders can have confidence in the decision-making and management processes of a company.
After the Enron scandal in 2001, transparency is no longer just an option, but a legal requirement that a company has to comply with.
Transparency is a necessity for the whole company. However, its presence is even more important at the top where strategies are planned and all the major decisions are made. Shareholders expect that the corporate board and upper management are open about their actions; otherwise, distrust will form and the stock price will likely suffer.
Why Is Governance and Transparency Important to Investors?
The reasons governance and transparency are important are self-evident.
Poor corporate governance can cast doubt on a company’s operations and its ultimate future profitability. In fact, S&P Global research on governance factors has shown that companies that rank well below average on good governance characteristics are highly prone to mismanagement and risk their ability to capitalize on business opportunities over time.
And there are studies that show a positive link between financial performance and strong corporate ESG policies and practices.
Aaron Yoon, an assistant professor of accounting information and management at Kellogg and George Serafeim at Harvard Business School, recently examined this question by analyzing data on more than 3,000 companies. They found that stock value did tend to rise after positive ESG news about a firm emerged, but only if the news was financially material—that is, related directly to the company’s sector.
The researchers also looked at what categories of ESG news elicited the biggest reaction from investors, given that ESG covers a huge range of company activities.
In looking at both material and nonmaterial news, they found that investors didn’t respond to every piece of ESG news. But they did react strongly to news about how products affected customers, such as changes in safety, affordability, or consumer privacy. So, if companies are looking for a positive market response, it might make sense for them to invest more resources in those areas. Improving labor practices and lowering products’ environmental footprints also were linked to bumps in stock prices.
That’s why understanding in particular the “G” in ESG is critical, as governance risks and opportunities will likely increase in the future as social, political, and cultural attitudes continue to evolve.
How to Invest in Transparent Companies With Good Corporate Governance
More and more investors are seeing the connection between ESG performance, value creation, and risk reduction. It makes sense that companies with strong ESG performance tend to be more efficient and less wasteful. They enjoy greater employee commitment and higher productivity. And they are more respected and better able to build brand equity. All of that reduces operational and reputational risks.
But of course, ESG investing covers a lot of ground, including governance and transparency.
Investing in such a broad theme can be challenging for investors, even professionals. Fortunately for individual investors, a search on Magnifi suggests that there are a number of ETFs and mutual funds that can help you access this rapidly growing style of investing.
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The information and data are as of the December 22, 2021 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.
Downside Protection
What Is Downside Protection?
No one wants to lose money on their investments, right?
After all, the whole purpose of investing is to build wealth in order to reach your financial goals – an early retirement, a college fund for your children, etc.
Achieving those goals is made a lot tougher with a substantial loss. For example, you would need a return of 100% in order to recoup a loss of 50%.
That’s why both individual and professional investors use various strategies to protect against losses.
All of these strategies can be called by the broad term ‘downside protection’ and may include the use of stop-loss orders, options contracts, or the buying of other assets that will hedge the risk of the underlying asset already owned.
Diversifying your portfolio is another, very broad-based way to provide downside protection on your total portfolio. As is lowering the percentage in your portfolio of volatile assets.
Why Is Downside Protection Important?
The pandemic-induced stock market selloff in March 2020 was just the latest example of why downside protection is important.
As with any insurance policy, a downside protection strategy is one of those things investors’ may not need… until they do. The whole point is to have the strategy in place before the unexpected happens, before the potentially catastrophic event occurs.
In other words, goal-oriented investors should place more emphasis on playing defense and minimizing drawdowns to their portfolio.
Let’s go back to the Great Recession. The S&P 500 fell 57.7% from its high in October 2007 before bottoming out in March 2009. The decline was the largest drop in the S&P index since World War II.
That type of decline would take a gain of about 125% just to get back to breakeven. That would be difficult if you are in or near retirement.
Examples of Downside Protection Strategies
Here are some examples of downside protection strategies:
Hedging is the most straightforward type of downside protection. Imagine you own 100 shares of XYZ company stock, which is trading for $33 per share. You can hedge your investment by purchasing one put option for 100 shares of the stock. Put options are contracts giving you the right to sell the stock at a guaranteed “strike price” for a limited period of time. Let’s say you bought a put option to protect your XYZ stock with a strike price of $30 per share. If the market price drops below $30, you can still sell your shares for $30 until the day the put option contract expires. If the price goes up, you let the option expire and all you lose is the premium you paid to buy the put option.
Another strategy for investing with downside protection is to write a covered call option. This means you write, or sell, a call option contract with a strike price that’s higher than the current market price. The purchaser of the call contract has the right to buy the shares from you at the strike price. If the price declines or does not go up to the strike price before the option expires, you keep the premium the purchaser paid. The premium provides some downside protection by offsetting part of any drop in the stock price. One negative feature of covered calls as downside protection is that you give up the possibility of making more money if the stock price goes above the strike price – you will lose the stock to the buyer of the call.
If you do not wish to use options, here are some other possibilities to consider:
- Traditional diversification – Treasury bonds and notes, real estate investment trusts (REITs) funds, precious metals.
- Riskier Hedges – managed futures, alternative assets
How Can You Manage Risk?
Each individual is different, with widely varying risk tolerance and views on what is risk. So it is a challenge to select the “right” approach to downside protection.
This challenge has been significantly more difficult in bullish market environments, as there is a temptation for investors to ignore downside risk in favor of capturing the seemingly endless upside for stocks. However, prudent investors are always prepared for the inevitable bear market.
There are several ETFs and mutual funds that aim to provide downside protection strategies. A simple search on Magnifi indicates numerous ways for investors to access these funds with low fees.
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Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Open a Magnifi investment account today.
The information and data are as of the December 22, 2021 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.
Quality Investments
What Is a Quality Investing?
Quality investing is an investment strategy based on a set of fundamental characteristics, such as a strong balance sheet, that is used to find the highest quality companies.
Warren Buffett’s mentor – Benjamin Graham – is considered to be the father of value investing. But he was also interested in quality investing.
Graham placed great emphasis on finding quality value stocks. His studies found that the biggest danger when buying value stocks was settling for low quality companies that were unable to compete.
Graham argued that finding quality stocks was the key to successful value investing. In other words, investors in general – but especially traditional value investors – leave money on the table when they ignore the quality dimension of value investing.
The characteristics of a quality company include: strong balance sheet (low debt levels), credible management, earnings stability, payment of dividends and operating efficiency. These companies have high profitability. High rates of return – particularly return on equity, cash flow generation and the profit margins of the business (which measure the ability of the company to generate profits from its assets) are found in quality companies.
There are also other two traits: the company has what Buffett described as an “economic moat,” giving it a competitive advantage over its rivals and a long enterprise life cycle, which means a company is investing in new technologies and products.
Why Is Quality Investing Important?
Quality investing is important simply from the fact that backtesting has shown that “boring” dividend-paying, stable companies have outperformed more risky investments for long periods of time.
Overall, quality stocks have outperformed both value and growth stocks since MSCI began tracking it in global markets in 2001.
An analysis done by the UK’s SN Financial Services comparing the MSCI World Quality index versus the MSCI World Value index was quite illuminating.
It found that from December 31, 1998 to December 1, 2020 quality outperformed value over the long term, +515.77% to +254.87%. Most of the outperformance came mainly from 2008 onwards (post-Financial Crisis).
This makes sense since a quality company is one that generates a lot of cash and reinvests it wisely so that it can defend and grow its competitive advantage.
What’s the Difference Between Quality Investing and Value Investing?
Many retail investors still confuse quality investing with value investing. But they shouldn’t.
Buying high quality assets without paying premium prices is just as much ‘value investing’ as is buying average quality assets at discount prices.
Quality companies have a high return on equity, low debt, and very stable earnings. And they are often among the most familiar names to investors.
These companies generate a return premium in excess of the market over time with lower risk. This return is accentuated when risk aversion is high or rising. Historically, many of these periods have often been associated with value strategies underperforming.
In addition, quality companies are able to sustain elevated profitability levels relative to the wider market for protracted periods. In contrast, investors actually tend to overpay for “growth”, getting sucked into glamour trades.
This leads directly to the outperformance of the “slow and steady” companies where strong fundamentals are not fully priced.
Quality investing also leads to a portfolio with lower volatility than the market.
Meanwhile, value stocks are simply perceived as being undervalued and investors buy a value stock for what they think to be less than its true worth.
However, value stocks are often cheap for very good reasons, such as poor management and a lack of innovation in a low-growth industry.
That’s why – as shown earlier – quality investing outperforms value investing over longer periods of time.
How to Participate in Quality Investing?
It is rather easy for you to be able to participate in quality investing.
Of course, you could buy individual stocks – the familiar names we all know. Many of them are members of the Dividend Aristocrats, which are S&P 500 companies that have paid and increased their dividend payments for at least 25 consecutive years.
However, an easier and more diversified approach is to invest in ETFs and mutual funds that focus on quality investing strategies. A simple search on Magnifi indicates numerous ways for investors to access these funds with low fees.
Unlock a World of Investing
with a Magnifi Account
Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Open a Magnifi investment account today.
The information and data are as of the December 22, 2021 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.