Focus Report

Gauging Governance Globally: 2015 Update A Governance Update — With some observers attributing recent volatility in EM

equities in part to governance issues, we update the analysis in our 2014 report.

Weakening Governance Generally — The percentile ranking of two-thirds of the countries in a governance composite declined in 2015 versus 2014.

Governance Even More of an Issue in Some EMs — Many Emerging Markets saw a notable deterioration in various governance metrics, including national governance (corruption in China and Russia) and corporate governance (India). Paradoxically, as some EMs seek to boost economic growth, it may be the case this only weakens governance — more corruption, an undermining of corporate ethics, etc.

Worrisome Trends — Given that the quality of country-level governance affects corporate governance and, thus, firm value, some valuations could be at risk of downward readjustment should governance weaken further.

Strategy Implications — Governance trends are one of the reasons why we are Underweight Latin America, India, Russia, China in our regional strategy model.

©Curraheeshutter/Crystal Graphics

Michael Geraghty Global Markets Strategist 212-874-7400

Figure 1: The Cornerstone Capital Governance Composite: Ranking 2015 vs. 2014

Source: Cornerstone Capital Group

Global Markets Strategy September 2, 2015

2

Please see important disclosures at the back of this report.

The Impact of National and Corporate Governance on Country Valuation

At its most fundamental, the valuation of a country’s financial assets is a function

of its long-term potential economic growth, which, in turn, is dependent on a

number of variables, including Environmental, Social & Governance (ESG)

factors. So, for example, in an analysis of sovereign credit risk, the United

Nations Principles for Responsible Investment (PRI) noted1 that:

Environmental factors showed the weakest correlations with sovereign bond

performance in studies carried out by AXA Investment…Its research showed

correlations between returns and governance and social ratings, but showed

a weaker link to environmental issues.

In our September 15, 2014 report Gauging Governance Globally: Macro and

Micro Metrics we referenced another PRI report2 that focused specifically on ESG

factors and equity valuation, and we highlighted the assertion that:

The importance of considering both national and corporate governance has

increased in recent times. It has become more apparent as investors have

sought to profit from growth in developing and emerging markets where lack

of transparency and underdeveloped legal structures exist [italics added].

In terms of the significance of national governance for corporate valuations, a

recent academic study3 stated that:

The quality of country-level governance affects corporate governance and, thus,

firm value [italics added].

Governance at the National Level

Two main proxies for country-level governance were used in the aforementioned

academic study:

1) Contracting institutions, which refer to the rules and regulations

governing contracting between two parties of similar power, such as

those between creditor and debtor.

2) Property rights institutions, which refer to the rules and regulations

protecting market participants against the power of the government.

Measures of property rights include (i) constraints on the executive (i.e.,

whether there are regulatory limitations on its actions and authority);

(ii) protection against the risk of expropriation of private foreign

investment and; (iii) private property protection.

1 “Sovereign Bonds: Spotlight on ESG Risks” 2013 2 “How Investors Are Addressing Environmental, Social and Governance Factors in Fundamental Equity Valuation,” February 2013 3 “Mutual Funds and Information Diffusion: The Role of Country-Level Governance,” Review of Financial Studies 2014, Lin, Massa and Zhang, July 2014

The quality of country-level governance affects corporate governance, and thus, firm value

3

Please see important disclosures at the back of this report.

A significant conclusion of the analysis was that:

For countries with poor governance, advances in institutions in either

property rights [that constrain governments and expropriation by the elite]

or [private] contracting quality are a necessary condition to further improve

their financial markets…Firms invest less in corporate governance in countries with poor institutions [italics added].

Similarly, another academic study4 concluded that:

Firm characteristics explain almost none of the variation in [corporate]

governance ratings in less-developed countries… [with] corporate

governance [dealing] with the mechanisms that ensure investors in

corporations get a return on their investments.

In our 2014 report, we utilized The World Bank’s Worldwide Governance

Indicators as a measure of national governance. These indicators, which

measure the traditions and institutions by which authority in a country is

exercised, report annually on six broad dimensions of governance for 215

countries:

Voice and Accountability: This indicator captures perceptions of the extent

to which a country's citizens are able to participate in selecting their

government, as well as freedom of expression, freedom of association, and a

free media.

Political Stability and Absence of Violence: This indicator measures

perceptions of the likelihood of political instability and/or politically

motivated violence, including terrorism.

Government Effectiveness: This indicator captures perceptions of the

quality of public services, the quality of the civil service and the degree of its

independence from political pressures, the quality of policy formulation and

implementation, and the credibility of the government.

Regulatory Quality: This indicator captures perceptions of the ability of the

government to formulate and implement sound policies and regulations that

permit and promote private sector development.

Rule of Law: This indicator captures perceptions of the extent to which

agents have confidence in and abide by the rules of society, and in particular

the quality of contract enforcement, property rights, the police, and the

courts, as well as the likelihood of crime and violence.

Control of Corruption: This indicator captures perceptions of the extent to

which public power is exercised for private gain, including both corruption,

as well as “capture” of the state by elites and private interests.

4 “Why do countries matter so much for corporate governance?” Journal of Financial Economics, Doidge, Karolyi and Stulz, 2007

In less developed countries, firm characteristics explain almost none of the variation in corporate governance ratings

4

Please see important disclosures at the back of this report.

Figure 2 illustrates that the updated R-squared of The World Bank’s Worldwide

Governance Indicators and country P/E multiples is unchanged at 0.07. (Note

that we again utilize the methodology of our 2014 report, whereby we only plot

data for the 33 countries with the largest weightings in the MSCI All Country

World Index, and with their percentile ranking being relative to all the other countries in the relevant sample.)

Somewhat worryingly, however, there was no material change in the year-on-year

percentile ranking of any of the 33 countries in the updated analysis. In other

words, there was little evidence of any improvements in national governance

that might have positive implications for corporate governance, particularly in

less-developed countries.

Figure 2: Country P/E vs. Average “World Bank Governance Index” Percentile 2007-2013

Source: World Bank and Cornerstone Capital Group

Corruption Perceptions: Worsening in Some EMs

As noted, one of The World Bank’s Worldwide Governance Indicators is “control

of corruption,” which measures corruption among public officials, a potential

cost of doing business. A separate measure of this issue — covering almost 200

countries — is the Corruption Perceptions Index of Transparency International,

an organization that defines corruption as the misuse of public power for private

benefit. Figure 3 illustrates that, for the countries in our sample, the updated

R-squared of the Corruption Perceptions Index and country P/E multiples is

unchanged at 0.10.

With regard to governance at the national level, there was no material change in the year-on-year percentile ranking of any of the 33 countries

5

Please see important disclosures at the back of this report.

Figure 3: Country P/E vs. Average “Corruption Perceptions Index” Percentile 2007-2014

Source: Transparency International and Cornerstone Capital Group

However, it was notable that, in the course of a year, two countries showed a

significant deterioration in terms of perceptions of public sector corruption:

Russia’s percentile rank declined from an already low 24% to just 20%, while

China’s rank plummeted from 55% to 42%.

These findings are corroborated by other studies. For example, a recent Pew

Research Center analysis5 revealed that, in both Russia and China, significantly

more respondents said that corruption was “a very big problem” for their

country as compared to “crime,” “health care,” “poor schools” or “pollution,” and

concerns about corruption increased markedly in recent years — Figure 4.

Figure 4: Percentage Saying “Corrupt Leaders” Are a “Very Big Problem” in 2007 and 2014

Source: Pew Research Center

5 “Crime and Corruption Top Problems in Emerging and Developing Countries,” November 6, 2014

In the course of a year, two countries showed a significant deterioration in terms of perceptions of public sector corruption: Russia, China

6

Please see important disclosures at the back of this report.

Ease of Doing Business: Little Changed

In addition to costs of doing business — such as corruption — the ease of doing

business is another factor that can potentially detract from (or add to) a

country’s growth rate. The World Bank “Doing Business 2015” report again

ranked 189 countries in terms of “ease of doing business.” In broad terms, this

report measures regulations that enhance business activity and those that

constrain it. Here, too, there was no material year-on-year change in the

percentile ranking of any of the 33 countries in our sample, or in the updated

R-squared — Figure 5.

Figure 5: Country P/E vs. Average “Ease of Doing Business” Percentile 2007-2015

Source: World Bank and Cornerstone Capital Group

World Economic Forum Corporate Governance Score:

A Micro Metric

At a more micro level, the World Economic Forum (WEF) Corporate Governance

score is the average of six specific scores for 144 countries that are based on a

WEF Executive Opinion Survey. This annual survey captures the opinions of over

14,000 business leaders in the 144 economies on specific issues within their

respective countries. The components of the WEF Corporate Governance score are:

Ethical behavior of firms: In your country, how would you rate the

corporate ethics of companies (ethical behavior in interactions with public

officials, politicians, and other firms)? [1 = extremely poor—among the worst

in the world; 7 = excellent—among the best in the world]

7

Please see important disclosures at the back of this report.

Strength of auditing and reporting standards: In your country, how strong

are financial auditing and reporting standards? [1 = extremely weak; 7 =

extremely strong]

Efficacy of corporate boards: In your country, how would you characterize

corporate governance by investors and boards of directors?

[1 = management has little accountability to investors and boards;

7 = management is highly accountable to investors and boards]

Protection of minority shareholders’ interests: In your country, to what

extent are the interests of minority shareholders protected by the legal

system? [1 = not protected at all; 7 = fully protected]

Reliance on professional management: In your country, who holds senior

management positions? [1 = usually relatives or friends without regard to

merit; 7 = mostly professional managers chosen for merit and qualifications]

Willingness to delegate authority: In your country, how do you assess the

willingness to delegate authority to subordinates? [1 = not willing at all—

senior management takes all important decisions; 7 = very willing—

authority is mostly delegated to business unit heads and other lower-level

managers]

Figure 6 illustrates that, for the countries in our sample, the updated R-squared

of the WEF Corporate Governance score and country P/Es is unchanged at 0.13.

Figure 6: Country P/E vs. Mean WEF Corporate Governance Percentile 2007-2015

Source: World Economic Forum and Cornerstone Capital Group

8

Please see important disclosures at the back of this report.

The Cornerstone Capital Governance Composite

A multiple regression reveals that the combination of (i) The World Bank’s

Worldwide Governance Indicators, (ii) Transparency International’s Corruption

Perceptions Index, (iii) The World Bank’s Ease of Doing Business Index and (iv)

The World Economic Forum’s Corporate Governance score again generates an R-

squared of 0.16. Note here that, in our March 5, 2015 report Environmental

Issues & Country Valuations: What Matters, we identified environmental factors

that generated an R-squared of 0.20 with country equity valuations. Combined, it

would seem that these governance and environmental factors might explain over

one-third of country equity valuations.

Figure 7 illustrates that, as before, we take a weighted average of the four

governance measures to derive a composite governance score.

Figure 7: The Cornerstone Capital Governance Composite: Change 2015 vs. 2014 Red indicates lower percentile ranking in 2015 than in 2014; green indicates higher percentile ranking

Source: Cornerstone Capital Group

For two-thirds of the countries in our sample, the percentile ranking in the

governance composite declined in 2015 versus 2014, although most of the

changes were relatively small. However, two countries at the bottom of the

governance composite experienced a material shift in rank, one upward, the other

downward:

Russia: As noted above, in terms of perceptions of public sector corruption,

Russia’s percentile rank declined from an already low 24% to just 20%.

However, in our governance composite, that was more than offset by a sharp

increase in the country’s WEF Corporate Governance percentile ranking. All

six components of the WEF Corporate Governance score for Russia

experienced an improvement, most notably “efficacy of corporate boards”

and “ethical behavior of firms.”

Governance and environmental factors might explain over one-third of country equity valuations

9

Please see important disclosures at the back of this report.

India: In contrast to Russia, India experienced a sharp decrease in its WEF

Corporate Governance percentile ranking. All six components of the WEF

Corporate Governance score for India deteriorated, most notably “strength of

auditing and reporting standards” and “reliance on professional

management.”

Governance Even More of an Issue in Some EMs

As outlined above, during the past year many emerging markets saw a

deterioration in various governance metrics, including national governance

(corruption in China and Russia) and corporate governance (India). In that

regard, it was recently pointed out6 in the Financial Times that:

The assumption that the major political features of emerging markets would

converge towards the US/UK model is no longer valid, as most have moved

toward less liberal forms of governance in the wake of the [2008/09

financial] crisis. The move away from liberal models of sovereign and

corporate governance has been the key driver of both the deterioration in

economic growth prospects and the poor returns from emerging equity

markets. The dominance of state-directed models of sovereign and corporate

governance in China, Russia, Brazil and elsewhere, has undermined the

return on invested capital across a large part of the corporate sector, thereby

reducing productivity and potential GDP growth across their respective

economies.

Then, too, it may also be the case that, as some Emerging Market economies seek

to boost economic development, this may actually weaken governance reflecting,

for example, more corruption at all levels of the economy, and a waning in

corporate ethics, particularly at some family-owned businesses that have

experienced rapid growth.

These trends are clearly worrisome. As was pointed out above, “the quality of

country-level governance affects corporate governance and, thus, firm value.”

Consequently, some emerging market valuations could be at risk of downward

readjustment should governance weaken further.

6 “Redefining EM: Governance Regimes Are the Key Distinction,” August 12, 2015

10

Please see important disclosures at the back of this report.

Michael Geraghty is the Global Markets Strategist for Cornerstone Capital Group. He has over three decades of experience in the financial services industry including working as an investment strategist at UBS and Citi.

michael.geraghty@cornerstonecapinc.com

11

Please see important disclosures at the back of this report.

12

Please see important disclosures at the back of this report.

Cornerstone Capital Inc. doing business as Cornerstone Capital Group (“Cornerstone”) is a Delaware corporation with headquarters in New York, NY. The Cornerstone Flagship Report (“Report”) is a service mark of Cornerstone Capital Inc. All other marks referenced are the property of their respective owners. The Report is licensed for use by named individual Authorized Users, and may not be reproduced, distributed, forwarded, posted, published, transmitted, uploaded or otherwise made available to others for commercial purposes, including to individuals within an Institutional Subscriber without written authorization from Cornerstone. The views expressed herein are the views of the individual authors and may not reflect the views of Cornerstone or any institution with which an author is affiliated. Such authors do not have any actual, implied or apparent authority to act on behalf of any issuer mentioned in this publication. This publication does not take into account the investment objectives, financial situation, restrictions, particular needs or financial, legal or tax situation of any particular person and should not be viewed as addressing the recipients’ particular investment needs. Recipients should consider the information contained in this publication as only a single factor in making an investment decision and should not rely solely on investment recommendations contained herein, if any, as a substitution for the exercise of independent judgment of the merits and risks of investments. This is not an offer or solicitation for the purchase or sale of any security, investment, or other product and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities. Investing in securities and other financial products entails certain risks, including the possible loss of the entire principal amount invested. You should obtain advice from your tax, financial, legal, and other advisors and only make investment decisions on the basis of your own objectives, experience, and resources. Information contained herein is current as of the date appearing herein and has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed and should not be relied upon as such. Cornerstone has no duty to update the information contained herein, and the opinions, estimates, projections, assessments and other views expressed in this publication (collectively “Statements”) may change without notice due to many factors including but not limited to fluctuating market conditions and economic factors. The Statements contained herein are based on a number of assumptions. Cornerstone makes no representations as to the reasonableness of such assumptions or the likelihood that such assumptions will coincide with actual events and this information should not be relied upon for that purpose. Changes in such assumptions could produce materially different results. Past performance is not a guarantee or indication of future results, and no representation or warranty, express or implied, is made regarding future performance of any security mentioned in this publication. Cornerstone accepts no liability for any loss (whether direct, indirect or consequential) occasioned to any person acting or refraining from action as a result of any material contained in or derived from this publication, except to the extent (but only to the extent) that such liability may not be waived, modified or limited under applicable law. This publication may provide addresses of, or contain hyperlinks to, Internet websites. Cornerstone has not reviewed the linked Internet website of any third party and takes no responsibility for the contents thereof. Each such address or hyperlink is provided for your convenience and information, and the content of linked third party websites is not in any way incorporated herein. Recipients who choose to access such third-party websites or follow such hyperlinks do so at their own risk.