Learning and the Disappearing Association between Governance and Returns – by Professors Bebchuk, Cohen and Wang

[From Lucian Bebchuk of Harvard Law School ] – Below is a link to a column in the New York Times DealBook, titled Investing in Good Governance <http://dealbook.nytimes.com/2012/09/12/investing-in-good-governance/> , that I thought you might find of interest. The column discusses the findings of a study co-authored with Alma Cohen and Charles Wang about the correlation between governance and stock returns.

Earlier research has shown that, during the 1990s, trading strategies based on the Governance Index and the Entrenchment Index would have produced abnormally high returns in the 1990s. Our new study shows that the correlation between governance and stock returns in the 1990s did not subsequently persist. The study also provides evidence that both the correlation in the 1990s and its subsequent disappearance were due to market participants' gradually learning to appreciate the difference between firms scoring well and poorly on the governance indices. Finally, the study establishes that, although the governance indexes could no longer generate abnormal returns in the 2000s, their association with operating performance and firm value persists. After discussing these findings, the DealBook column concludes with a discussion of whether there are any ways left for investors to make money from governance.

The DealBook column is available at:
http://dealbook.nytimes.com/2012/09/12/investing-in-good-governance/

The study that the column discusses – Learning and the
<http://ssrn.com/abstract=1589731> Disappearing Association between
Governance and Returns, forthcoming in the Journal of Financial Economics – is available at:
http://papers.ssrn.com/abstract
=1589731

(Or on BDTI Data Library: http://bdti.mastertree.jp/f/rugq35ac)

Abstract

During the period 1991-1999, stock returns were correlated with the G-Index based on twenty-four governance provisions (Gompers, Ishii, and Metrick (2003)) and the E-Index based on the six provisions that matter most (Bebchuk, Cohen, and Ferrell (2009)). This correlation, however, did not persist during the subsequent period 2000-2008. We provide evidence that both the identified correlation and its subsequent disappearance were due to market participants’ gradually learning to appreciate the difference between firms scoring well and poorly on the governance indices. Consistent with the learning hypothesis, we find that:
(i) The disappearance of the governance-return correlation was associated with an increase in the attention to governance by a wide range of market participants;
(ii) Until the beginning of the 2000s, but not subsequently, stock market reactions to earning announcements reflected the market’s being more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms;
(iii) Stock analysts were also more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms until the beginning of the 2000s but not afterwards;
(iv) While the G-Index and E-Index could no longer generate abnormal returns in the 2000s, their negative association with Tobin’s Q and operating performance persisted; and
(v) The existence and subsequent disappearance of the governance-return correlation cannot be fully explained by additional common risk factors suggested in the literature for augmenting the Fame-French-Carhart four-factor model.

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