Learning and the Disappearing Association between Governance and Returns
The Harvard Law School Forum on Corporate Governance and Financial Regulation 2012-04-17
The Journal of Financial Economics has recently accepted for publication our study, Learning and the Disappearing Association between Governance and Returns. The paper, which was earlier issued as a working paper of the Program on Corporate Governance, is available here.
Our study seeks to explain a pattern that has received a great deal of attention from financial economists and capital market participants: 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)). We show that this correlation did not persist during the subsequent period 2000-2008. Furthermore, 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.
Here is a more detailed account of our analysis: