NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Corporate Governance and Shareholder Returns

"A portfolio strategy based on purchasing shares in companies with the strongest investor protections and selling short those firms with the greatest management power earned an abnormal return of 8.5 percent a year."

Corporate raiders. Hostile takeovers. Poison pills. Golden parachutes. Deal mania in the 1980s drove many managements at established companies to erect steep barriers to unwanted suitors, especially from financial engineers brilliant at exploiting the power of leverage. A number of state legislatures also heeded pleas from leading companies headquartered in their state for additional protection against a hostile advance. Still, other companies heeded the mantra of shareholder value. These managements installed independent directors and protected the voting rights of minority shareholders.

The diverse corporate governance landscape that evolved during the 1980s remained relatively stable in the 1990s. And that constancy allows economists Paul Gompers, Joy Ishii, and Andrew Metrick to look at the relationship between shareholder rights, stock returns, and corporate performance over time. In Corporate Governance and Equity Prices (NBER Working Paper No. 8449), the researchers find that a company's governance rules make a big difference. "Our results demonstrate that firms with weaker shareholder rights earned significantly lower returns, were valued lower, had poorer operating performance, and engaged in greater capital expenditure and takeover activity," write the authors.

Corporate governance is shorthand for the rules and regulations that have developed to handle the problem of control and power with the separation of management and ownership in most publicly traded corporations. Management can wield enormous power with widely scattered ownership. The primary check and balance on management power is takeovers, an independent board of directors, and voting protection of minority shareholders. For this paper, the authors create a "Governance Index" built out of 24 distinct corporate governance provisions for an average of 1500 firms from September 1990 to December 1999. They find that a portfolio strategy based on purchasing shares in companies with the strongest investor protections and selling short those firms with the greatest management power earned an abnormal return of 8.5 percent a year.

Their "G-index" is also correlated with firm value. In 1990, a one-point increase in the index toward fewer shareholder protections was associated with a 2.4 percentage point lower "Tobin's Q." (A measure of how the market values a company, Tobin's Q is the market value of assets divided by the replacement value of assets.) By 1999, the gap had more than tripled, with a one-point rise in the index linked to an 8.9 percentage point lower "Q."

The authors are careful to say that they aren't making any claims about the direction of causality between corporate governance and corporate performance. Still, their results are striking and certainly suggest that company owners benefit if management doesn't hide behind takeover barriers and a lazy inbred board. "If an 8.9 percentage point difference in firm value were even partially 'caused' by each additional governance provision, then the long-run benefits of eliminating multiple provisions would be enormous," they conclude.

-- Christopher Farrell


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