Learning and the Disappearing Association between Governance and Returns

Lucian Bebchuk, Alma Cohen, and Charles C.Y. Wang are all affiliated with Harvard Law School’s Program on Corporate Governance.

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:

In an influential study, Gompers, Ishii and Metrick (2003) (hereinafter GIM) identified a governance-based trading strategy that would have produced abnormal profits during the period 1990-1999. This strategy was based on a G-Index that GIM constructed on the basis of 24 governance provisions that weaken shareholder rights. These intriguing findings have attracted a great deal of attention ever since they were first reported. The G-Index, as well as the E- Index that is based on the subset of these 24 provisions (Bebchuk, Cohen, and Ferrell (2009)) that matter the most, have been extensively used.

Our study documents that the G-Index and E-Index were no longer associated with abnormal returns during the period of 2000-2008 (or any sub-periods within it), and then proceeds to investigate what explains both the existence of the governance-returns correlation during the 1990s and its subsequent disappearance. We identify several systematic differences between the 1990s and subsequent years and relate them to the disappearance of the governance-returns correlation. We provide evidence that is consistent with the hypothesis that both the existence and disappearance of the correlation were due to market participants’ learning to appreciate the difference between well-governed and poorly-governed firms.

GIM suggested that governance provisions – or the characteristics of firms’ governance and culture that they reflect – are associated with lower industry-adjusted Q, lower profits, lower sales growth, and more corporate acquisitions. Subsequent work found additional links between the G and E indices and firm performance. For example, Masulis, Wang and Xie (2007) find that worse G-Index and E-Index scores are correlated with worse acquisition decisions (as measured by the stock market returns accompanying acquisition announcements), and Dittmar and Mahrt-Smith (2007) find that worse scores are correlated with a less valuable use of cash holdings.

That the G-Index and E-Index are associated with lower firm value and worse firm performance, however, does not imply that these indices should be associated with abnormal stock returns, as GIM found for the period 1990-1999. To the extent that market prices already reflect fully the differences between well-governed and poorly-governed firms, trading on the basis of the governance indices should not be expected to yield abnormal profits.

We conduct a series of tests for one possible explanation of the abnormal returns during the 1990s. According to this “learning” explanation, investors in 1990 did not fully appreciate the differences between firms with good and bad governance scores. The legal developments that shaped the significance of the G-Index provisions took place largely during the 1980s, which was also when many of these provisions were adopted. In 1990, investors might not yet have had sufficient experience to be able to forecast the expected difference in performance between well-governed and poorly-governed firms. Under the “learning” hypothesis, the association between governance indices and returns during the 1990s was expected to continue only up to the point at which a sufficient number of market participants would learn to appreciate fully the differences between well-governed and poorly-governed firms.

We begin by showing that, consistent with learning, the association between the governance indices did not persist. Using the exact methods employed by GIM for 1990-1999, we find that this association did not exist during the subsequent period of 2000-2008. Core, Guay, and Rusticus (2006) noted that the GIM strategy did not produce abnormal returns during the four-year period 2000-2003, but were naturally cautious about drawing inferences from the relatively short period they examined, and did not focus on the change or seek to explain it. Our robust findings for a period of similar length to the one studied by GIM enable concluding that the documented governance-returns association did not persist after the 1990s.

Note that, to the extent that the disappearance of abnormal returns was due to learning, such learning did not necessarily have to involve learning about the significance of the provisions in the governance indices. While some market participants might have learned to appreciate that certain governance provisions are associated with worse expected performance, other market participants might have directly identified the differences in future performance between the firms that score well and poorly on the governance indices. For our purposes, the learning hypothesis involves market participants, in the aggregate, coming to appreciate the difference between firms that score well and poorly on the governance indices regardless of whether all or some of these participants made use of all the components of the indices themselves.

To investigate further the learning hypothesis, we study how the existence of abnormal returns to governance strategies was associated with changes in the attention paid to governance by market participants. We identify proxies for the attention to governance by the media, institutional investors, and academic researchers, as well as construct an aggregate attention index. We find that the decrease in the returns to the governance strategies was associated with an increase in levels of attention to governance. Furthermore, analyzing potential structural breaking points in the pattern of returns, we find that their location corresponds to the period in which attention to governance rose sharply.

The number of media articles about governance, and the number of resolutions about corporate governance submitted by institutional investors (many of which focused on key provisions of the governance indices), jumped sharply in the beginning of the 2000s to historically high levels and remained there. Academic research, proxied by the fraction of NBER discussion papers related to corporate governance, also rose sharply around this point in time, with the GIM paper being issued as an NBER discussion paper in 2001. Given our findings about the relationship between attention to governance and returns to the governance strategies, we proceed to test the hypothesis that, by the end of 2001, markets had sufficiently absorbed the governance differences reflected in the G-Index and the E-Index.

In particular, we examine whether, by the end of 2001, market participants learned to appreciate the differences between well-governed firms and poorly-governed firms in terms of their expected future profitability. In particular, we examine the extent to which markets were differentially surprised by earning announcements as proxied by (i) the abnormal reactions accompanying earning announcements, and (ii) analyst forecast errors. Consistent with the learning hypothesis, we find a marked difference between the 1990-2001 and 2002-2008 periods. During the 1990-2001 period, but not during the 2002-2008 period, the earning announcements of good-governance firms were more likely than the earning announcements of poor-governance firms both (i) to be accompanied with more positive abnormal stock returns, and (ii) to produce a meaningful positive surprise relative to the median analyst forecast. Our analysis here extends the work of Core et al. (2006) and Giroud and Mueller (2011), who examined (with mixed results) whether the GIM findings were due to markets’ forecasting errors about the difference between good-governance and poor-governance firms, but which did not consider whether such forecasting errors changed over time during the 1990-2008 period.

Under the learning hypothesis, while the governance indices can be expected at some point to cease to be correlated with abnormal trading profits, as their relevance for firm value and performance becomes incorporated into market prices, the correlation of these indices with firm value and performance can be expected to persist. We find that, indeed, the relationship that the governance indices have with Tobin’s Q and various measures of operating performance remained strong during the 2000s (and, if anything, becomes more significant in the 2002-2008 period). Thus, while governance indices may no longer be able to provide a basis for a profitable trading strategy, they should remain valuable tools for researchers, investors, and policy-makers interested in governance and its relationship with firm performance.

We also explore an alternative explanation that has been suggested in the literature to the correlation between governance and returns identified for the 1990s by GIM. Under this explanation, governance is correlated with some common risk factor that is not captured by the standard four-factor model used by GIM to calculate abnormal returns (Core et al. (2006); Cremers et al. (2009)). Under this explanation, governance can be expected to continue to play a role in explaining the cross-section of returns as long as the common risk factor correlated with governance continues to have such a role. To investigate this possibility, we examine the consequences of augmenting the Fama-French-Carhart four-factor model with additional common factors suggested in the literature – the liquidity factor of Pastor and Stambaugh (2003), the downside risk factor of Ang et al. (2006), and the takeover factor of Cremers et al. (2009). We find that adding these factors cannot fully explain both the existence of the governance-returns correlation and its subsequent disappearance.

Finally, we conduct three types of robustness checks for our results concerning how the periods 1990-2001 and 2002-2008 differ in terms of the association in abnormal returns with the governance indices, as well as in the ability of investors and analysts to forecast the differences in expected future earnings between good-governance and poor-governance firms. In particular, we examine whether our results are robust to excluding new economy firms (Murphy (2003)), to excluding firms in the most competitive industries (Giroud and Mueller (2011)), and to adjusting returns to take into account industry effects (Johnson, Moorman, and Sorescu (2009); Metrick and Lewellen (2010)). We find that our findings concerning the differences between 1990-2001 and 2002-2008 are all robust to these issues.

In addition to the literature on governance indices and governance provisions, our paper contributes to the large body of asset pricing and behavioral finance literature on the persistence and disappearance of abnormal returns associated with trading strategies based on public information. Estimating the future effects of (publicly known) governance provisions (or governance characteristics correlated with them) is far from a straightforward matter, and requires not only knowing the public information about the provisions but also plugging it into an appropriate structural model of the firms and their environment. Our evidence is consistent with such a process being one that takes significant time to develop, refine, and to accurately execute (Brav and Heaton (2002)).

Our study is available here.

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