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Pricing Corporate Governance

Once upon a time, in the 1990's, investors could out-perform the market by trading solely on firms' anti-takeover provisions. Nowadays, investors have learned to price these provisions - rewarding firms whose managers are exposed to the market for corporate control - but there might be other features of governance on which they could trade profitably.

CAMBRIDGE – Do markets appreciate and correctly price the corporate-governance provisions of companies? In new empirical research, Alma Cohen, Charles C.Y. Wang, and I show how stock markets have learned to price anti-takeover provisions. This learning by markets has important implications for both managements of publicly traded companies and their investors.

In 2001, three financial economists – Paul Gompers, Joy Ishii, and Andrew Metrick – identified a governance-based investment strategy that would have yielded superior stock-market returns during the 1990’s. The strategy was based on the presence of “entrenching” governance provisions, such as a classified board or a poison pill, which insulate managements from the discipline of the market for corporate control.

During the 1990’s, holding shares of firms with no or few entrenching provisions, and shorting shares of firms with many such provisions, would have outperformed the market. These findings have intrigued firms, investors, and corporate-governance experts ever since they were made public, and have led shareholder advisers to develop governance-based investment products.

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