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Pricing Corporate Governance

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.

Even if anti-takeover provisions hurt firms’ performance, however, investors may be unable to make trading profits if prices come to reflect the effects of these publicly-known provisions. Indeed, in our study, Cohen, Wang, and I show that the association between governance and returns documented for the 1990’s subsequently disappeared. No such association existed during the 2000’s or any sub-period within this decade. After out-performing the market during the 1990’s, the governance-based strategy subsequently performed on par with it.