Does corporate governance matter for stock returns?

This article summarizes the findings of the paper co-authored with Mohammed Zakriya, ‘Governance, Information Flow, and Stock Returns,’ published in the Journal of Corporate Finance. 

The relationship between corporate governance and stock returns has been a significant subject of debate and study in financial literature. Traditionally, companies with good corporate governance practices tended to perform better in the stock market. This positive association between corporate governance and stock returns is due to the fact that companies with strong governance structures make better business decisions, manage risks more effectively, and generate more sustainable long-term value for shareholders. Investors often prefer to invest in such companies because they perceive them as less risky and more likely to provide stable returns over time. 

Many studies have provided empirical evidence supporting this positive relationship between corporate governance and stock returns. Gompers et al. (2003) found that companies with better governance practices tend to outperform their counterparts with weaker governance structures. Similarly, Bebchuk et al. (2009) documented a positive correlation between governance quality and stock returns, particularly in the period before 2002. 

Investors, including institutional investors such as pension funds and asset managers, have increasingly recognized the importance of corporate governance in investment decision-making. Consequently, many institutional investors have developed strategies to identify and invest in companies with strong governance practices, leveraging this arbitrage opportunity until it disappeared. Bebchuk et al. (2013) show that the correlation between stock returns and corporate governance indices ceased to exist in the 2002-2008 period. 

However, the relationship between corporate governance and stock returns continued to evolve after 2008. In our study, we show that the relationship between governance and returns indeed disappeared after 2000, but reappeared in the opposite direction (negative correlation) in the period following the 2008 financial crisis. During this period, companies with poor governance were undervalued, and a zero-investment strategy that buys stocks of poorly governed companies and short sells those with good practices generates more than 2.5% risk-adjusted returns monthly. In our study, we conclude that the reversal of the relationship between governance and returns may be driven by prices reflecting high information asymmetry and the effect this had on the demand of institutional investors. We find that the aggregate information in the prices of stocks with good and bad governance diverges after the financial crisis: while the aggregate information in the price of stocks with good governance increases, that of stocks with poor corporate governance decreases after the dissociation period (2001-2008). We show that this is because institutional investors can understand the governance risks that other market participants cannot recognize. This demonstrates that information flow played a crucial role in making the correlation between governance and returns reappear in the opposite direction. Additionally, by exploring how institutional investors respond to these changes, we find that information-induced learning changed their governance preferences. After 2008, short-term institutional ownership (long-term) in stocks with poor (good) governance is higher compared to the dissociation years. 

While there was a positive relationship between corporate governance and stock returns before 2000, in the more recent period, the relationship reversed. The relationship between governance and returns can be influenced by various factors, including external events such as financial crises, changes in investor preferences, and information asymmetry. Understanding these dynamics is essential for investors seeking to profit using zero-investment strategies. However, investors who want to reduce the risk of their investments should continue investing in companies with good corporate governance, as good corporate governance acts as an insurance policy against things that can go wrong in the company both by reducing risk and by helping to increase the information included in the company's prices.