December 07, 2001
Study Correlates Shareowner Rights with Strong Stock Price Performance
by William Baue
Through the 1990s, stock in firms that preserved shareowner rights outperformed companies that
bolstered management's power, according to an academic paper.
Governance and Equity Prices," a paper co-authored by Harvard economists Paul A. Gompers and
Joy L. Ishii and Wharton School professor Andrew Metrick, suggests companies that protect
shareowner rights perform better in the stock market than companies where management controls the
board. The study builds upon a growing body of evidence reporting similar findings.
"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," reads the paper, which Dr. Metrick presented on September 28 at
the Yale School of Management Finance and Accounting Seminar series. However, the authors clarify
that "we make no claims about the direction of causality between governance and
The study proceeds from the observation that the 1980s "takeover wave"
resulted in the 1990s' adoption of corporate provisions that eroded shareowner rights as well as
state legislation protecting against takeovers. Corporations adopted takeover defenses such as
"poison pills," which increase the takeover cost by planting severe redemption penalties in their
Such measures "can either benefit shareholders, if managers use their
increased bargaining power to increase the purchase price, or hurt shareholders, if managers use
the defense to entrench themselves and extract private benefits," reads the paper.
study tracked data on corporate governance provisions collected by the Investor Responsibility Research Center (IRRC) on about 1,500 firms
from September 1990 through December 1999. The authors then constructed a straightforward
"Governance Index," assigning one point for every provision that reduced shareowner rights. The
higher the score, the weaker the shareowner rights and the stronger the management power.
High-scoring firms comprise the "Management Portfolio," while firms that scored lower (and thus
protected shareholder rights) make up the "Shareholder Portfolio." Comparing the performance of
the two portfolios throughout the decade, the study discovered the "Shareholder Portfolio
outperformed the Management Portfolio by a statistically significant 8.5 percent per year."
Moreover, comparing the results to Tobin's Q, or the ratio of the market value of assets
divided by their replacement value, the authors found that every one point added to the Governance
Index resulted in a 2.4 percent decrease in Q value in 1990. By 1999, each single-point
increase in the Governance Index resulted in an 8.9 percent decrease in Q value. So as the
1990s passed, the increase in management's interference in corporate governance correlated to an
ever-greater decrease in the company's value.
Although the authors do not profess to
establish a direct causal relationship between corporate governance and equity prices, they do
strongly suggest such an association, offering three possible scenarios.
explanation, suggested by the results of other studies, is that governance provisions that decrease
shareholder rights directly cause additional agency costs," or the inefficiencies inherent
when shareowner interests differ significantly from the director's interests, a phenomenon that can
lower stock returns.
"An alternative explanation is that managers understand that future
firm performance will be poor," prompting them to institute provisions to insulate them from blame
when performance lags.
"A third explanation is that governance provisions do not
themselves have any power, but rather are a signal or symptom of higher agency costs - a signal not
properly incorporated in market prices."
Peter Gleason, vice president of research for the
National Association of Corporate Directors,
says that the NACD assumes a relationship between strong shareowner rights and strong stock
performance. Much recent research, including a series of McKinsey Quarterly studies (see
"Good Governance" link below), supports this connection, though no study has proven the correlation
NACD's own 2001-2002 Public Company Governance Survey canvassed
5,000 companies. More than 91 percent of directors favor regular board evaluations by the board
itself. The majority of directors - 61 percent - favor fully independent compensation committees,
with 13 percent favoring one or more "insider" on the compensation committee. The NACD recommends
as much independent corporate governance as possible, with boards comprised primarily (if not
exclusively) of members unaffiliated with the company, according to Mr. Gleason.