Investors Weigh corporate governance

Choosing stocks of companies with good corporate governance does not necessarily provide investors with greater profits, according to a study at Mays.

Theodore C. Moorman, an August 2005 finance doctoral graduate now teaching at the University of New Hampshire, said it is true that firms with good corporate governance, and which do not have many anti-takeover provisions to shield managers from the disciplining effects of the takeover market, give a bigger portion of earnings to stockholders than firms with more such provisions.

However, investors do not necessarily gain greater profits from buying stocks of companies with good corporate governance. That’s because the relatively higher earnings of the stocks are offset by their higher prices, he explained.

Moorman said the stock market is fairly efficient in incorporating information. Firms that move towards poor corporate governance can quickly be detected by investors, he added. Fearing that such firms will not provide good returns on their stocks, investors start to sell the firms' stocks immediately. So prices of the stocks fall. On the other hand, prices for stocks that move towards good corporate governance are driven up as more investors start to buy them, he notes.

"For example, a share of stock for a poor corporate governance firm costs $100 and provides $10 in dividends or cash paid to shareholders. A share of stock for a good corporate governance firm can provide $20 in dividends or cash paid to shareholders, but it costs $200. The rates of returns of the two stocks are the same — 10 percent," Moorman says.

To compare firms with different governance, Moorman said he made sure the firms were otherwise similar. The firms had to be in the same industry and have similar market capitalization, similar past stock returns and book-to-market ratios.

Moorman’s conclusion is based on an examination of 1,300 firms. The examination covered manufacturing, retail, pharmaceutical and high technology. Moorman said he looked at what it would be like to own a different set of stocks chosen according to corporate governance about every three years over the 1990s, and then found that they provided similar rates of returns.

"My study implies that investors should choose stocks based on other dimensions such as the firms' market capitalization, the stock's past return and book-to-market ratios, etc.," said Moorman.

The governance data used in the study was from the Investor Responsibility Research Center. A part of the study has been included in a co-authored paper with Mays Business School’s Halliburton Professor of Finance Shane A. Johnson and Mays Associate Finance Professor Sorin Sorescu, and is now under review at The Journal of Finance.

- Staff Reports



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