Study Correlates Shareowner Rights with Strong Stock Price Performance

Through the 1990s, stock in firms that preserved shareowner rights outperformed companies that bolstered management’s power, according to an academic paper.

“Corporate 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 performance.”

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 stock shares.

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.

The 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.

“One 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 conclusively.

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.