DIvIDEnD - Stephen M. Ross School of Business - University of ...

A: coRPoRATE GoVERnAncE AnD STocK RETURnS
Corporate governance impacts firm performance in a number of ways. For Erica Li, assistant professor of finance, scrutinizing
corporate behavior opened a path to researching expected stock returns. She found there are plenty of papers that assess a
company’s characteristics and use them to forecast returns. But to Li, it’s a board’s corporate policy and behavior that create
those characteristics in the first place. Her research confirmed some common-sense notions — but also found more to the story.
What are you thinking about? i’m looking at how
corporate governance affects a company’s risk level
and, therefore, returns on the company’s shares.
most research connects a firm’s observable characteristics
with returns. those are things such as
size and book-to-market ratio. But those characteristics
are consequences of corporate policies in
response to economic fundamentals. so what i’m
trying to do is fill in the firm’s policies — how they
invest, what kind of business they are doing, and
how they finance their projects. then i look at how
those actions will generate such characteristics as
historical returns, size, and book-to-market. in my
mind, all those firm characteristics are reflections
of corporate policies.
so i’m looking to answer the following: if we
examine how well the managers of the firm are
monitored by the board and corporate bylaws,
how does that affect how the managers invest, how
they choose to finance their projects? and then
how does that impact the firm’s returns? there are
some corporate governance measurements, and
there’s a hypothesis that managers tend to over-
invest, that they want to manage a larger firm so
they can have more personal perks. spending too
much on an acquisition to get bigger or not scaling
back production during a recession are examples
of over-investment.
what my theory predicts is that during economic
booms, when things are going relatively well, firms
where management is not well-monitored tend to
over-invest in new opportunities, and that reduces
the firm’s risk level and expected returns. so even
though they are spending more than they should,
the risk level goes down because that’s a weighted
average between a company’s existing business and
the new investment. not investing at an optimal
level in the new venture (i.e., overpaying) means
that venture has a lower option value. the lower
the option value, the lower the weighted average
risk level and the lower the expected returns.
the firms with better corporate governance invest
closer to the optimal level and have better expected
returns in a good economy.
what’s interesting is that this is reversed in
recessions. During a recession, a company should
reduce production. But companies that tend to
over-invest don’t scale down as much. scaling
down production is a hedge against the bad
economic shock, and it works like insurance.
it reduces a firm’s risk level, whereas not cutting
back on production increases the risk, which
means investors require a higher return. so in
a recession, firms with poor governance
actually will have higher returns because
their risk average is higher. so this relationship
between governance and returns
is time-variant. it varies with the business cycle.
Why is this interesting to you? corporate governance
is an important and exciting topic, especially
after this financial crisis. i’m really trying to find
out how to keep management disciplined and how
that affects firms’ performances. there’s a lot of
work in this area and a lot of empirical papers, but
not a lot of conclusive results. some people find a
positive relationship, some find a negative relationship.
from a theoretical point of view, i think we
need some guidance to do the empirical work, and
looking through this i realize there is no single,
one-directional relationship.
What implications do you see for industry?
this has practical applications because if you want
to look at the relationship between governance and
returns, you really have to distinguish whether we
are in an economic boom or a recession. if you just
run a regression over a long period of time without
distinguishing the business cycle, what you’re
going to get is nothing. a lot of people are looking
for ways to forecast returns, and this gives some
theoretical guidance.
spring 2010 DIvIDEnD 25