Bauer et al. (2003) construct value weighted corporate governance factor portfolios to analyze the impact of corporate governance on equity returns. Their approach is as follows: First, rank firms on the basis of their corporate governance ratings. Second, assign the 20% (25%) of companies with the highest ranking to the “good governance portfolio” and the bottom 20% (25%) to the “bad governance portfolio” for the EMU (U.K.) sample. Third, compute the equal weighted returns to a zero investment strategy, which is holding a long position in the “good governance portfolio” and a short position in the “bad governance portfolio”. They report an annual return of 2.1% for the EMU portfolio and 7.1% for the U.K. portfolio from January 1997 till July 2002. When controls for risk factors with Carhart’s (1997) four factor model, Bauer et al. find a positive, though statistically insignificant abnormal return for U.K. firms.
As in Bauer et al. (2003), we build a zero investment portfolio by buying the 20% highest ranked firms and selling the 20% lowest ranked firms. The portfolios are reset in each January from year 1999 to year 2003, assuming the corporate governance scorecard is available in January for each firm. Since such assumption is not valid for every firm, we reset the portfolios in April and July respectively to do the robust check. As the results are qualitatively similar, we only report the January results. Our sample period is from January 1999 to December 2003.
Even though the governance level is important to equity returns, a more interesting question is whether the change of governance has any association with stock returns. We employ the similar methodology to construct another zero investment strategy. Specifically, all firms are ranked on the basis of the one year change of their corporate governance ratings. We assign the 20% of companies with the greatest improvement in the ratings to the “improvement portfolio”. The 20% of companies with the largest deterioration in the ratings are allocated to the “deterioration portfolio”. These portfolios are reset in January of each year from 1999 to 2003.
For each of the strategies, we compute both the value weighted and the equal weighted cumulative returns. Table 9 presents the annual returns for the “good governance portfolio” and “bad governance portfolio”. And Table 10 demonstrates the annual returns for the “improvement portfolio” and “deterioration portfolio”.
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