Programme: M.Sc.

in Finance (MFCM)
Module: Strategic Finance (EF5159)
Module Lecture: Prof Ruchira Sharma
Assessment 2

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Pragya Jaiswal 20210403

Gompers, Ishii and Metrick(2003) showed that firms with weak shareholder rights exhibit

significant stock market underperformance. What's not clear is whether weak shareholder

rights cause stock market underperformance. The paper by Core, Guay, Rusticus (2006)

addresses this by testing for causality. Explain the logic of the methodology they use. Give

YOUR view on whether the methodology makes sense and whether you think the

methodology will do what it claims

(Paul Gompers, Ishii & Metrick, 2003) have published a technical paper under the title of

“Corporate Governance and Equity Prices” and based on their finding they suggest that the

firm those are having strong shareholder rights(democratic) are outperformed compared to

firm those are having weak shareholder rights (Dictatorship). They also find that the value

and profit of strong shareholder firms are higher than weak shareholder right firm and having

fewer acquisition/takeover rate. Later John E. Core, Wayne R. Guay and Tjomme O. Rusticus

published their paper in which they proved that weak governance is not a cause of poor stock

returns. They proved their finding through their methodology used, in which they were able

to find the evidence that weak shareholder right firms have lower operating performance,

which GIM were failed to prove. According to them weak governance have lower operating

performance but investor and analyst are able to forecast this difference which means that this

was not a surprising factor for investors. They used ROA as their measure for operating

performance rather than ROE which was used by GIM. I also agree with the John et al. that

ROA is good measure for measuring operating performance compare to ROE because for

calculation of ROA debt has taken into consideration while in ROE calculation only equity

has taken.
(Core et al., 2006) used other methods such as, “Analyst Forecasts ” and “Earning

Announcement Returns” to examine whether analyst/investors are able to understand, the

effect of shareholder right on firms’ earnings or not. They find that analyst are aware of the

relationship between strong/weak shareholder rights on operating performance and this is not

a primarily cause of overperformance/underperformance of strong/weak shareholder firms.

Later they exhibit that strong governance firms are acquire/takeover by same rate as of weak

governance firms and difference in takeover probability are not the cause of abnormal return

earned by strong /weak governance firms. They also did the further tests and displayed the

evidence that abnormal return is not related to merger or acquisition announcement and poor

capital expenditure made by weak shareholder firms. They not only used all this methodology

but also they further looked into research done by other researcher in this field. They obtained

the supporting evidence for finding of (CREMERS & NAIR, 2005) and suggested that

abnormal returns may be due to risk or other factors those are corelated to governance.

John et al. further studied abnormal return earned by GIM sample time period (1990-1999)

and additionally four year following the GIM sample period (2000 to 2003). They found

strong shareholder firms outperformed during GIM time period (1990-1999), but after that

(2000 to 2003) weak shareholder rights firm outperformed over strong shareholder rights

firms. They also came across that weak governance firm continue to have lower operating

performance in period (2000-2003) and analyst are able to forecast this difference. However

they found in later sample period (2000-2003) that weak shareholder firms earned abnormal

returns.

Thus in nut shell it can be said that Corporate Governance is an umbrella terms and

shareholder right is an integral part of it. Week (strong) governance could lead to unexpected

return but not the cause of always poor (good) stock return. Shareholder rights are connected
to abnormal returns but other factors are also responsible and important to learn which cause

these abnormal returns.

Bibliography

 Core, J. E., Guay, W. R., & Rusticus, T. O. (2006). Does weak governance cause weak

stock returns? An examination of firm operating performance and investors’

expectations. Journal of Finance, 61(2), 655–687. https://doi.org/10.1111/j.1540-

6261.2006.00851.x

 CREMERS, K. J. M., & NAIR, V. B. (2005). Governance Mechanisms and Equity Prices. The

Journal of Finance, 60(6), 2859–2894. https://doi.org/10.1111/j.1540-

6261.2005.00819.x

 Paul Gompers, Ishii, J., & Metrick, A. (2003). Corporate Governance and Equity Prices.

Economics, Journal, 118(1), 107–155.