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Transcript of CG and Stock Return
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Master Programme in Economics
Master Essay I
Corporate Governance and Stock Returns in China
A Long-Horizon Event Study
August 2012
Author: Susannah Gardiner
Course: NEKN03
Supervisor: Hans Bystrm
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Abstract
This study investigates the relationship between the adoption of good corporate
governance practices and the subsequent stock performance of Chinas publicly listed
firms. Using the Shanghai Stock Exchange Corporate Governance Index (SSE CGI) that
was launched in January 2008, a portfolio of CGI firms is benchmarked against a
portfolio of matched conventional firms, their sector indices and market index for the
four-year period following the launch. The results indicate that CGI firms were able to
significantly outperform their respective sector indices as well as the Shanghai
Composite Index, but were unable to significantly outperform their control firms matched
on size and market-to-book ratios. Additionally, wealth relative cross-sectional
regressions compliment these results, showing no significant support for the hypothesis
that the acquisition of CG status is linked to subsequent superior performance. These
results provide evidence that Chinese investors are not yet willing to pay a premium for
CGI stocks.
Keywords: Corporate governance, stock performance, Shanghai Stock Exchange, China.
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Table of Contents
1. Introduction................................................................................................................... 1
2. Corporate Governance An Overview... 3
2.1 Agency Theory..........................................................................................................3
2.2 Literature Review..4
2.3 Corporate Governance Mechanisms and Models..........5
3. Corporate Governance in China......................7
3.1 The Persistence of State Ownership A Governance Dilemma...8
3.2 The Non-tradable Share Reform (2005)..10
3.3 The Corporate Governance Practices of Chinas Listed Firms...11
4. The Governance-Performance Relationship.....................................13
4.1 Empirical Research..13
4.2 Governance, Firm Valuation and Performance in the Context of China....14
4.3 Corporate Governance and Stock Returns .............................................................16
4.4 SSE Corporate Governance Index...17
5. Hypotheses Development.18
6. Long Run Abnormal Returns (LRARs)....................................................................19
6.1 Data.196.2 Method.........20
6.3 Results 23
7. Wealth Relative Cross-Sectional Regressions...27
7.1 Data.27
7.2 Method....29
7.3 Results.33
8. Discussion of Results36
9. Summary and Conclusion...37
10. References...40
11. Appendix A: SSE CGI Appraisal Measures"..........5012. Appendix B: LRARs Matching Procedure ....................51
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1. Introduction
As a consequence of major events such as the 1997 Asian financial crisis, the Enron
scandal and the more recent global financial crisis, greater international focus has been
placed on governance reform in general, and in particular the corporate governancepractices of public firms. In the Asia-Pacific region, the corporate governance issues are
more complex and considered less market-orientated, with many Asian companies being
family owned, directly and indirectly state-owned, or dominated by majority
shareholders. However countries such as China have been showing their commitment to
moving towards an International Model of corporate governance. Furthermore the
question of a governance-performance relationship has also gathered more attention in
recent years. Empirical evidence regarding this relationship is however inconclusive, with
most prior research focusing on developed markets (Gompers, Ishii & Metrick (GIM),
2003; Bebchuk, Cohen, Ferrell (BCF), 2008, Bhagat & Bolton, 2008). However, the body
of emerging market research has started to grow with some cross-sectional evidence
linking good corporate governance to good performance (Black, Jang and Kim, 2006;
Black, Love and Rachinsky, 2006; Connelly Limpaphayom, and Nagarajan, 2008). A
contentious issue that has arisen from the study of the governance-performance
relationship, is the possibility of endogeneity i.e. that governance structures may change
in response to a favorable valuation of the firm, rather than the firm being valued
favorably because of good governance practices. In a Chinese setting Cheung et al.
(2008) develop their own corporate governance index (CGI) to measure the quality of
corporate governance practices of the 100 largest Chinese firms in 2004. They conclude
that there is no statistically significant relationship between the quality of corporate
governance and the market valuation of the firms in the sample. On the other hand, Wang
and Xus (2005) study is one of few that examine the validity of Fama and Frenchs
(1992) risk factors in explaining expected returns. They find that a firms floating ratio (aproxy for expected corporate governance) improves their model by 10 %.
This study will contribute to the governanceperformance research of emerging markets
by focusing on the stock performance of Chinas CGI firms. The Shanghai Stock
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Exchange Corporate Governance Index (SSE CGI) has outperformed the Shanghai
Composite by 7% over the last four years, giving annualized adjusted holding period
returns of 1.71% to its investors. However this is insufficient support for the notion that
CG has contributed to significantly superior relative stock returns. Thus this study will
use the methodology of long run abnormal returns (LRARs) and cross-sectional
regressions to investigate the existence of the governance-stock performance link. This is
done by constructing a Corporate Governanceportfolio using the constituents of the SSE
CGI and comparing it to a portfolio of conventional firms, matched on size and market-
to-book ratios. In addition to this, cross-sectional regression analysis is undertaken to
assess the impact (if at all), of acquiring corporate governance status, on subsequent stock
performance. In this way, this study also contributes to research on expected returns in
emerging markets.
The rest of the paper is organized as follows: section 2 will start with a concise overview
of the theory, literature and models related to corporate governance. This is followed by
an overview of Chinas institutional environment as it relates to corporate governance,
discussing recent reforms and the CG practices of Chinese firms. Section 4 focuses on
the governance-performance relationship and prior related research both international
and within a Chinese context, ending with a summary of the SSE Corporate Governance
Index. After the hypotheses development in Section 5; sections 6 and 7 will describe the
data, methodology and results of the Long Run Abnormal Returns (LRARs) and the
Wealth Relative Cross-sectional Regressions respectively. Finally, this is followed by a
discussion of overall results and conclusions.
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2. Corporate Governance An Overview
The most basic definition of corporate governance refers to the process whereby
shareholders attempt to ensure that the managers of the firms in which they invest,
provide a sufficient return. Measures are put in place to solve the agency problem, whichoccurs when managers (agents) have incentive to act in their own best interests rather
than those of the shareholders (principals). Thus the essence of the agency problem is the
separation of finance and management (or ownership and control).
2.1 Agency Theory
Agency theory developed from the important notion of the separation of ownership and
stewardship, which has its origins as far back as Adam Smiths The Wealth of Nations(1776) in which he wrote about his belief that negligence and profusion were a direct
consequence of this separation. However, it was the seminal work of Berle & Means
(1932) that uncovered the issue of what has become known as the agency problem,
providing evidence that managers of a firm will pursue their own interests over the
interests of shareholders. Agency theory makes use of the following axioms:
organizations are profit seeking, people are self-interested, and information is
asymmetric. Jensen and Mecklings (1976) Nexus of Contracts View of the Firm takes a
broader perspective on corporate governance, acknowledging that governance
mechanisms are influenced not just by principal and agent problems but the interests of
many stakeholders including employees, suppliers and customers, as well as the
surrounding institutional environment. A broader perspective on corporate governance
that accounts for the influence of institutional factors on organizational practices can thus
be found in Institutional Theory(See for example North (1990), DiMaggio and Powell
(1991). A broader institutional perspective becomes important when analysing the
governance situation in a country such as China, where there are many tiers of principals
(ultimately connected to the state), leading to principal-principal problems (Wang, 2011).
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2.2 Literature Review
The topic of corporate governance practices has received considerable attention from
scholars in recent years. The diversity that exists across borders, especially the disparity
between developed and emerging countries, has also piqued interest and debate aroundthe diffusion of cross-border governance practices and whether there is a worldwide
convergence towards the Anglo-American model (Guillen, 2000; Aguilera & Jackson,
2003). More recently, additional conflicts of interest have been identified. La Porta,
Lopez de Silanes, Shleifer and Vishny (LLSV, 1998) posit that: ..the central agency
problem in large corporations around the world is the restriction of the expropriation of
minority shareholders by controlling shareholders. An example of the expropriation
of minority shareholders is the transfer of resources out of firms for the benefit of
controlling shareholders, known as tunnelling (Johnson, La Porta et al., 2000). Events
such as the Asian financial crisis have revealed tunnelling as a serious agency problem in
emerging markets.
Denis and McConnell (2003) define corporate governance as the set of mechanisms that
ensure that self-interested controllers of a company, be they managers or shareholders,
make decisions that will maximize the value of the company for its owners. A more
general conceptual framework is provided by Becht et al. (2004) who define corporate
governance as a set of mechanisms that are used to overcome the collective action
problem, as well as ensure the interests of all parties are concerned with the same
collective action problem. Most literature on the topic deals with two main systems of
corporate governance: the shareholder model and the stakeholder model (otherwise
known as the outsider and insider model respectively). The shareholder model is
synonymous with the Anglo-American model or international model and views the
maximization of shareholder value as the main objective of corporate governance. The
stakeholder model, on the other hand, considers the interests of all stakeholders including
creditors, suppliers, customers, employees, and society (Mitchell, Agel & Wood, 1997).
This model is used in Asian and Continental European countries e.g. Germany and Japan.
While the Anglo-American model is based on an independent board, dispersed
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ownership, transparent disclosure, established legal institutions and an active takeover
market, the latter displays characteristics such as an insider board, concentrated
ownership, lack of transparency and disclosure, a weak legal system, and powerful
families and banks as sources of finance (Bai et al., 2004).Furthermore, some scholars
argue that there is a global trend of convergence towards the Anglo-American model
(Bradley et al.,1999; Hansmann & Kraakman, 2001). Indeed there is increasing
international promotion of the adoption of the Anglo-American model as a way for
emerging economies to gain access to international capital.
2.3 Corporate Governance Mechanisms and Models
The mechanisms of corporate governance fall into one of two groups: internal or external
to the firm. Figure 1 depicts the Simple BalanceSheetModelof corporate governance.
Internally, management makes decisions on behalf of shareholders e.g. what assets to
invest in and how to finance those investments. The board of directors (BOD) must
advise, compensate and monitor management (Jensen, 1993). External governance arises
from the firms need to raise capital. The separation that exists between the capital
providers and those who manage the capital creates this demand for corporate governance
structures. Internal governance covers ownership structure and control, characteristics
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and composition of the board of directors, anti-takeover measures 1 , executive
compensation, transparency and disclosure; while external governance refers to the
takeover market, production market, labour market and the state regulatory system.2
Figure 2 depicts the more comprehensive perspective of the firm: Jensen and Mecklings
(1976) Nexus of Contracts View of the Firm, where governance mechanisms are
influenced by the interests of many stakeholders, not only those of principal and agent.
Building on this framework, four corporate governance paradigms exist in the world
today: 1) the Anglo-American model characterized by outside supervisory and a one tier
board system, 2) the German/Japan model, characterized by inside supervisory and a two
tier board system, 3) the South East Asian model, characterized by family control and 4)
the former Soviet Union model, characterized by internal control 3. Approaches to
corporate governance have been shaped by the historical and institutional settings of the
countries in question. This has inevitably led to unique views on what corporate
governance should be. Many of the Anglo-American corporate governance practices and
structures reflect a preoccupation with the reduction of agency costs (Tam, 1999). It took
1 E.g. poison pills (or shareholder rights plans) are used to avoid hostile takeovers.2 For a thorough explanation of these governance topics and related research see Gillan (2006).
3For a detailed comparison of these paradigms see Davis (2002), Tam (1999).
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the corporate scandals and crises that emerged in these countries during the 1980s for
alternative views such as the German/Japan model to garner attention.
No single discipline, no one paradigm, can make claim to the subject of corporate
governance, whether that be financial economics, jurisprudence, organisation theory or
the restUntil we develop an integrative theory the subject is best served by the
pluralism of paradigms and a proper intellectual scepticism respect for all: but belief in
none Tricker (1994a).
3. Corporate Governance in China
The concept of corporate governance has not been well developed or understood in our
country. This may be partly due to our transitional stage from a planned economy to a
market economy, and partly due to the entanglement of ownership rights with
management responsibilities
* Laura Cha, former Vice Chairman of the CRSCChina Securities Regulatory Commission
Known as gongsi zhili, corporate governance in China is being recognized as a pivotal
issue in the progression of Chinas development and growth. Now one of the largest
emerging economies, the country is still in the process of transition towards a market-
based economic system, and is thus experiencing fundamental institutional change in
many areas, one of them being corporate governance. It is a believed that the adoption of
an appropriate corporate governance model will increase international investment, curb
corporate scandals and improve investor sentiment. Another important reason for this
change is Chinas accession into the World Trade Organization (WTO) in 2001. In doing
so, it agreed to harmonize with international corporate governance practices.
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Current corporate governance practice in China is best described as a control-based
model, as opposed to the market-orientated model used in the UK and theUS (This is a
different distinction to the shareholder vs. stakeholder model discussed earlier). The
control-based model has developed from the administration governance approach,
which is the responsibility of the Chinese regulatory authorities (Pistor & Xu, 2005).
Under administrative governance the economy is heavily regulated, making it difficult to
separate business and politics. As a result, politicians or politically connected
businessmen are able to hijack governance systems and seek rent for themselves
(Clarke, 2003). Therefore the quality of Chinaspublicgovernance is vital in shaping the
overall quality of its corporate governance (Chen et al.,2004).
3.1 The Persistence of State Ownership A Governance Dilemma
Prior to Chinas opening up in 1978, the business landscape was dominated by state
owned enterprises (SOEs), now referred to as traditional SOEs (TSOEs). Corporatization4
of these SOEs started in the mid 1990s. This strategy was meant to address criticisms of
state control and bureaucratic interference. With the modern enterprise system came
the rapid development of the stock market. In 2006 there were a total of 1,500 publicly
listed companies on the Shanghai and Shenzhen Stock Exchanges. The Shanghai Stock
Exchange is now ranked 5th in the world with a market capitalization of US $2.3 trillion
as of December 20115. But due to state policies, the government still owns a large
proportion of shares in these listed companies (Qiang, 2003). It was reported that around
84 % of listed firms were controlled by the state, with 8.5 % owned directly and 72.5 %
owned indirectly via pyramid shareholding schemes (Liu and Sun, 2005). Using CCER-
DATA6Yang et al. (2011) calculated that the government ultimately owned more than 50
% of listed company shares at the end of 2009. The states majority ownership in many
listed firms gives them control over resources and the allocation of retained earnings
(Keister, 2004). Furthermore, in China, ownership is concentrated rather than dispersed
4 Corporatization refers to the transformation of state assets or agencies into state-owned corporations in
order to introduce corporate management techniques to their administration.5www.world-exchanges.org
6Database of the China Center for Economic Research at Peking University
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in 1999 it was reported that the five largest shareholders were holding 58% of shares (Xu
& Wang, 1999). Corporatization may have allowed non-state investors to contribute to
the enterprise, but as minority shareholders they are unable to share control. The state
maintains the same level of control it had before, but now over a larger pool of assets
(Clarke 2003). As Clarke (2003) points out, under this model, there is neither a market
for corporate control nor a market for managerial talent.
Now a dilemma exists - while on the one hand there is growing recognition of the
benefits of a more market orientated model (such as increasing investor confidence,
investor protection, minimizing corporate scandals, and attracting investment), there is
persisting state policy of maintaining full or controlling ownership in key sectors.Thus
policymakers who are meant to design policies based on the Anglo-American model find
themselves having to adjust the rules to allow for continuing state ownership. Instead of
the state-sector enterprises being made more efficient by being forced to follow the rules
of the private sector, potential private sector enterprises are hamstrung by having to
follow rules that make sense only in a heavily state-invested economy (Clarke, 2003).
Table 1 outlines the legal and regulatory milestones that have affected corporate
governance in China, the most recent being the non-tradable share (NTS) reform of 2005.
China has taken a top-down legalistic approach to corporate governance, attempting to
transplant structures from the market based Anglo-American system (Tam, 2000).
1994Company Law- establishes a modern enterprise system and specifies the rights
of shareholders, boards and management
1998 Securities Law- addresses capital market and trading activities
1999 Contract Law- assigns rights and securities to all parties
2002
China Securities Regulatory Commission (CSRC) issues 'code of corporate
governance' for listed companies in China' addressing shareholder rights, board
structure and disclosure requirements
2005CSRC launches a state share reform, aimed at converting nontradable shares
(NTS) into tradable shares (TS)
Table adapted from Wang (2011)
Table 1. Legal and Regulatory Milestones affecting Corporate Governance in China
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According to Jiang (2000), the Company law is actually part of the problem because it is
designed to address the issues within the state sector, particularly the reform of TSOEs.
As mentioned above, this is a major obstacle to a more market orientated governance
model. Critics have also argued that it is about more than getting the rules right - it also
requires an institutional environment that fosters and nurtures non-state enterprises (Roe,
2002). China has underperformed in both the legal infrastructure and law enforcement,
with weak enforcement of investor rights and contractual rights disputes (Pistor & Xu,
2005).
3.2 The Non-tradable Share Reform (2005)
Since the establishment of the stock market in the 1990s, listed firms had a split-share
structure with approximately one-third freely traded public stocks (tradable shares) and
two-thirds non-tradable state owned shares (Huang et al., 2008). Tradable shares consist
of A-shares, B-shares, H-shares and N-shares7, while the two classes of non-tradable
shares are state-owned shares and legal person shares. The holders of NTS have the
same rights as holders of tradable shares (TS) but they cannot sell the stocks. Typically,
NTS are owned by state financial institutions,which are ultimately owned by central or
local governments. As a consequence, the Chinese stock market was illiquid and volatile.
Xu and Wang (1999) point out that the negligible fraction of shares owned by individual
investors allows them to play the role of free riders and short-term speculators. They also
provide evidence that the proportion of shares held by individuals was negatively
associated with firm value. For these reasons, non-tradable shares have long been
considered a major obstacle to Chinas financial market development. In April 2005, the
China Securities Regulatory Commission (CSRC) launched a state share reform, aimed at
converting the NTS into TS. Subsequently, the Chinese stock market improved
dramatically and according to a 2006 report, 90 percent of Chinese firms had complied
with the orders to reform their share structure (Huang et al., 2008).
7For further explanation of these share types see Yang et al. (2011).
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3.3 The Corporate Governance Practices of Chinas Listed Firms
Broadly speaking there are two types of mechanisms used to resolve conflicts among
stakeholders, especially principal- agent conflicts and those between controlling and
minority shareholders. The first type consists of various internal mechanisms e.g. theownership structure, executive compensation, the board of directors and financial
disclosure. The second are external mechanisms e.g. an effective takeover market, legal
infrastructure, and product market competition. The following is a brief summary of the
more important mechanisms employed internationally and where Chinese firms currently
stand in their ability to effectively implement them.
Internal governance
Ownership structure is crucial to a firms value maximization. Concentrated equity
ownership gives the largest shareholders discretionary power to use the firms resources
for personal gain at the expense of other shareholder e.g. tunnelling. Before the start of
non-tradable share reform, about two thirds of shares on issue were non-tradable. Post
reform, to date, more than 99 % of listed firm have compensated tradable shareholders,
and the non-tradable shares are gradually becoming tradable (Yang, 2011).
Supervisory boards are important mechanisms through which shareholders can exert
influence on the behaviour of managers in order to ensure that the company is run in their
best interests (Hemalin & Weisbach, 2003). Unlike North America, China has adopted a
two-tier board structure, which involves the addition of a board of supervisorsto monitor
the board of directors and report back at the general shareholders meeting. However, the
board of supervisors is not given the right to vote on executive decisions, elect directors,
managers or financial officers. Chen et al. (2009) find that the supervisory board does not
contribute significantly to firm efficiency.
Independent directors are mandatory in China. According to the Guidelines for
Introducing Independent Directors to the Board of Directors of Listed Companies issued
in 2001 by the CSRC, all listed firms are required to have at least two independent
directors.
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CEO dualitymeans that the positions of CEO and chairperson of the board cannot be
held by the same person. Research shows that this improves monitoring and control of
the CEO. In China, according to the Company Law, a chairman of the board must be
democratically elected, and the appointment of the CEO must be approved by more than
50 % of board members, but nowhere does it explicitly restrict CEO duality.
CEO compensationrelates to the incentive-related pay of executives, which is used to
align the interests of top managers and shareholders. Before Chinas economic reforms in
1978 the pay differential between general managers and unskilled workers was fairly
small, with the main objective of a general manager being to satisfy the interests of the
state. It was found that firms with substantial government ownership still have lower
CEO compensation than privatized firms (Firth et al. 2007)
Transparency and disclosure: The full disclosure of accurate and timely information
regarding the firms operations and financial status is important for shareholders to be
able to monitor the firm and make investment decisions affecting the firm. According to
Bushman and Smith (2001), local accounting firms audit most listed companies in China
but no reliable information exists to determine which accounting firms are more
reputable. Companies that issue H shares, which are traded on the Hong Kong Stock
Exchange, or B shares which are open mainly to foreign investors in domestic stock
exchanges, are require to maintain international accounting standards.
External governance
Active take-over market: This market allows managers to gain control of sufficient
shares in a short period of time to remove inefficient managers. Hostile takeovers occur
quite frequently in the US and the UK, but much less so in Germany, France and Japan.
In Chinas case, prior to the non-tradable shares reform to it was almost impossible for
firms to gain control of another listed firm through buying tradable shares. Moreover, a
company could not acquire another without state approval. However the share reform of
2005 is expected to bring about a more active takeover market (Yang, 2011).
Legal Infrastructure ensures that investors receive a fair return on their investment. The
Chinese stock market has been heavily criticized for the lack of effective law
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enforcement (Zou et al. 2008). It is argued that the interests of minority shareholders
cannot be adequately protected because of a lack of independent judiciary, and the dual
role of the state as both a regulator and a market participant.
4. The Governance- Performance Relationship
4.1 Empirical Research
In recent years, various studies have investigated the relationship between different
aspects of corporate governance and the performance of the firm. While some have found
more evidence based on accounting performance (Bhagat & Bolton, 2008) and firm
valuation, others have discovered a correlation between corporate governance measures
and long run stock returns (Gompers, Ishii & Metrick (GIM), 2003; Bebchuk, Cohen,
Ferrell (BCF), 2008).
Previous research shows Tobins Q as a popular measure of firm valuation and
performance. Tobins Q is the ratio of market value of a firms assets to the book value of
its assets. It is a measure of good management because a high Tobins Q suggests that
firms managers have produced a greater market value from the same assets. Using a
1980 cross-section of 371 Fortune 500 firms, Morck, Shleifer and Vishny (1987) findevidence of a significant non-monotonic relationship between management ownership
and a firm value i.e. Tobins Q first increases, then declines, and finally rises slightly as
ownership by the board of directors rises. Analysing 452 large U.S. industrial
corporations between 1984 and 1991, Yermack (1996) finds a significant negative
correlation between the proportion of independent directors and contemporaneous
Tobins Q, but no significant correlation for other performance variables such as
sales/assets, operating income/assets, and operating income/sales. Gompers et al. (2003)
construct their own governance index as a proxy for the strength of shareholder rights in
US firms. They find that an investment strategy that buys firms with stronger rights and
sells those with weaker ones, will have earned abnormal returns of 8.5 % per year during
the sample period in the 1990s. They also find that firms with stronger shareholder rights
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had higher firm value, higher profits and higher sales growth. Bebchuk et al. (2008)
investigate 24 provisions followed by the Investor Responsibility Research Center
(IRRC)8. They then develop their own entrenchment index based on 6 of the provisions:
staggered boards, limits to shareholder by-law amendments, poison pills, golden
parachutes and supermajority requirements for charter amendments. They find that
increases in the index level are associated with significant reductions in firm valuation
and negative abnormal returns during the years 1990 -2003. Core, Holthausen & Larcker
(1999) focus on CEO compensation as a component of corporate governance. They
attempt to measure the predicted "excess" compensation of CEOs as a function of board
structure and ownership structure variables. The predicted excess compensation measure
is then used as an independent variable (along with control variables such as standard
deviation of stock returns, market value, market-to-book and year and industry factors) to
explain stock returns over subsequent one, three, and five-year periods. They find the
predicted excess compensation variable to be significant and negative. Thus when CEO
compensation is determined to be excessive, the impact on stock returns is negative.
Bhagat & Bolton (2008) find that stock ownership of board members and CEO-Chair
separation are significantly positively correlated with better present and future operating
performance. They also contradict the claims made by GIM and BCF, that governance
measures are correlated with future stock market performance. They give warning that
inferences made about the link between market performance and governance should take
into account its endogenous nature. They go on to say that stock market based
performance measures are susceptible to investor anticipation. Thus if investors
anticipate the corporate governance effect on performance, long-term stock returns will
not be significantly correlated with governance, even if a significant correlation does
indeed exist.
4.2 Governance, Firm Valuation and Performance in the Context of China
Earlier research on Chinese firms focuses on the relationship between state ownership
and firm performance. Xu and Wang (1999) report that Chinese firms accounting
8Investor Responsibility Research Center (IRRC) (1990, 1993, 1995, 1998, 2000, 2002).
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performance is negatively related to the level of state ownership, while Sun and Tong
(2003) find that share issue privatization (a reduction in state ownership) is associated
with improved earnings ability and worker productivity. Furthermore, Tian (2002) finds
that government ownerships impact on stock market valuation is non-linear i.e. it
worsens a firms performance when government ownership is small, but improves a
firms performance when government ownership gets significantly larger.
Other research has attempted to gauge whether the Chinese market actually values
corporate governance. Cheung et al (2008) develop a corporate governance index (CGI)
to measure the overall quality of corporate governance and disclosure practices of the 100
largest Chinese listed firms in 2004. The results show that some Chinese companies have
been making progress in corporate governance but no statistically significant relationship
exists between the quality of corporate governance practices and market value among the
firms in the sample. From this they conclude that the benefits of good corporate
governance had not been fully incorporated into the market valuation of these companies.
Bai et al. & Zhang (2004) find that issuing shares to foreign investors helps to improve
firms valuation, partly due to the monitoring effect of the relatively more sophisticated
foreign investors, and partly due to more transparent financial disclosure required for
cross-border listings. They also find that when the largest shareholder is the state, the
firms tend to have lower market valuation.Chen, Fan and Wong (2004) report that almost28 percent of the CEOs in their sample are ex- or current government bureaucrats. They
also find that the 3-year post-IPO average stock returns of these politically connected
firms under-perform the market by almost 30 percent.
Despite strong theoretical support for the positive relationship between governance
mechanisms and performance, researchers have been unable to provide consistent
evidence regarding such a relation. Finding a causal link between governance and
corporate performance is made inherently difficulty by the possibility of endogeneity i.e.
that governance structures may change in response to a favorable valuation of the firm,
rather than the firm being valued favorably because of good governance practices.
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Another perspective is that firm performance and corporate governance are
simultaneously determined by unobservable firm-specific factors, and that governance
changes are determined by past, present and/or expected characteristics of the firm
(Hermalin & Weisbach, 2003).
4.3 Corporate governance and stock returns
Previous research has shown that corporate governance structures have the ability to
affect the market valuation and performance of the firm. It is therefore natural to expect
that they would also affect a firms stock returns. There is however, minimal evidence to
support this line of reasoning, especially in developing capital markets. According to the
Capital Asset Pricing model (CAPM) (Sharpe, 1964; Lintner, 1965; and Black, 1972),
differences in the expected returns of individual stocks are solely determined by the
magnitude of the systematic risk measure known as beta(!). But in a seminal paper by
Fama and French (1992a), it was found that the variables size (measured by market
capitalization) and book-to-marketare better at explaining an individual stocks expected
return, rather than the ! measure. Wang and Xus (2005) research is one of few that
actually examines the validity of these factors as well as the governance- stock return
relationship in a cross-section, within Chinas capital market. Studying data from 1996 to
2002, they find that size and not book-to-market helps to explain cross-sectional stock
returns in China. They argue that due to the speculative nature of the Chinese capital
markets and low quality of the accounting information, book-to-market does not reflect
fundamentals in Chinas stock market. Instead they find evidence to suggest that a firms
floating ratio9is a significant predictor of a firms future cash flow, increasing their asset
pricing models fitness level from 81 to 90 percent. The floating ratio is considered a
good proxy for expected corporate governance in China. As mentioned before, Bhagat
and Bolton (2008) argue that investor anticipation can prevent long-term stock returns
from being significantly correlated with governance, even if a significant correlation does
exist. Other reasons for insignificance include the possibility that stock returns are not
, The floating ratio is the ratio of a firms publicly traded shades to total number of shares i.e. the number
of outstanding shares in the hands of public investors as opposed to company officers, directors, or
controlling-interest investors.
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#)
reflecting fundamentals, signaling an inefficient market 10 . Thus even if corporate
governance has a positive affect on accounting performance, it may not be reflected in
the share price, especially in developing stock markets where prices are heavily
influenced by speculative trading. Furthermore fundamentals could take time to show
positive change as a result of governance practices. Despite this, CG status could still
have an effect on medium term stock performance due to the possibility of initial under-
reaction and long-run overreaction of investors in response to certain corporate events.11
4.4 The SSE Corporate Governance Index
On January 1, 2008 Chinas leading stock exchange, the Shanghai Stock Exchange (SSE)
launched the SSE Corporate Governance Index. As part of the on going attention tocorporate governance reform in China, this index creates the opportunity for Chinese
firms to voluntarily apply for CG status. According to the SSE12, the aim of the index is
to encourage listed firms to improve their corporate governance practices, as well as
promote rational investment by investors. This will also allow them to be easily
recognized by the market and thus more likely to be supported e.g. through refinancing.
Among 255 voluntary firms, 199 firms were chosen to be constituents of the index. The
selection process involved self-evaluation, public assessment, and expert review by the
Corporate Governance Sector Award Advisory Committee of Experts. The SSE CGI is
also expected to encourage fund managers to developCG- related products, the aim being
to intensify the correlation between the market and corporate governance, encouraging
shareholders to play active roles and strengthening the supervision function of investors
over corporate governance.
The CGI Appraisal Measuresare based on the principles of the Corporation Law, the
Securities Law, and the Rules for Listed Companies. Some important issues addressed by
the evaluation include management incentive plans, board structure, the role of
10 See for example Fama (1970)Efficient Capital Markets: A review of theory and empirical work.
## Phenomenonreported by recent behavioral finance research, see for example Barberis, Schleifer and
Vishny (1998):A model of investor sentiment.#$ http://www.sse.com.cn/
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controlling shareholders, the voting of minority shareholders, whether the independent
directors have been nominated by controlling or minority shareholders and the disclosure
and auditing procedures undertaken by the firm13. Although the laws, on which these
appraisal measures were based, reflect North American governance principles, they also
take into account the local institutional environment (Wang, 2011). For example, a two-
tier board system is not part of the international model of corporate governance but is
considered an appropriate CG mechanism within China. The central government has also
chosen a strategy of top-down legal reforms as opposed to privatization. In summary, it is
impossible for China to wholly adopt the North American model of governance
standards. Chosen constituents are therefore those firms who are achieving the best
governance practices in the context of China.
5. Hypotheses Development
Despite a slowly transitioning institutional environment, international pressures have led
to the development and launch of the SSE Corporate Governance Index in January 2008.
Although the evaluation criteria are based on much criticized state laws and regulations it
still claims to be a step towards a more market-orientated governance model. This paper
seeks to evaluate the effect of being selected as an SSE CG constituent on a firms stock
performance.If corporate governance is linked to firm performance, and this relationshipis incorporated by the market, then a stocks valuation should reflect changes in corporate
governance (GIM, 2003). In this case, changes in corporate governance are represented
by an event a firms inclusion in the CGI index. After this event investors make an
assumption about the quality of the constituents corporate governance practices. This
can therefore be viewed as a long-run event study and an investigation into whether
Chinese investors are willing to pay a premium for what is considered better corporate
governance. A range of CG returns are measured and benchmarked against control firms
matched by size and book-to-market ratios; their respective sector indices and the
Shanghai Composite Index. Furthermore, wealth relative performance measures (using
the Shanghai Composite as a benchmark) are calculated for a new sample comprised of
13See Appendix A for SSE CG Index Appraisal Measures
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#,
both CG and conventional firms. Using an independent dummy variable of CG status
and appropriate control variables, a cross sectional regression analysis will attempt to
measure the impact (if any) of CG status on subsequent relative performance.
Hypothesis 1: SSE Corporate Governance constituents significantly outperform control
firms matched on size and book-to-market ratios.
Hypothesis 2: SSE Corporate Governance constituents significantly outperform their
respective industry indices.
Hypothesis 3: SSE Corporate Governance constituents significantly outperform the
Shanghai Composite Index.
Hypothesis 4: The acquisition of CG status is significantly positively correlated with
subsequent medium to long run stock performance.
All of the above hypotheses are tested over a period of four years after the CGI launch
date, and are tested at the 5% significance level.To address each of the aforementioned
hypotheses, the data, methodology and results of this study will be divided into two
sections: 1) Long-run Abnormal Returns (LRARs) and 2) Wealth Relative Cross-
sectional Regressions.
6. Long-Run Abnormal Returns
6.1 Data
The long-run returns analysis makes use of an initial sample of 276 firms from the SSE
Corporate Governance Index (CGI). In order to create a sample appropriate for the
chosen methodology, CG firms were excluded if they were not constituents at the time of
the CGI launch (02 January, 2008) or were subsequently removed from the index in the
four years following the launch. Stock prices and accounting data such as market-to-book
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$-
ratios, P/E ratios and market capitalization were gathered from Datastream. Only those
firms with information from 02 January 2004 onwards were retained. This ensured that
the companies in the sample were reasonably well-established public firms and also
allowed for the option of a prelaunch analysis. In addition to this, data from 229 potential
control firms were collected. The matching process left a final sample of 32 CG firms
with an average of 73 control firms per year 14for the purpose of calculating control firm-
adjusted returns. Sector index returns are used to calculate sector-adjusted returns whilst
the Shanghai Composite Index is used as a proxy for market returns. Table 2 shows the
sector representation in the CG sample and the control sample.
6.2 Method
Previous research that has made use of abnormal returns methodology has focused
heavily on the post- event returns of Initial Public Offerings (IPOs) and testing the
Efficient Market Hypothesis (EMH) (Ritter, 1991; Loughran and Ritter, 1995; Brav
and Gompers, 1997). Returns have been measured as the total return on a rebalanced
portfolio, the total return on a buy-and-hold portfolio, and as cumulative returns. To
judge whether a stocks return was abnormal usually required that it be benchmarked
against some asset- pricing model. In the last ten years researchers have veered away
from the traditional asset-pricing model (Sharpe, 1964; Lintner, 1965; and Black, 1972),
#&For matching procedure and full breakdown of the rebalanced control firm portfolio per year see
Appendix B.
Sector Total (N)
Industrial 8 21.62% 17 15.45% 25
Materials 6 16.22% 23 20.91% 29Consumer Discretionary 5 13.51% 20 18.18% 25
Healthcare 5 13.51% 10 9.09% 15
Information Technology 4 10.81% 6 5.45% 10
Transportation 3 8.11% 7 6.36% 10
Energy 1 2.70% 3 2.73% 4
Infrastructure 1 2.70% 3 2.73% 4
Real Estate 1 2.70% 7 6.36% 8
Telecommunications 1 2.70% 2 1.82% 3
Utilities 1 2.70% 5 4.55% 6
Natural Resource 1 2.70% 6 5.45% 7
Total 37 110 146
Control FirmsCorporate Governance Firms
Table 2. Sector Representation: Corporate Governance and Control Portfolios
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$#
with empirical models such as Fama and Frenchs 3 and 4 factor regressions (1992a,
1993) becoming increasingly popular. Other methods include size-, book-to-market, and
momentum-matched portfolios (Kothari &Warner, 2001); and characteristic matched
control firms (Ritter, 1991).
This study will measure average adjusted returns and buy-and-hold returns based on the
methodology outlined in Ritter (1991), making use of size and book-to-market control
firms. The performance period under review is January 2, 2008 to January 2, 2012. At the
beginning of each year, the 37 CG constituents are matched against appropriate control
firms according to size (market capitalization) and market-to-book ratio. These
characteristics are based on the aforementioned risk factor controls for expected stock
returns (Fama and French, 1992a). Control firms matched in sector, as well as size and
market-to-book ratio would have been ideal but this proved to be a difficult task. Thus
two equally weighted portfolios are created: a Corporate Governance portfolio and a
Conventional portfolio. The conventional portfolio is rebalanced at the beginning of
each year under review, providing each CG with four different benchmarks over the four
- year period. If more than one control firm was found for each CG firm at the beginning
of a given year, then an average return was calculated across the set of control firms.
In addition to this, CG constituents are benchmarked against their respective sector
returns and overall market returns (as measured by the Shanghai Composite Index). The
aim is to gauge whether the CG portfolio significantly outperforms the three benchmarks.
If this occurs, it will provide support for the notion that a firms inclusion in the CG index
is associated with increased corporate value and thus support the investigation of
Hypothesis 4. The following long run return methodology is used to assess the stock
performance of the firms and their respective portfolios. Due to the lack of dividends
information for the sample, all returns are calculated on price return only.
1.2.1)Monthly benchmark adjusted returns: the monthly return on a CG stock minus the
monthly benchmark return for the corresponding trade period.
!"!" = !!!- !!"#
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$$
Benchmarks (bm) are (1) well established companies listed on the SSE matched by size
(market capitalisation) and book-to-market ratios (2) sector indices and (3) Shanghai
Composite Index.
1.2.2) Average benchmark adjusted returns across all CG firms, where the average
benchmark adjusted return on a portfolio of n stocks for event month t is the equally
weighted arithmetic average of benchmark -adjusted returns. A standard comparison of
means test-statistic (t-stat) is used to test for abnormal returns.
!"! !!
!
!"!"!
!!!
1.2.3) Cumulative Adjusted Returns from event month q to event month s, calculated as
the summation of average benchmark-adjusted returns.
!"#!!! ! !"!
!
!!!
1.2.4) Holding period returns: measures the return on a buy and hold strategy where a
stock is purchased at first closing market price after index launch.
!"#!" ! !!! !!"!
!!! !! !
Misspecification issues
Barber and Lyon (1997a) report misspecification (specifically skewness) when abnormal
returns use a benchmark reference portfolio. Skewness imparts a severe downward bias
to the t-statistics used to evaluate buy-and-hold abnormal returns, thus making it harder to
detect positive abnormal returns when they are truly present. To address this skewness
bias they provide simulation evidence that a control firm approach can deal with the bias
in the t-statistics. Fama (1998) also recommends a CARapproach to address this bias.
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$%
Furthermore Kothari and Warner (1997) find that tests for long-horizon abnormal returns
tend to be misspecified and warn that conclusions should be interpreted with caution,
suggesting nonparametric and bootstrap tests to reduce misspecification. On the other
hand, according to Blume and Stambaugh (1984) the rebalancing of portfolios (used in
the control firm approach) can cause an upward bias in the measured returns of small
firms, thus if the benchmark portfolio is rebalanced this can impart a downward bias in
measured abnormal returns (since the portfolio of focal stocks is not rebalanced and the
benchmark is subtracted). The recommended solution to the rebalancing bias is to use the
buy-and-hold approach. For these reasons, buy-and-hold returns and the cumulative
adjusted returns are calculated in an attempt to provide two different perspectives,
dealing with the rebalancing bias caused by rebalanced portfolios on one hand, and the
skewness bias inherent in buy-and-hold returns on the other hand. Finally, regarding bad
model problems, Lyon, Barber and Tsai (1999) show that size and book-to market
matched portfolios work well when the sample of focal firms is random, but not when the
focal firms are uniformly large, from the same set of three or less industries, or have large
pre-event price momentum15.
6.3 Results (LRARs)
Table 3 reports adjusted returns (AR), cumulative adjusted returns (CAR), and adjusted
holding period returns ("HPR) for the 48 months after the CGI launch. These are all
averaged results, but will not be labeled as such in the following discussion or results.
Matching firmARs are made up of 17 negative and 31 positive monthly returns, however
only 3 of the 48 monthly returns are significantly positive. The matching- firm CARs are
negative up until month 9, implying that the CG portfolio was underperforming the
conventional portfolio. From month 9 to 48, the CARs become positive, but significant
superior performance is not achieved. Figure 3 illustrates how CG cumulative rawreturns
are negative until month 22. That matching firm adjusted returns are able to remain
positive from month 10 to 22 is due to matched firms performing even more poorly than
the CG firms. As 2008 marked the beginning of a global financial crisis, an average
#'Price momentum is not used in this study, but more information can be found in Carhart (1997)
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negative performance from both CG and conventional firms over this period is
unsurprising. After month 22, CGcumulative raw returns become positive, taking a dip
around month 27, but gaining positive momentum again after month 30. Matching- firm
CARs reach a minimum of -4.94% in month 5 and a maximum of 8.10% in month 47,
reflecting minor discrepancies between CG and conventional raw returns over the 48
month period. CARs of sector-adjusted and market adjusted returns show sustained
significant over-performance of the CG portfolio from month 11 onwards (this coincides
with the beginning of an upward trend in CG raw returns) with 48 month sector and
market CARs of 52.35 % and 72.06 % respectively. Moving attention towards to the
holding period returns, a slightly different story unfolds. This is expected considering the
holding period matching- firm portfolios are not rebalanced. Otherwise known as buy-
and-hold returns, holding period returns show the return that is actually realized by the
investor. Matching firm -adjustedHPRs exhibit a consistent and gradual increase over the
48- month period, with only two negative holding periods, experienced at the end of
month 2 and 5. However, these adjustedHPRs are onlysignificantlypositive in 6 out of
48 holding periods, two of them being in the final 2 months. It is also interesting to note
that CGHPRrawreturns at month 48 are -25.41 %, compared with CARrawreturns of
6.75%. This difference is owed to the way the returns are calculated, with holding period
returns being compounded, rather than just summed over 48 months. When comparing
sector and market matched CARandHPRwe see parallel patterns of sustained significant
superior returns of the CG portfolio, with 48 month adjusted HPRs of 23.84 % and
32.87% respectively. Absolute rawHPRs of the CG portfolio are however still negative.
The matching-firm benchmarked returns and Shanghai Composite are the most important
finding here CARnot showing significant cumulative over-performance, andHPR only
showing significance at the very end of the period. These results do not show preliminary
support for the significance of CG status as an explanatory factor in post CGI launch
relative performance, but this second stage of analysis is performed nonetheless.
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$'
Average benchmark-adjusted returns (!"!!, cumulative average adjusted returns (!"#!!!) and adjusted holding
period returns !!HPR).!"! ! !!
!!!" ! !!"#!!!! !, where !!"is the price return on a CG firmi in event month t,and !!"# is the corresponding price return on a benchmark firm (or averaged return on a set of benchmarks).
!HPR=HPRit! HPRbmt , where !"#!" ! !! ! !!"!
!!! ! ! !. A standard comparison of means test is used to
calculate test-statistics for all adjusted returns. (*) indicates a significant over-performance achieved by the CG
firm, using a significance level of 5%. Benchmark average returns are based on a rebalanced matched portfolio,
while benchmark holding period returns are calculated using the same matched firms over 48 months (76 firms).
Market adjusted returns use the Shanghai Composite Index as a benchmark. Four year annualized returns are
calculated as ((1+HPR)1/4
-1).
CG (N)Matched
(N)Month AR t (%) CAR 1,t (%) !HPRT (%) AR t (%) CAR 1,t (%) !HPRT (%) AR t (%) CAR 1,t (%) !HPRT (%)
37 !" 1 0.47 0.47 0.57 2.06 2.06 2.16 6.46* 6.46* 6.56*
37 !" 2 -1.74 -1.28 -0.64 3.75* 5.81* 5.64* 7.51* 13.97* 13.37*
37 !" 3 1.18 -0.10 1.02 1.69 7.5* 6.34* 0.45 14.42* 11.35*
37 !" 4 -1.67 -1.78 0.71 -1.49 6.01 5.71* -8.04 6.37* 6.18*
37 !" 5 -3.16 -4.94 -1.53 -1.16 4.85 4.52 0.71 7.08* 6.34*
37 !" 6 3.02 -1.92 1.10 -1.26 3.59 2.53 -3.65 3.43 2.42
37 !" 7 0.80 -1.12 2.10 5.16* 8.75* 5.24* 6.70 10.13* 6.03*
37 !" 8 0.22 -0.90 1.36 -1.93 6.82* 2.61 -8.53 1.60 -0.28
37 !" 9 3.77* 2.87 3.09 -3.49 3.33 1.18 -0.99 0.62 -0.58
37 !" 10 0.62 3.49 2.56 -1.39 1.94 0.16 -2.66 -2.04 -1.46
37 !" 11 -0.94 2.55 2.17 6.87* 8.81* 1.57 10.91* 8.87* 1.19
37 !" 12 1.50 4.05 3.12 5.79* 14.6* 3.54* 9.39* 18.26* 4.76*
37 #$ 13 0.00 4.05 2.46 4.23* 18.83* 5.01* 7.03* 25.29* 7.12*
37 #$ 14 2.41 6.47 2.19 4.69* 23.52* 7.38* 6.06* 31.36* 9.96*
37 #$ 15 0.42 6.88 3.75 3.54* 27.07* 10.33* 7.09* 38.44* 14.47*
37 #$ 16 -3.20 3.69 3.85 -0.27 26.80* 10.59* 0.87 39.31* 15.57*
37 #$ 17 3.30 6.99 5.59 3.64* 30.44* 12.71* 1.06 40.37* 16.37*
37 #$ 18 -3.01 3.98 5.98 -3.08 27.36* 11.51* -7.55 32.82* 13.09*
37 #$ 19 2.57 6.55 7.23 -0.58 26.78* 12.93* 0.98 33.80* 15.05*
37 #$ 20 -4.85 1.70 7.55* 0.82 27.61* 11.09* 4.45* 38.25* 15.55*
37 #$ 21 0.74 2.44 9.23* 2.69* 30.30* 13.45* 1.76 40.01* 17.78*
37 #$ 22 -1.67 0.76 10.49* 2.99* 33.29* 16.60* 4.25* 44.26* 22.20*
37 #$ 23 -0.83 -0.06 9.84 1.56 34.85 19.27* 5.39* 49.65 27.72*
37 #$ 24 0.47 0.40 8.54 0.25 35.10* 20.08* 0.05 49.65* 28.63*
37 !% 25 1.02 1.42 12.45 6.44* 41.53* 25.57* 9.74* 59.443* 36.32*37 !% 26 -1.26 0.17 12.13 1.49 43.03* 27.39* 2.48 61.92* 39.19*
37 !% 27 0.26 0.43 13.93 1.54 44.56* 29.32* 0.47 62.39* 40.54*
37 !% 28 0.52 0.95 14.98* -0.74 43.82* 27.81* 2.25 64.64* 41.24*
37 !% 29 -2.14 -1.19 13.97 -1.02 42.81* 25.56* 0.08 64.72* 39.32*
37 !% 30 2.52 1.33 11.64 -0.43 42.38* 22.15* -2.71 62.01* 32.80*
37 !% 31 -2.72 -1.39 10.03 1.48 43.86* 25.05* 3.60* 65.61* 37.77*
37 !% 32 2.67 1.29 13.39 5.74* 49.60* 32.48* 11.05 76.66* 49.39*
37 !% 33 1.27 2.56 14.92 0.29 49.89* 33.99* 3.45* 80.11* 53.49*
37 !% 34 -0.08 2.47 17.72 -1.13 48.75* 37.05* -0.96 79.14* 57.61*
37 !% 35 1.92 4.40 22.21 3.64* 52.39* 41.84* 5.80* 84.94* 65.02*
37 !% 36 1.14 5.53 22.50 -0.71 51.68* 40.95* -1.91 83.04* 61.98*
37 &' 37 2.00 7.53 18.68 -0.11 51.57* 36.67* -3.08 79.96* 54.41*
37 &' 38 -3.78 3.76 18.19 1.85* 53.43* 41.33* 4.76* 84.72* 61.87*
37 &' 39 1.73 5.49 16.06 0.32 53.74* 40.53* -2.19 82.52* 58.64*
37 &' 40 -0.20 5.29 13.90 -1.19 52.55* 37.42* -2.91 79.61* 53.97*
37 &' 41 -4.84 0.44 11.51 -2.39 50.17* 31.43* -3.79 75.82* 46.21*
37 &' 42 2.75* 3.20 14.13 0.67 50.84* 33.99* 2.17* 78.00* 49.87*
37 &' 43 0.81 4.01 17.59 1.33 52.17* 36.56* 3.50* 81.50* 54.35*
37 &' 44 -0.61 3.40 16.28 0.79 52.96* 34.29* 0.48 81.97* 51.09*
37 &' 45 1.57 4.97 13.98 -0.21 52.75* 28.65* -2.99 78.98* 41.85*
37 &' 46 0.52 5.50 17.55 1.96* 54.71* 31.69* 0.52 79.50* 44.73*
37 &' 47 2.60* 8.10 19.01* 2.72* 57.42* 32.06* 2.49 81.99* 44.82*
37 &' 48 -0.95 7.15 15.20* -5.07 52.35* 23.84* -9.93 72.06* 32.87*
Matching firm -Adjusted (Size and M2B) Sector- Adjusted Market- Adjusted
Table 3. Average Adjusted Returns and !Holding Period Returns of a Chinese Corporate Governance Portfolio: 2008-2012
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$(
Figure 3. Cumulative average adjusted returns for an equally weighted portfolio of 37 Corporate
Governance firms from 2008-2012, with yearly rebalancing. Four CAR series are plotted for 48 months
after the launch of the CGI Index. 1) no adjustment (raw returns), 2) matching-firm adjusted, 3) sector-
adjusted, and 4) Shanghai Composite- adjusted.
Figure 4. Holding period adjusted returns for an equally weighted portfolio of 37 Corporate Governance
firms from 2008-2012 with no rebalancing. Four Holding Period Return series are plotted for 48 months
after the launch of the CGI Index. 1) no adjustment (raw returns), 2) matching-firm adjusted, 3) sector-
adjusted, and 4) Shanghai Composite-- adjusted.
!"# !%&'()*+ ,-./0
12")32"4 56786*4&%9:;
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7. Wealth Relative Cross-Sectional Regressions
Hypothesis 4: The acquisition of CG status is significantly positively correlated with
subsequent medium to long run stock performance.
In an attempt to find sound statistical support for the final hypothesis, wealth relatives are
calculated for a larger sample of 166 firms. These are used as dependent variables for
cross-sectional regressions over a four-year period. The aim of this approach is to
investigate whether the acquisition of CG status has indeed had a significant impact on
the stock performance of these publicly listed firms.
7.1 Data
The cross-sectional regressions make use of a sample of 166 firms consisting of both
corporate governance and conventional firms. Table 4 provides a breakdown of CG vs.
conventional firms, as well as sector representation, mean HPRs and wealth relatives.
Prebetas are calculated from the 2007 stock returns for 6 months and 12 months prior to
the launch. Market-to-book, P/E ratios, and market capitalizations on the launch date of
02 January 2008 were gathered from Datastream. Tables 4, 5 and 6 show descriptive
statistics and mean performance categorized by sector. The mean size of the
conventionals are less than half the mean size of the CG firms. Also CG firms and
conventional firms had mean wealth relatives that exceed 1 for all of the holding periods
under review.
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Tables 4 and 5: Descriptive statistics for wealth relative cross-sectional regression variables for CG and
Conventional firms. Market-to-book is calculated as the total market capitalization divided by the
companies book value (the value of assets less liabilities. P/E is the valuation ratio of the market value per
share (share price) divided by the earnings per share (EPS). Size is represented by market capitalization (a
stocks price multiplied by shares outstanding) measured in RMB (thousands). Holding period returns
measure the return on a buy and hold strategy where a stock is purchased at first closing market price after
index launch:!"#!" ! !! ! !!"!
!!! ! ! !! !"#!"! !! ! !"#!"!!!! !! !! ! !"#!"#!!!! ! . A ratiogreater than one represents a superior return to that of the benchmark, while a ratio less than one represents
an underperformance of the CG firm.
Variable Obs Mean Std Dev Min Max
Size (RMB, Thousands) 53 21,992.44 18,149.58 2,122.82 81,685.75
P/E ratio 53 58.10 28.88 23.80 153.30
Market-to-book ratio 53 5.84 2.59 2.56 14.42
Prebeta 6 months 53 0.87 0.07 0.77 1.05
Prebeta 12 months 53 0.97 0.07 0.84 1.161 Yr HPR 53 -61.87% 16.75% -84.63% -3.92%
2 Yr HPR 53 -21.45% 26.37% -66.93% 44.13%
3 Yr HPR 53 -6.81% 62.71% -67.88% 285.22%
4 Yr HPR 53 -37.02% 41.03% -81.88% 130.87%
1 YR Wealth Relative 53 1.10 0.49 0.45 2.78
2 YR Wealth Relative 53 1.26 0.42 0.53 2.32
3 YR Wealth Relative 53 1.75 1.18 0.60 7.23
4 YR Wealth Relative 53 1.28 0.60 0.51 3.78
Table 5. Descriptive Statistics for Cross-Sectional Regression Variables of Conventional Firms
Variable Obs Mean Std Dev Min Max
Size (RMB, Thousands) 103 7,688.76 9,867.69 1,701.54 82,984.69
P/E ratio 100 77.09 50.52 19.20 221.90Market-to-book ratio 103 5.26 2.28 1.79 13.47
Prebeta 6 months 103 0.8459261 0.061215 0.7488602 1.059329
Prebeta 12 months 103 0.95 0.06 0.81 1.11
1 Yr HPR 103 -59.55% 13.47% -82.15% -17.44%
2 Yr HPR 103 -7.24% 36.04% -59.15% 121.23%
3 Yr HPR 103 5.37% 51.00% -68.51% 199.06%
4 Yr HPR 103 -30.61% 35.20% -77.85% 126.17%
1 YR Wealth Relative 103 1.17 0.39 0.52 2.39
2 YR Wealth Relative 103 1.49 0.58 0.66 3.56
3 YR Wealth Relative 103 1.98 0.96 0.59 5.62
4 YR Wealth Relative 103 1.50 0.61 0.66 3.56
Table 4. Descriptive Statistics for Cross-Sectional Regression Variables of Corporate Governance Firms
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Table 6. Mean Performance Categorized by Sector: Holding period returns measure the return on a buy and
hold strategy where a stock is purchased at first closing market price after index launch and wealth relativesare measured as the ratio of holding period returns of all sample firms to market returns (using a proxy of
the Shanghai Composite Index). !"#!" ! !! ! !!"!
!!! ! ! !! !"#!"! !! ! !"#!"!!!! !! !! !!!!!
!"#!"#!. For wealth relatives, a ratio greater than one represents a superior return to that of the
benchmark, while a ratio less than one represents an underperformance of the CG firm.
7.2 Method
Cross-sectional regressions are used to assess the impact of CG status on the performance
of firms in the post-launch period. The dependent variables are wealth relatives for one to
four -year holding periods, using the Shanghai Composite, a proxy for the market, as a
benchmark. In their seminal paper of 1992, Fama and French find that size and book-to-
market equity combined, are able to explain cross-sectional variation in average stock
returns associated with market !, size, leverage, book-to-market and E/P ratios. In the
Chinese context Wang and Xu (2005) find that size, and notbook-to-market are powerful
explanatory variables of cross-sectional returns for the period 1996-2002. They argue that
this makes perfect sense in the Chinese investment environment where fundamentalswere reported with less accuracy and thus were paid less attention by investors.
Modelling cross-sectional regressions allows for the measuring of the persistence of the
influence of Famas (1992) risk variables, and when (if at all) a CGeffectemerges within
the four- year post launch period
Table 6. Mean Performance Categorized by Sector
Industry CG Conventional CG Conventional CG Conventional Total
Consumer Discretionary -26.58 -37.02 1.54 1.61 5 9 14
Industrials-27.63 -32.67
1.63 1.49 9 21 30
Information Technology -44.81 -26.23 1.16 1.68 7 10 17
Energy -50.65 -7.69 1.06 1.59 3 4 7
Materials -52.52 -36.88 1.02 1.45 7 26 33
Healthcare 56.18 12.24 2.05 1.90 4 9 13
Real Estate -58.30 -27.28 1.29 1.36 2 5 7
Transportation -72.61 -52.16 0.77 1.17 4 7 11
Infrastructure -44.76 -38.89 1.32 1.37 1 4 5
Utilities -61.37 -30.13 0.92 1.42 6 5 11
Natural Resources -30.33 -61.48 1.25 1.13 5 3 8
Total -37.58 -30.74 1.27 1.47 53 103 156
Average 4-year Holding Period
Returns (%)
Average 4 -year Wealth
RelativesObservations (N)
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7.2.1 Variables
Based on these previous findings the following variables were chosen for wealth relative
cross-sectional regressions:
Dependent Variables: Wealth relatives (WR) for the one to four year periods post CGI
launch, measured as the ratio of holding period returns of all sample firms to Shanghai
Composite Index holding period returns. It is defined as the ratio of the end-of-period
wealth from holding the CG portfolio to the end-of-period wealth from holding the
benchmark portfolio. A ratio greater than one represents a superior return to that of the
benchmark, while a ratio less than one represents an underperformance of the CG firm.
!"! !!! !"#!"!!!! !! !!! !"#!"#!!!! !
Main Independent Variable: CG Status is measured as a dummy variable (where 1=
CGI constituent and 0= Conventional firm), taken on 02 January 2008.
Control Variables
LnSize: Size is represented by market capitalization (a stocks price multiplied by sharesoutstanding) measured in RMB (thousands). The size effect was first discovered by Banz
(1981). For the purpose of normal distribution the natural log of market equity is used,
but skewness is still present.
Ln(Market-to-Book Equity): Contrary to previous research, this study will make use of
the inverse of book-to-market equity.This does not affect the conclusions that are drawn
from the regressions, only the direction of the relationships found. Market-to-book is
calculated as: the total market capitalization divided by the companies book value (the
value of assets less liabilities. This measure is synonymous with the Tobins Q measure
mentioned in section 4. It is generally used by analysts to judge whether a company is
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under or overvalued by the market. A low market/book ratio is usually considered a good
investment opportunity.
Ln(Price/Earnings ratio): Similar to the market-to-book ratio, the inverse of the E/P ratio
will be used: the P/E ratio. This is the valuation ratio of the market value per share (share
price) divided by the earnings per share (EPS). A high P/E ratio means that investors are
paying more for each unit of net income i.e. the stock is expensive (this is usually
evaluated against a benchmark such as the industry P/E). Fama and French (1992a, 1993)
find that book-to-market equity and size are sufficient to explain the relationship between
E/P and expected returns. However Wang and Xu (2005) find E/P to be an insignificant
predictor of expected returns in the context of the Chinese stock market.
Beta (!): According to the CAPM Model (Sharpe, 1964; Lintner, 1965; and Black, 1972),
expected returns are a positive linear function of their market !s. Although Fama and
French (1992) find that size and book-to-market capture this effect, pre-!s from 2007, 6
and 12 months prior to the CGI launch date will be tested. For the purpose of this study, !
is calculated as: != [COVARIANCE(ra, rp) / VARIANCE(rp)], where ra = the rate of return
of the asset and rp = the rate of return of the market.
Sector dummies: Lastly, sector dummy variables will be used to control for a sector effect
on returns. The 12 sectors tested are Consumer Discretionary, Industrials, Information
Technology, Energy, Materials, Healthcare, Real Estate, Transport, Infrastructure,
Utilities, Telecommunications and Natural Resources.
Thus the cross-sectional regression equation estimated for all four wealth relatives is:
!"!"!=!CG-status+!LnSize1+!LnBook-to-Market1+!P/E +!Industry+!Prebeta1+cDespite the logging of variables for normal distribution, skewness was still found to exist
in the LnSize and LnP/E variables. Table 7 shows a pairwise correlation matrix of all
variables except for sector dummies.
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Table 7. Pairwise correlation matrix of cross-sectional regression variables, excluding sector dummies.
Significance levels: ** p
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%%
when measured against the market. This implies that conventional firms are better at
outperforming the market (this is also evidenced by the mean wealth relatives in tables 4
and 5). The problem of persistent skewness in the size variable pre-empts a general
model misspecification. Figure 5 shows a scatter plot depicting the skewness present in
the size variable.
Figure 5. Scatter Plot of 4 -year wealth relatives against market capitalization. Wealth relatives are
measured as!"! !! ! !"#!"!!!! !! !! ! !"#!"#!!!! !, the ratio of holding period returns of samplefirms to Shanghai Composite Index holding period returns.
7.3 Results: Cross-sectional Regressions
Table 8 reports the cross-sectional regressions on the wealth relatives spanning one to
four year periods. No heteroscedasticity was found to be present in any of the models,
although the fourth and final regression did not pass the omitted variables test. As this is
a cross-sectional analysis, the same initial P/E ratios, market-to-book ratios and size
values are used for each regression.
!"!!
!"$!
%"!!
%"$!
&"!!
&"$!
'"!!
'"$!
("!!
! %!)!!! &!)!!! '!)!!! (!)!!! $!)!!! *!)!!! +!)!!! ,!)!!! -!)!!!
4-YearWealthRelatives
Market Capitalization (RMB Thousands)
Figure 5. Scatter Plot of 4-Year Wealth Relatives Vs. Market Capitalization
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%&
Table 8. Wealth Relative Cross-Sectional Regressions where CGstatus is a dummy variable
(1=CG, 0= Conventaional). Prebetas are calculated as!= [COVARIANCE (ra, rp) / VARIANCE (rp)],
where ra = the rate of return of the asset and rp = the rate of return of the market, calculated
using data from 2007. Market-to-book is calculated as the total market capitalization divided
by the companies book value (the value of assets less liabilities. P/E is the valuation ratio of
the market value per share (share price) divided by the earnings per share (EPS). Size is
represented by market capitalization (a stocks price multiplied by shares outstanding)
measured in RMB (thousands). Wealth relatives are measured as !"! !! ! !"#!"!!!! !!!! ! !"#!"#
!
!!! !, the ratio of holding period returns of all sample firms to Shanghai
Composite Index holding period returns. 11 sector dummies were tested for significance.
1 YR (I) 2 YRS (II) 3 YRS (III) 4 YRS (IV)
CG Status -0.026 0.035 0.117 0.048(0.052) (0.062) (0.084) (0.071)
Ln Size - -0.162*** -0.287*** -0.217***
(0.034) (0.045) (0.038)
Prebeta (12 months) -1.077*** -
(0.383)
Ln Market-to-Book -0.291*** -0.204***
(0.062) (0.064)
Healthcare 0.274*** - 0 .45***
(0 .089) (0.123)
Industrials 0.158** !
(0.063)
Transport - -0.181* -0.305** -0.214*
(0.084) (0.132) (0.111)
constant 1.537*** 2.065*** 3.038*** 2.982***
( 0.360) (0.286) (0.394) (0.342)
R-squared 25.50% 27.59% 35.12% 24.55%
Adjusted R-squared 23.02% 25.67% 33.40% 23.06%
Observations 156 156 156 156
***p
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The most important finding is that CGstatushas no significant effect on the ability of the
sample firms to outperform the market. The negative correlation between CGstatusand
the wealth relatives discovered from the correlation matrix, is adequately captured by the
inclusion of the LnSize variable. Unfortunately the persistent skewness in the LnSize
variable (present only in conventional firm sample) means that the relationship found
between size and wealth relatives can not be interpreted with certainty. Even after log
transformation this skewness bias is still present. Nonetheless the models can still provide
evidence of what factors have contributed to the medium to long-run performance of the
sample firms.
Model I is the only model that includes both the prebeta (12) and market-to-book ratio,
while excluding thesizevariable. Market-to-book is the same as Tobins Q, so a negative
relationship with expected returns (low market-to-book leads to overperformance) is what
is expected, since undervalued firms are associated with higher expected returns. A
higherprebeta(12)is correlated with lower or negative relative returns. In this case, these
two variables rendered the size variable useless as an explanatory variable. Together
prebeta(12) andmarket-to-book accounted for 14% of the explanatory power of model I,
with Healthcare and Industrial sectors accounting for the remaining 11% of relative
over/underperformance. Throughout all holding periods, P/E was found to have an
insignificant contribution to future performance. Unsurprisingly, both of the !s from
2007 were unable to explain WRs in the other three models. Size andmarket-to-book
adequately capture the effect ofprebeta(6) in model II with market-to-book dropping off
after year two. The latter result is intuitive, considering the variation of a firms market-
to-book ratioover time. The sector variable Transportwas found to have a significant
negative relationship (at the 10% level) with relative performance in the three and four
year holding periods, accounting for 10% of the variation in WR(4).
From these results, however, we do not find support for the final hypothesis. If anything
we find a negative relationship that is captured bysize.
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8. Discussion of Results
Two complimentary analyses were performed on a sample of CG and conventional
publicly listed firms from the Shanghai Stock Exchange. The LRAR (Long Run
Abnormal Returns) measured the long run performance of CG firms against threedifferent benchmarks, using two different returns methodologies. Despite the
overwhelming evidence of significant sector and market-benchmarked over-performance
by the CG firms (HPRs of 23.84% and 32.87% respectively), it was the adjusted
matching-firm returns that were most pertinent in this study. They provided evidence that
a CG portfolio was indeed able to outperform a Conventional portfolio using
measurements of cumulative adjusted returns (CARs) andholding period returns (HPRs)
by 7.15% and 15.20% respectively. However they also show this over-performance to be
insignificant from a CARperspective,and only significant by the final two months of the
HPRs. As mentioned previously, HPRs represent the experience of the investor (Barber
Lyon Tsai, 1999), but CARs allow for rebalancing of the matching firm portfolio. The
graphed matching-firm CARs depict a negligible discrepancy between CG and
conventional returns over the four-year period. Judging from the preliminary results
alone, there was already a lack of support for the final hypothesis of CG status being
significantly positively correlated with subsequent medium to long run relative
performance.
The second stage of analysis involved the cross-sectional regressions, using market-
adjusted one to four-year wealth relatives as dependent variables. Well-known Fama
(1992) risk factors are used as control variables along with a dummy variable of
CGstatus. The estimation results from models II to IV, are somewhat consistent with
Wang and Xus (2005) research that showed size, notmarket-to-book to be influential
predictors of expected returns. However model I shows the ability of market-to-book and! to capture the size effect on first year wealth relatives. This leads one to believe that
panel data regressions might have showed similar results for each 12 month period i.e.
using panel data, perhaps a size effect wouldnt have been as prevalent in models II to IV
providng a more consistent findings related to the factors affecting expected returns.
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But the cross-sectional regressions served a different purpose, allowing one to gauge how
long it takes (if at all) for the acquisition of CG status to become a significant explanatory
variable of future relative performance. As suspected, the results lead to the rejection of
the fourth and final hypothesis at the 5% significance level, and if anything, the
relationship between CGstatusand WRs is a negative one.
The conclusions from this regression study are however interpreted with caution,
considering the bad modelling caused by the persistent skewness in the size variable,
even after implementing log transformation. They are however consistent with the
suspicions that arose after the preliminary analysis of LRARs,thus the combined results
of the LRARs and the WR Cross-sectional Regressions provides sufficient statistical
support for the rejection of the final hypothesis.
9. Summary and Conclusion
For the purpose of attracting international investment, improving investor confidence and
curbing corporate scandals, China is showing increasing commitment to achieving an
international standard of corporate governance. Corporate governance has been
implemented through a top down legalistic approach, attempting to transplant structures
from the market based Anglo-American System. This was followed by the code of
corporate governance for listed companies in China, which addressed the shareholder
rights, board structure and disclosure requirements. In 2005, the CSRC launched the state
share reform, which was aimed at converting non-tradable shares into tradable shares and
allowed individuals to hold a larger proportion of shares in listed companies. This has
made a large contribution to the transformation of Chinas capital markets, weakening the
governmental stranglehold on listed firms.
On January 2, 2008 the Corporate Governance Index was launched by the SSE, with theaim of encouraging listed firms to improve their corporate governance practices, and
promote rational investment by investors. Past theoretical and empirical research
provides evidence of an association (if not a causal link) between corporate governance
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practices and performance. There is however limited evidence of abnormal stock returns
as a result of corporate governance improvements (GIM, 2003; BCF, 2008).
This study aimed to investigate 1) whether SSE CG constituents achieved positive
matching-firm, sector and market-adjusted returns in the four years after the CGI launch.
and 2) whether a significant relationship exists between the adoption of better corporate
governance standards and the subsequent relative stock performance of Chinas publicly
listed companies.
The results of this study have shown solid support for rejection of Hypothesis 4: The
acquisition of CG status is significantly correlated with subsequent medium to long run
stock performance.This was in line with the findings of LRARs, which showed that CG
firms were not able to significantly outperform their matched control firms. Thus, four
years after the launch of the CGI, acquiring CGstatus has not had a significant influence
on subsequent abnormal returns. Although the higher corporate value could be given on
the belief of more western, market orientated corporate governance; there is very little
evidence is to support this. It could be the case that their pledge of better corporate
governance will only show a significant effect in the longer term.
These findings not only make a contribution to corporate governance research, but also
Chinese expected returns research. Chinas stock market is showing signs of more
efficiency, with Fama (1992) risk factors (found to influence expected returns in
developed markets), showing signs of predicting expected returns. Although Chinas
stock market has always been considered more speculative in nature (Cheung, 2008),
perhaps things are starting to change. Limitations of this study are that it reviews a single
period of four years, only afterthe launch of the CGI, using a relatively small subsample
of approximately 150 firms (of which only 37 were CG firms), compared to the
population of approximately 900 listed firms on the exchange. These issues combined
make it difficult to extrapolate and apply findings to the entire population and future