This paper shows that the relationship between corporate governance indices and stock returns has reappeared after a few years of its disappearance.

We find that poor governance stocks have outperformed good governance stocks in recent years, indicating a directionally opposite relation to the one that existed in the past.

To explain this puzzling reversal, we present a hypothesis that is characterized by the investors understanding governance risk, which other market participants – and markets at large (as proxied by common risk factors) – do not yet seem to understand and appreciate.

Using a natural experiment that is set around an exogenous shock to governance information flow, we show that investors did potentially benefit through learning by better adjusting their returns expectations. Subsequent tests confirm that learning via price and risk channels may have helped investors recognize the uncertainty surrounding poorly governed firms’ future earning power, hence, making them demand risk premia to mitigate increased information asymmetry.

By: Ariadna Dumitrescu (ESADE Business School) and Mohammed Zakriya (ESADE Business School (Ramon Llull University))

You can read the full SSRN paper here