CG and Stock Return

8/12/2019 CG and Stock Return

1/62

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


2/62

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.


3/62

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


4/62

#

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


5/62

$

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.


6/62

%

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).


7/62

&

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


8/62

'

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


9/62

(

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).


10/62

)

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.


11/62

+

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


12/62

,

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


13/62

#-

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).


14/62

##

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.


15/62

#$

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


16/62

#%

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


17/62

#&

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).


18/62

#'

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.


19/62

#(

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.


20/62

#)

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/


21/62

#+

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


22/62

#,

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


23/62

$-

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


24/62

$#

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.

!"!" = !!!- !!"#


25/62

$$

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.


26/62

$%

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)


27/62

$&

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.


28/62

$'

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


29/62

$(

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:;


30/62

$)

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.


31/62

$+

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




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%





Table 4. Descriptive Statistics for Cross-Sectional Regression Variables of Corporate Governance Firms


32/62

$,

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)


33/62

%-

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


34/62

%#

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.


35/62

%$

Table 7. Pairwise correlation matrix of cross-sectional regression variables, excluding sector dummies.

Significance levels: ** p


36/62

%%

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


37/62

%&

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


38/62

%'

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.


39/62

%(

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.


40/62

%)

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


41/62

%+

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

Documents

CG and Stock Return