Firms with stronger governance are less risky, generate higher equity returns and perform significantly better during market downturns

In our fifth article of the Winter 30.1 issue our authors discuss how good internal governance helps firms perform better.

Firms with stronger governance are less risky, generate higher equity returns and perform significantly better during market downturns

Although few doubt that good internal governance helps firms perform better, the statistical evidence is actually mixed because the positive effects of good corporate governance matters much more so at some times than others. The statistical link is strongest during “flights to quality,” when market sentiment turns bearish and pessimistic but weakens for long periods of time during bull markets and low market volatility. Using more than ten years’ evidence from Australian firms, the authors show that internal governance is related to both firm value and performance and that firms with stronger governance are less risky, generate higher equity returns and perform significantly better during market downturns. When risk aversion is high, demand for well-governed firms increases and investors discount the value of firms with potential agency conflicts. This time-varying relationship between internal governance and returns may explain both the limited explanatory power of governance on firm value and the mixed empirical evidence reported in previous studies.

Firms with strong internal governance do earn significantly higher stock returns compared with firms with weak governance; but that also means that the value of governance is not fully incorporated into prices, thereby explaining the limited explanatory power of governance on firm value.

Authored by Peter Brooke, Platypus Asset Management, Paul Docherty, Monash University,
Jim Psaros, The University of Newcastle and Michael Seamer, The University of Newcastle

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