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Do Investors Really Value Corporate Governance?

Evidence from the Hong Kong Market

Prof. Stephen Y. L. CheungCity University of Hong Kong

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1. Background

• Corporate governance (CG) reform in Asian market

• Various efforts from both regional (PECC, 2001) and international (OECD, 2004)

• In Hong Kong (Code of Best Practice, 1999, Hong Kong Code on Corporate Governance, 2004)

• Family-controlled firms and Anglo-Saxon legal system in Hong Kong market

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2. Research Question

• Do CG practices pay in Hong Kong market?

• What are the determining factors for good CG practices in Hong Kong?

• Do investors reward improving corporate governance practices or penalize firms with deteriorating corporate governance practices in the same manner?

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3. Literature

• Testing results of whether CG leads to better performance are mixed (e.g. Weiss and Nikitin, (1998), Klein (1998))

• Limited studies on the association between overall corporate governance practice and firm value (e.g. Gillan et al.(2003))

• Board responsibilities and composition are the focus of CG studies (e.g. Fama and Jensen(1983), Black et al.(2003))

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4.1 Methodologies - Data• More than 160 largest companies are covered

in each sample year• Constituent stocks of four main indices in HK

market– Hang Seng Index (HSI)– Hang Seng Hong Kong Composite Index (HSHKCI)– Hang Seng China-Affiliated Corporations Index

(HSCCI), Red-chip– Hang Seng China Enterprises Index (HSCEI), H-share

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4.1 Methodologies – Data (Cont’)

• H-share: incorporated in Mainland China• Red-chip: incorporated in Hong Kong but

controlled by organizations in Mainland China

• Based on publicly available information (e.g. annual reports, AGM minutes, articles of association), year 2002, 2004, and 2005.

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4.2 Methodologies – Survey Design

• Based on Revised OECD Principles (OECD, 2004) and Code of Best Practices (HKEx, 1999)

• Including five categories and 86 criteria • Overall CG index ranges from 0~100• Transparency index and non-transparency

index are constructed

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Scorecard Followed The Five OECD Corporate Governance Principles

OECD principleNumber of questions & sub-questions

A. Rights of shareholders

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B. Equitable treatment of shareholders

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C. Role of stakeholders

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D. Disclosure and transparency

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E. Board responsibilities

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Total 86

• OECD is internationally recognized

• HKEx guidelines comprehensively covered

• 168 public companies surveyed

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4.2 Methodologies – Survey Design (cont’)

• Companies were ranked as good, fair and poor for each criterion

• Each company was rated by two different members

• The overall results were cross-checked by academics

• Avoids selection bias• Measure the CG Index quantitatively, give credit to

the “amount” of information for each of the criteria under study

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5.1 Results – Descriptive Statistics

• The average of CG overall Index is 61.702.

• Perform well in Section B and D, poor in Section E and C relatively

• Highest scores for HSI stocks, lowest for H-share stocks

• Finance and utilities sectors are on the top, property sector is on the bottom

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Corporate Governance Performance by Indices in year 2002

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35

40

45

50

55

60

65

70

75

80

Scor

es

AllHSI

HSHKCI HSCCI

HSCEI

Range

Mean

Weak

Strong

• HSI (Hang Seng Index ) • HSHKCI (Hang Seng Hong Kong Composite Index ) • HSCCI (Hang Seng China-Affiliated Corporations Index )• HSCEI (Hang Seng China Enterprises Index )

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Corporate Governance Performance by Industries in year 2002

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35

40

45

50

55

60

65

70

75

80

Scor

es

Range

Mean

IndustrialAll Properties Finance Utilities ConsolidatedEnterprises

Hotel &Misc

Weak

Strong

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Positive Correlation between Good Corporate Governance and One-year Buy

and Hold Return0

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40 50 60 70 80 90CGI

bhr12 Fitted values

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5.3 Results – Regression Results in year 2002

• Market-to-book ratio (MTBV) was used as proxy for company’s market value

• Positive and significant relationship between MTBV and CG Index was found

• Number of executive directors has negative impact

• The top 5 shareholders’ holding has negative impact

• The inclusion in the MSCI has positive impact

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5.4 Results – Robustness Test

• Why we use 86 questions?

• Performance measurement (ROE or MTBV)

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Performance Measurement

• Use Return on Equity (ROE) to measure operating performance

• Replace MTBV by ROE in OLS regressions

• Similar results were found • Confirm the robustness of the OLS results

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Fixed Effects Regression Results for CGI and Stock Returns

Model 1 Model 2 Model 3

Constant -1.4636 -1.2487 -0.9747CGI 0.0445*** 0.0445*** 0.0445***LN(TA) -0.0144 -0.0119 -0.0109D/E -0.0017 -0.0019 -0.0017ROA 1.0914 1.2714 1.4494

BEXC -0.0042 -0.0031

DUMMY_BOARD -0.6507 -0.6863

DUMMY_AUDIT -0.0872

DUMMY_COMP 0.0303

DUMMY_DUAL -0.3199

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Fixed Effects Regression Results for Changes in CGI and Stock Returns

Model 1 Model 2 Model 3 Model 4Constant 1.1063*** 2.0429*** 2.2263*** 2.6291*** CGI 1.6904*** 1.3506*** 1.4278*** 1.4345***LN(TA) -0.0672 -0.0619 -0.0604D/E 0.0014 0.0015 0.0019ROA 1.2130 1.4355 1.6056BEXC -0.0045 -0.0017DUMMY_BOARD -0.7003 -0.7530DUMMY_AUDIT -0.2366DUMMY_COMP 0.0590DUMMY_DUAL -0.3387

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The Asymmetric Response of CGI Changes to Stock Returns

Model 1 Model 2 Model 3 Model 4Constant 1.2599*** 2.0060*** 1.5650*** 1.9877*** CGI×Positive 0.7564* 0.9483** 0.9728** 0.9219* CGI×Negative -5.9015*** -3.3976** -3.2270* -3.6369**LN(TA) -0.0586 0.05071 -0.0476D/E 0.0011 -0.0011 -0.0009ROA 0.9335 0.8717 0.9462BEXC 0.0219 0.0306DUMMY_BOARD 0.0321 0.0383DUMMY_AUDIT -0.3665DUMMY_COMP 0.0635DUMMY_DUAL -0.3254

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Positive Correlation between Corporate Governance and Company Value

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810

40 50 60 70 80 90CGI

mtbv1 Fitted values

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6. Conclusion

• We find that a positive relation between CGI scores and one-year buy-and-hold returns.

• An asymmetric response to changes in the quality of corporate governance practices.

• Specifically, the magnitudes of the decline in stock returns when firms show deteriorating CGI scores are much larger than the magnitudes of return increases when firms show improving CGI scores

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6. Conclusion

• Comparison among different markets • Policy Implication - encourage adoption of best pr

actice of corporate governance in Hong Kong

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7. Further Research

• Survey conducted in 2006 and in China• Impact of voluntary and non-voluntary

disclosure on corporate valuation• Investment implications.

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Thank you