Core et al. (2006) in their paper focused on the findings of Gompers et al.

(2003) which states

that weak shareholder rights cause poor stock return performance .The authors followed GIM

as their measure of corporate governance measure .They used G-index as the index of

shareholder rights and used return on assets (ROA) as an indicator of operating performance .

They used the same sample period as in the GIM study (1990-1999) and used the OLS

method. They provided the evidence that firms with weak shareholder rights have low

operating performance and then after using analysts earnings forecasts and returns around

earnings announcements as proxies for investor expectations they came to a result that

analysts and investors are not surprised by the difference in operating performance and stated

that analysts are aware of the negative effects of weak investor rights on the operating

performance.

Hypothesis 1- Shareholder rights are not associated with future operating performance.

The measure of operating performance they used was ROA because it is not affected by

leverage and other extraordinary items . The authors stated that ROA has more desirable

distributional properties compared to return on equity which was used by GIM because total

assets are positive but equity may be positive or negative.They found that weak shareholder

rights are associated with low operating performance but they did not have a causal

relationship.

Hypothesis 2- Shareholder rights are not associated with analyst forecast errors.

In order to show that operating cash flow differences caused by differences in governance

cause the future stock return variations , the authors tried to investigate whether the variation

in operating performance was expected or unexpected by the investors. They investigated this

through analyst forecast errors because they expect that investors expectations about future

earnings are as sophisticated as the expectations of analysts and analysts' forecasts have been
more accurate than time series models. They found that analysts are aware of the relation

between shareholder right and operating performance .

Hypothesis 3- Shareholders rights are not associated with excess returns around

earnings announcements.

To see if market is affected by the unexpected operating performance they examined the

returns around the earnings announcements.The authors stated that this method is more

beneficial as it does not rely on analysts expectations of earnings rather it uses market

expectations directly because this is already incorporated in the stock price before the

announcement.The earnings announcements test confirms that surprises about operating

performance fails to explain variations in the stock returns between the companies of

different level of shareholder rights.

Hypothesis 4- Shareholder rights are not associated with takeover probability.

They tested this by comparing the completed takeovers of democracies and dictatorships.

They divided it into two panels. Panel A showing the frequency of takeovers during four

intervals in the same period .In Panel B they converted these frequencies into annualised

probabilities. In both the cases dictatorships and democracies had the takeovers but the

takeover probabilities of dictatorships were less than democracies. Thus they concluded that

variation in takeover probability is not considered to be a major cause of future stock return

variations between companies with different levels of shareholder rights.

Conclusion

The authors finally concluded that time-period specific returns and differences in expected

returns play a vital role in explaining the abnormal stock returns of strong governance firms.
BIBLIOGRAPHY

Core, J.E., Guay, W.R., Rusticus, T.O., 2006. Does Weak Governance Cause Weak Stock
Returns? An Examination of Firm Operating Performance and Investors’
Expectations. J. Finance 61, 655–687.

Gompers, P.A., Ishii, J.L., Metrick, A., 2003. Corporate Governance and Equity Prices
(SSRN Scholarly Paper No. ID 278920). Social Science Research Network,
Rochester, NY.