Print

News

 

Regent News Article

  
The stock market reaction to criticism of corporate governance practices of companies listed on the JSE
Professor Narendra Bhana



Regent Business School

Abstract of paper to be presented at SAFA 2010 conference in Cape Town

This paper investigates a key aspect of possible damage to a company; the publication of criticism of corporate governance practice in the financial press. The sample was derived from reading all articles published in the Business day and Business Report reporting the criticism by Theo Botha the shareholder activist of corporate governance practices of JSE listed companies during the period January 2003 to June 2006. The final sample consisted of 44 companies that met the selection criteria. An event study using the single factor market model was conducted to determine the valuation effect associated with these publications.

Month 0 is the month of the publication of the criticism and the sample companies provided an abnormal return of -5, 74%. During the two year and one year preceding the publication the sample companies earned positive abnormal returns of 39, 61% and 22, 33% respectively. Thus, the results of the pre-publication period suggest that the sample companies were experiencing a large run-up in share prices.

In the first year following the publication, the sample companies provided a abnormal return of -15, 15 %. For the time horizon of two years the sample portfolio underperformed the market by 22, 4%. For the 36-month holding period, abnormal return for the sample companies deteriorated to -25, 69%. Overall, the results show that the valuation effects of Botha’s criticism of corporate governance practice is not restricted to the time immediately surrounding the day of publication in the financial press. The market continues to adjust to the information for a period up to three years after the publication of the articles.

In an effort to understand the source of the abnormal share price performance of the companies in the sample, it was decided to investigate their operating performance around the time of the publication of the articles. The operating profit was defined as return on assets (ROA), computed as the ratio of operating earnings to total assets. The raw and industry-adjusted mean and median ROAs for three years before publication starting at Year -3 and for each year up to YEAR +3 relative to the publication year were computed.

The results of the raw as well as industry-adjusted ROA show that both the mean and median ROAs in the post-publication years to be significantly lower than ROAs in the year prior to publication. In particular, there is a continuous decline in the mean ROAs of the sample companies from 14, 27% in Year -3 to 8, 73% in Year +3. Overall, the decline in operating performance is large (economically meaningful) and statistically significant.

The results provide clear evidence of adverse share price reaction to the publication of criticism of corporate governance practices of companies listed on the JSE. The results support the hypothesis tested and suggests that the stock market does consider the publication of corporate governance criticism to contain information. This implies that either the details of specific corporate governance problems are not known to all market participants, or that this new information is considered sufficiently significant to cause a reappraisal of share prices. Furthermore, any criticism of the quality of management implicit in the financial press publications is also considered sufficiently significant to impact on share prices.

The results indicate that Botha through his criticism was better able to foresee the coming decline in company performance than the market, on average. Does Botha identify some red flags that the market has overlooked? There has been much press coverage highlighting his role as a shareholder activist. It could be suggested that corporate governance and its disclosure is a relatively new concept and that many investors may not be fully aware of its impact on company performance. The professional investment analyst by tradition and training concentrate on analyzing the data contained in the main section of the financial statements. It would seem that they do not give sufficient attention to corporate governance disclosure that is required to be presented in narrative form. This is consistent with evidence that narrative reports are free style and open to confusion and manipulation (Balata and Bretton, 2005). Theo Botha specializes in corporate governance issues and it appears that his skill lies in probing the issues to generate incisive and coherent analysis of possible deficiencies (Rose, 2007).

The share prices of companies criticized by Botha experienced large negative and statistically significant returns for a period of two years following the publication of his criticism in the financial press. This can be described as the “Botha sting” which could be used by astute investors to earn superior returns by following a trading strategy of selling short those companies whose corporate governance policies are criticized by him.