Corporate Governance and Expected Stock Returns : Evidence from Germany

Recent empirical work shows that a better legal environment leads to lowerexpected rates of return in an international cross-section of countries. Thispaper investigates whether differences in firm-specific corporate governancealso help to explain expected returns in a cross-section of firms within asingle jurisdiction. Constructing a corporate governance rating (CGR) forGerman firms, we document a positive relationship between the CGR andfirm value. In addition, there is strong evidence that expected returns arenegatively correlated with the CGR, if dividend yields and price-earningsratios are used as proxies for the cost of capital. Most results are robustfor endogeneity, with causation running from corporate governance prac-tices to firm fundamentals. Finally, an investment strategy that boughthigh-CGR firms and shorted low-CGR firms would have earned abnormalreturns of around 12 percent on an annual basis during the sample period.We rationalize the empirical evidence with lower agency costs and/or theremoval of certain governance malfunctions for the high-CGR firms.