Do stock prices reflect the corporate governance quality of Japanese firms?

We construct a governance index based oil several attributes known to be associated with good corporate governance. After checking that the index is positively associated with standard indicators of firm performance, we use it to evaluate the returns oil governance-sorted portfolios. Our main finding is that poorly governed firms significantly outperform better-governed firms. However, this result derives from the greater risk exposure of poorly governed firms. After adjusting for size and book-to-market, excess returns become insignificant across all portfolios. We verify that neither the sample period nor the behavior of specific industries is responsible for this outcome. Consistent with market efficiency, stock prices appear to fairly reflect the higher (lower) risk associated with poor (good) corporate governance. J. Japanese Int. Economies 22 (4) (2008) 647-662. Department of Economics, Nagasaki University, 4-2-1 Katafuchi, Nagasaki, Japan: School of Finance and Economics, University of Technology Sydney, NSW 2007, Australia. (C) 2008 Published by Elsevier Inc.