There has been a long debate in the finance literature about the positive relation between the level of R&D expenditures and future stock returns (i.e., R&D premium). A number of studies argue that ZM336372 the R&D premium is driven by mispricing (Chan et al., 2001, Eberhart et al., 2004 and Lev et al., 2005). Others, such as Chambers et al. (2002), Bens et al. (2004), and Chu (2007), contend that the R&D premium results from the failure to control for systemic risk, concluding that risk compensation is the explanation. Yet these studies all suggest that the R&D level is positively associated with future stock returns.
In this paper, we use the “governance index” (Henceforth G-index) developed by Gompers et al. (2003) to measure the strength of external corporate governance.1 The G-index is complement system a proxy for the level of shareholder rights. A firm with a low G-index is regarded as being well governed, having strong shareholder rights, and offering managers fewer incentives to waste resources on low-return projects. By contrast, a firm with a high G-index is regarded as poorly governed, displaying a preference for strong management power, and offering managers more incentives to invest in negative NPV projects or pursue personal interests.