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Vanita Tripathi
Senior Lecturer Department of commerce Delhi School of Economics
University of Delhi, Delhi-110007
Tel: 91-011-27667891; 9213269951
E-mail: vtripathi@commerce.du.ac.in
Abstract
This paper examines the relationship between four company fundamental variables
(viz. market capitalization, book equity to market equity ratio, price earnings ratio and debt
equity ratio) and equity returns in Indian stock market using monthly price data of a sample
of 455 companies over the period June 1997 to June 2007. We also investigate whether the
inclusion of any one or more of these fundamental variables can better explain cross
sectional variations in equity returns in India than the single factor CAPM and whether
there are any seasonality patterns in equity returns. We find that market capitalization and
price earnings ratio have statistically significant negative relationship with equity returns
while book equity to market equity ratio and debt equity ratio have statistically significant
positive relationship with equity returns in India. The investment strategies based on these
variables produced extra risk adjusted returns over the study period. We further find that
Fama French three factor model ( viz. market risk premium, size premium and value
premium) explains cross sectional variations in equity returns in India in a much better way
than the single factor CAPM. However we did not find any seasonality patterns ( April or
January Effect) in equity returns in India. These results have important implications for
market efficiency, asset pricing and market microstructure issues in Indian stock market.
Keywords: Size Effect, Value effect, P/E effect, Leverage effect, CAPM, Asset pricing,
Seasonality effect.
JEL Classification Codes: G12, G14
I. Introduction
In an emerging stock market like India, investment analysts and market participants are continuously in
search for investment strategies that can outperform the market. Efficient Market Hypothesis (EMH)
rules out the possibility by anybody to consistently earn extra normal return in an efficient stock
market. According to this hypothesis securities are correctly priced and return is solely determined by
the amount of risk one assumes (as per the standard Capital asset Pricing Model – CAPM). However a
plethora of empirical studies doubts such a phenomenon and documents the availability of extra normal
returns by using investment strategies based on firm specific variables such as size (Banz (1981)),
leverage (Bhandari (1988)), price earnings ratio (Basu (1977)), book equity to market equity ratio
(Stattman (1980), Rosenberg, Reid and Lanstein (1985)) etc. These empirical evidences have been
commonly cited as anomalies to CAPM based on company fundamentals and popularly known as the
size effect (small capitalization stocks outperform large capitalization-stocks), leverage effect (high
debt-equity stocks outperform low debt-equity stocks), Price Earnings Effect (low p/E stocks
International Research Journal of Finance and Economics - Issue 29 (2009) 189
outperform high P/E stocks) and value effect (high book equity to market equity stocks outperform low
book to market equity stocks).
Two schools of thought have emerged in search for possible explanation of persistent departure
from the standard CAPM. One argument is that CAPM is mis specified; there is/are some missing risk
factor(s) which beta fails to capture. Hence there is a move towards multifactor asset pricing
framework as specified by Fama and French (1996). The other school blames the investors'
irrationality for the existence of the phenomenon. Whatever be the cause, the presence of these CAPM
anomalies provide gainful investment opportunities to the investing community. The robustness of size
and value effects in US stock market motivated Fama and French (1992, 1993, 1996) to suggest the
inclusion of a size and value factor in asset pricing model. A number of research studies have explored
the economic feasibility of investment strategies based on fundamental variables, but most of these
studies relate to US and other mature markets. Similar evidence for emerging markets including India
is limited and more recent in origin. Moreover no attempts have been made in Indian context to seek
the opinion of practitioners (e.g. equity analysts, mutual fund managers and investors at large) and
simultaneously perform secondary data analysis to substantiate (or disprove) their perceptions about
Indian stock market in general and performance of company fundamentals based investment strategies
in particular. The present study attempts to fill up this gap.
As a result of financial sector reforms initiated since early 1990s the Indian stock market has
witnessed metamorphic changes as regards to the size, structure and turnover. With more than 4700
listed companies, 2 crore shareowners and a market capitalization of Rs.30,257,720 million (in 2005-
06) developments in Indian stock markets are now comparable to those in other mature markets. Hence
there is a felt need for a study which can examine the relationship between various company
fundamentals and equity returns in Indian stock market in this changed regime and test for the
economic feasibility of fundamentals based investment strategies in the advent of technological up
gradation. The results of the study are of pertinent use by investment analysts, mutual fund managers
as well as marginal investors in devising fundamentals based investment strategies to earn extra-
normal returns in Indian stock market.
• Whether there has been any change in the investment strategies of Indian investors over the
past five years.
II. Regarding cross sectional variations in equity returns in Indian stock market.
(i). Company size can better explain cross sectional variations in equity returns in Indian stock
market than market factor.
(ii). P/E ratio can better explain cross sectional variations in equity returns in Indian stock market
than market factor.
(iii). BE/ME ratio can better explain cross sectional variations in equity returns in Indian stock
market than market factor.
(iv). D/E ratio better explain cross sectional variations in equity returns in Indian stock market than
market factor.
(v). A two factor model (excess market return and size premium) can better explain cross sectional
variations in equity returns in Indian stock market than the single factor CAPM.
(vi). A two factor model (based on excess market return and P/E risk premium) can better explain
cross sectional variations in equity returns in Indian stock market than the single factor CAPM.
(vii). A two factor model (based on excess market return and BE/ME risk premium, also known
popularly as value premium) can better explain cross sectional variations in equity returns in
Indian stock market than the single factor CAPM.
(viii). A two factor model (based on excess market return and leverage risk premium) can better
explain cross sectional variations in equity returns in Indian stock market than the single factor
CAPM.
International Research Journal of Finance and Economics - Issue 29 (2009) 191
(ix). A two factor model (based on size premium and P/E risk premium) can better explain cross
sectional variations in equity returns in Indian stock market than the single factor CAPM.
(x). A two factor model (based on size premium and BE/ME or value premium) can better explain
cross sectional variations in equity returns in Indian stock market than the single factor CAPM.
(xi). A two factor model (based on size premium and leverage risk premium) can better explain
cross sectional variations in equity returns in Indian stock market than the single factor CAPM.
(xii). A two factor model (based on P/E risk premium and BE/ME or value premium) can better
explain cross sectional variations in equity returns in Indian stock market than the single factor
CAPM.
(xiii). A two factor model (based on P/E risk premium and leverage risk premium) can better explain
cross sectional variations in equity returns in Indian stock market than the single factor CAPM.
(xiv). A two factor model (based on value premium and leverage risk premium) can better explain
cross sectional variations in equity returns in Indian stock market than the single factor CAPM.
(xv). A three factor model (based on excess market return, size premium and P/E risk premium) can
better explain cross sectional variations in equity returns in India than single factor CAPM
(based on excess market return only) or two factor models cited above (from (vi) to (xv)).
(xvi). A three factor model (based on excess market return, size premium and value premium) can
better explain cross sectional variations in equity returns in India than single factor CAPM
(based on excess market return only) or two factor models cited above (from (vi) to (xv)).
This is the famous Fama-French multifactor asset pricing model.
(xvii). A three factor model (based on excess market return, size premium and value premium
and leverage risk premium) can better explain cross sectional variations in equity
returns in India than single factor CAPM (based on excess market return only) or two
factor models cited above (from (vi) to (xv)).
(xviii). A three factor model (based on excess market return, P/E risk premium and value
premium) can better explain cross sectional variations in equity returns in India than
single factor CAPM (based on excess market return only) or two factor models cited
above (from (vi) to (xv)).
(xix). A three factor model (based on excess market return, P/E risk premium and leverage
risk premium) can better explain cross sectional variations in equity returns in India
than single factor CAPM (based on excess market return only) or two factor models
cited above (from (vi) to (xv)).
(xx). A three factor model (based on excess market return value premium and leverage risk
premium) can better explain cross sectional variations in equity returns in India than
single factor CAPM (based on excess market return only) or two factor models cited
above (from (vi) to (xv)).
(xxi). A three factor model (based on size premium, P/E risk premium and value premium)
can better explain cross sectional variations in equity returns in India than single factor
CAPM (based on excess market return only) or two factor models cited above (from (v)
to (xv)).
(xxii). A three factor model (based on size premium, P/E risk premium and leverage risk
premium) can better explain cross sectional variations in equity returns in India than
single factor CAPM (based on excess market return only) or two factor models cited
above (from (v) to (xv)).
(xxiii). A three factor model (based on size premium, value premium and leverage risk
premium) can better explain cross sectional variations in equity returns in India than
single factor CAPM (based on excess market return only) or two factor models cited
above (from (v) to (xv)).
(xxiv). A three factor model (based on P/E risk premium, value premium and leverage risk
premium) can better explain cross sectional variations in equity returns in India than
192 International Research Journal of Finance and Economics - Issue 29 (2009)
single factor CAPM (based on excess market return only) or two factor models cited
above (from (v) to (xv)).
(xxv). A four factor model (based on excess market return, size premium, P/E risk premium
and value premium) can better explain cross sectional variations in equity returns in
Indian stock market than any of the single factor two or three factors model.
(xxvi). A four factor model (based on excess market return, size premium, value premium and
leverage risk premium) can better explain cross sectional variations in equity returns in
Indian stock market than any of the single factor, two or three factors model.
(xxvii). A four factor model (based on excess market return, size premium, P/E risk premium
and leverage risk premium) can better explain cross sectional variations in equity
returns in Indian stock market than any of the single factor, two or three factors model.
(xxviii). A four factor model (based on excess market return, P/E risk premium, value premium
and leverage risk premium) can better explain cross sectional variations in equity
returns in Indian stock market than any of the single factor, two or three factors model.
(xxix). A four factor model (based on size premium, P/E risk premium, value premium and
leverage risk premium) can better explain cross sectional variations in equity returns in
Indian stock market than any of the single factor two or three factors model.
(xxx). A five factor model (based on excess market return, size premium, P/E risk premium
value premium and leverage risk premium) can better explain cross sectional variations
in equity returns in Indian stock market than any of the single factor, two factor, three
factor or four factor model.
capitalization, P/E ratio, BE/ME ratio and D/E ratio. The data have been primarily collected from
PROWESS (a financial database of Centre for Monitoring Indian Economy) and web sources such as
rbi.org, sebindia.com and nseindia.com.
a =Intercept term
b = Slope coefficient (or beta coefficient) of the market factor.
et = error term
It musts be mentioned here that if ap = 0 then equation (2) reduces to Black Jensen Scholas
(1972) version of single factor CAPM. The null hypothesis is that there are no extra normal returns
earned on portfolios sorted on the basis of various company fundamentals which is equivalent to
testing ap = 0 for all sorted portfolios. The alternate hypothesis is ap ≠ 0. The hypothesis is tested at 5%
level of significance.
In order to test whether the investment strategy based our company fundamentals yields any
extra normal returns in Indian equity market, equation (2) is estimated for the following portfolios.
i. Portfolio consisting of long position in P1MC and a short position in P5MC which is SMB
(i.e. small minus big) i.e. size based investment strategy.
ii. Portfolio consisting of long position in P1PE and short position in P5PE and which is LMH
(low minus high) i.e. the P/E ratio based investment strategy.
iii. Portfolio consisting of long position in P5BEME and short position in P1BEME which is
HML (high minus low) i.e. BE/ME ratio based investment strategy.
iv. Portfolio consisting of long position in P5DE and short position in P1DE which is LEVG
(high leverage minus low leverage) i.e. leverage or D/E ratio based investment strategy.
In order to test whether inclusion of any one or more of the four company fundamentals (viz.
Market capitalization : MC, Price Earnings ratio : P/E, Book equity to market equity ratio : BE/ME and
Financial Leverage : D/E ratio) can better explain cross sectional variations in average equity returns in
Indian stock market we have used the methodology followed by [Davis, Fama and French (DFF) :
2000] with the following modifications.
i. DFF (2000) constructed and used only nine portfolios based on size and book to market
equity. We have constructed, and used 20 portfolios based on size, P/E ratio, book to
market equity ratio and D/E ratio.
ii. DFF (2000) used the following 3 factors and tested Fama-French three factor asset pricing
model equation :
Factors used by DFF (2000)
(a.) Market Risk Premium = (RM – RF)
(b.) Size Premium = SMB = Return differential between small & large firms portfolios.
(c.) Value Premium = HML (High Minus Low) = Return differential between high BE/ME
stocks portfolio and low BE/ME stocks portfolio.
Instead we have used the following five factors :
Factors used in the present study
(a.) Market Risk Premium = R M − R F
(b.) Size Premium = SMB (Small Minus Big) = Monthly Return differential between PIMC
(Smallest Stocks Portfolio) and P5MC (Largest Stocks Portoflio).
(c.) P/E risk premium = LMH (Low Minus High) = Monthly return differential between PIPE
(lowest P/E stocks portfolio) and P5PE (highest P/E stocks portfolio).
(d.) Value risk premium = HML (High Minus Low) = Monthly return different between P5DE
(Highest BE/ME stocks portfolio) and P1BEME (Lowest BE/ME stocks portfolio)
(e.) Leverage risk premium = LEVG = Monthly Return differential between P5DE (Highest
D/E stocks portfolio) and PIDE (Lowest D/E stocks portfolio).
Then we have estimated the following first pass time series regression equations for each
portfolio over the 120 months between July 1997 – June 2007. The standard notations used in
equations (3 to 33) are given below :
R pt = Portfolio return in month t
R ft = Risk free return in month t
International Research Journal of Finance and Economics - Issue 29 (2009) 195
The null hypothesis of no significant difference between the average return in seasonality
month and average return in non-seasonality months is equivalent to testing that b = 0. The alternative
hypothesis is b > 0, i.e. the average return differential between seasonality and non-seasonality months
is positive (i.e. seasonality months provide higher average return than the non-seasonality months). The
hypothesis is tested at 5% level of significance.Related propositions of the study have been examined
using disruptive statistics, frequency distribution, Pearson coefficient of correlation and dummy
variable regression. We have used Statistical Package for Social Sciences (SPSS) and Excel for the
purpose of data analysis.
VIIa. Relationship Between Company Fundamentals and Equity Returns in Indian Stock
Market
To begin with the relationship between four company fundamentals viz. market capitalization, P/E
ratio, BE/ME ratio and debt equity ratio and average security returns are analysed using correlation
coefficients. The results are presented in Table 3. It can be observed that there exists a
i. statistically significant negative relationship between company size and average stock returns
over the study period.
ii. Statistically significant negative relationship between P/E ratio and average stock returns over
the study period.
iii. Statistically significant positive relationship between BE/ME ratio and average stock returns
over the study period.
iv. Statistically significant positive relationship between Debt Equity ratio and average stock
returns over the study period.
These results are further substantiated by constructing various portfolios on the basis of these
four company fundamentals and then analyzing the pattern of mean monthly returns and mean monthly
excess returns.
Table 3 provides summary statistics of monthly excess returns of all 20 portfolios sorted on the
basis of four company fundamentals, while Table 4 provides results of the market factor model.
per month as against 1.02% per month or P5MC. This clearly provides a size premium (the return
differential between PIMC and P5MC) of 2.32% per month (t-value 5.800) or about 24% per annum
which is quite robust. However the standard deviation of PIMC is also higher than that of P5MC
pointing towards the intuitive fact that small firms are more risky than their large counterparts.
Table 3: Summary Statistics of monthly excess returns of Portfolios sorted on the basis of various company
fundamentals (Total Period July 1997- June 2007)
Panel A: Size Based (Firm Size increases as one moves from P1MC to P1MC)
Panel A of Table 4 presents the results of the market model equation used to check for the
relationship between company size and equity returns in Indian stock market. It is clear that intercept
value (i.e. a) decline monotonically as one moves from PIMC to P5MC. The smallest sized portfolio
has provided an extra normal return of 3.06 percent per month as revealed by its "a" value which is
statistically significant (t-value 2.573 as against its critical value of 1.96). Thus we can reject null,
hypothesis (i.e. ap = 0) as intercept value for this portfolio is positive and statistically significant. The
same is true for P2MC. However as one moves from P1MC to P5MC there has been a sharp decline in
intercept value and for P3MC, P4MC and P5MC we do not find any statistically significant extra
normal returns. These findings indicate that the stocks of small firms outperformed those of large firms
over the study period. These results are in line with the results presented earlier by Mohanty (2001)
Sehgal & Muneesh (2002), Sehgal and Tripathi (2005) for Indian stock market. A look at the R2 value
reveals the fact that market factor is important in capturing a large amount of variation in equity returns
especially for the large stocks portfolios. It is important to note were that the R2 value (coefficient of
determination) is low for small stocks portfolio (e.g. 50.5% for PIMC as against 63.1% for P5MC)
suggesting that the portfolio of small stocks have larger unexplained variations in their returns.
The slope coefficient "b" (i.e. commonly known as beta coefficient) of all the portfolios have
been statistically significant but there has been no substantial difference between the beta coefficient of
small and large stocks portfolios. This might indicate that market risk of small firms is not substantially
higher than that of large firms.
(ii). Regarding Price Earnings Ratio (P/E ratio) and Equity Returns
These results are presented in Panel B of Table 3 and Panel B of Table 4. It can be clearly seen from
the summary statistics of monthly excess returns of all P/E ratio sorted portfolios that low P/E stocks
provided a statistically significant mean monthly excess return of 3.01% (t value 3.040) over the study
period as against 1.33% per month by high P/E stocks portfolio during the study period. The mean
monthly excess return declines as one moves from PIPE to P5PE. However as was the case with size
200 International Research Journal of Finance and Economics - Issue 29 (2009)
based portfolios, portfolio returns of low P/E stocks have also shown higher standard deviation (or
variability) than those of high P/E stocks. The LMH (low minus high) risk premium based on P/E ratio
has been found to be a statistically significant 1.68% per month (t value 3.111) or about 20% per
annum over the study period. If one looks at the intercept values of the market model results presented
in Panel B of Table 5, one finds that the "a" values decline monotonically as one moves from PIPE to
P5PE, showing that low P/E stocks portfolio provided the investors with statistically significant extra
risk adjusted returns over the study period. The lowest P/E stocks portfolio i.e. PIPE provided an extra
risk adjusted return of 2.17 percent per month (t value 2.879) as against 0.45 percent per month (t value
1.015) on highest P/E stocks portfolio i.e. P5PE.
(iii)Regarding Book Equity to Market Equity Ratio (BE/ME Ratio) and Equity Returns
The summary statistics and market model results of portfolios sorted on the basis of BE/ME ratio are
presented in Panel C of Table 3 and Panel C of Table 4 respectively. As expected mean monthly excess
return of high BE/ME stocks portfolio (P5BEME) is much larger and statistically significant (3.06%
per month with t value 3.091) than that of low BE/ME stocks portfolio (P1BEME: 1.49% per month
with t value 1.886). Moreover the standard deviation of high BE/ME stocks portfolio is also higher
than that of low BE/ME stocks portfolio. The intercept value "a" as shown in Panel C of Table 4 also
increases monotonically from 0.67 per cent per month (t value 1.434) for P1BEME to 2.23 percent per
month (t value 2.957) for P5BEME suggesting that high BE/ME stocks portfolio generated higher risk
adjusted extra return during the study period. The value premium (i.e. the return differential between
P5BEME and P1BEME) is as high as 1.57 percent per month (t value 2.492) which is also statistically
significant. Hence we can conclude that during the study period a strong value effect existed in the
Indian stock market.However the intensity of this effect is slightly lower as found by Muneesh Kumar
and Sehgal (2004) and Sehgal and Tripathi (2005).
Table 3: Summary Statistics of monthly excess returns of Portfolios sorted on the basis of various company
fundamentals (Total Period July 1997- June 2007)
Panel C: BEME Ratio Based (BEME ratio increases as one moves from P1BEME to P5BEME)
Table 3: Summary Statistics of monthly excess returns of Portfolios sorted on the basis of various company
fundamentals (Total Period July 1997- June 2007)
Panel D: Financial Leverage or D/E ratio based (D/E ratio increases as one moves from P1DE to P5DE)
The summary statistics of monthly excess returns of various portfolios sorted on the basis of
D/E ratio show that mean monthly excess return of high D/E stocks portfolio (P5DE) has been 2.71
percent (t value 2.823) as against 1.40 percent (t value 1.750) on low D/E stocks portfolio (PIDE). As
expected the standard deviation of high D/E stocks portfolio is also higher than that of low D/E stocks
portfolio. The return differential between high and low D/E stocks portfolio, popularly known as
leverage risk premium (LEVG) has been found to be 1.31 percent per month (t value 2.673).
Panel D of Table 4 shows that the intercept terms 'a' of P3DE, P4DE and P5DE are higher and
statistically significant than those of PIDE and P2DE. The extra normal return of P5DE is 1.86 percent
per month (t value 2.845) as against 0.61 percent per month (t value 1.186) for PIDE. This suggests
that during the study period stocks of high financial leverage firms outperformed those of low financial
leverage firms implying the presence of a "leverage effect" in the Indian stock market.
A peculiar feature of all the above results has been that the slope coefficients (or beta
coefficients) of all portfolios have been statistically significant but R2 values have been lower for
PIMC, PIPE, P5BEME and P5DE portfolios and high for P5MC, P5PE, PIBEME and PIDE portfolios
suggesting that portfolios of small capitalization stocks, low P/E stocks, high BE/ME stocks and high
202 International Research Journal of Finance and Economics - Issue 29 (2009)
D/E stocks have larger unexplained variations in their returns than those of large capitalization stocks,
high P/E stocks, low BE/ME stocks and low D/E stocks although market factor has been important in
capturing cross sectional variations in average stock returns of all portfolios.
VIIc. Frequency of Portfolio Rebalancing and Relationship between Company Size and Portfolio
Returns
In order to assess the effect of frequency of portfolio rebalancing on the relationship between company
size and portfolio returns we rebalanced the portfolios (based on market capitalization) after every six
months i.e. June end and December end every year and calculated their monthly excess returns using
the same procedure as discussed in Section 3.2. The results are shown in Panel A and B of Table 6.
Here the size premium becomes 2.19% (t value 5.763) as against 2.32% (with annual rebalancing). The
results are not found to be drastically different from those of annually rebalanced portfolios and hence
we reject the hypothesis that more frequent rebalancing provides higher risk adjusted returns on small
stocks portfolios in Indian stock market.
Table 6: Results with half-yearly Rebalanced Portfolio (July 1997 – June 2007)
Panel A: Summary Statistics of Monthly Excess Returns of Size Sorted Portfolios
The empirical results regarding the role of company fundamentals in explaining cross sectional
variations in equity returns in Indian stock returns are presented from Table 7 to 11.
Panel C show results of single factor model with size as independent variable, Panel D shows
results of single factor model based on P/E risk premium while Panel E and F shows single factor
model results based on value premium and leverage risk premium.
It is clearly visible from Panel A to F of Table 7 that market factor (excess return on market
portfolio) captures the most part of cross-sectional variations in equity returns in India, but not all. No
other factor (be it size premium, P/E risk premium, value premium or leverage premium) can capture
any significant portion of cross sectional variations in average equity returns, in isolation, as all other
single factor models have very low R2 value as compared to the single factor market model. Hence we
conclude that the company fundamentals, per se, are not capable of explaining cross sectional
variations in equity returns in India. They must be clubbed with market factor (or some other
independent variable) to check whether the two factor model can better explain cross sectional
variations in equity returns in India or not.
The results regarding various two factor regression models have been presented in Panel A to
Panel J of Table 8. It has been observed that here has been considerable improvement in adjusted R2
value when both excess market return and size premium are used as independent variables (See Panel
Aof Table 8). This can also be confirmed by the fact that the slope coefficient of size premium i.e. s is
statistically significant for all 20 portfolios while all (except six) intercept values i.e. 'a' values are very
low and not statistically significant. Hence we conclude that size and market factors together can better
explain cross sectional variations in equity returns in India than the market factor alone.
International Research Journal of Finance and Economics - Issue 29 (2009) 207
Table 8: Results of Two Factor Regressions for various portfolios
Panel A: Market and Size
R Pt − R ft = a + b(R mt − R ft ) + s(SMB t ) + e t
The following two factor regression models did not produce any significant results in
explaining cross sectional variations in equity returns in India, as their adjusted R2 values have been
found to be very low.
Size and P/E risk premium
Size and value premium
Size and leverage premium
P/E and value premium
P/E and leverage premium
Value and leverage premium
The results of various three factor models are presented in Panel A to Panel J of Table 9. It is
clear visible that the following three factor models in which one of the factors is excess market return
have still higher adjusted R2 values as compared to any of the two factor models:
Market, Size and P/E risk premium (Panel Aof Table 9).
Market, Size and value premium (Panel B of Table 9).
Market, Size and leverage risk premium (Panel C of Table 9).
Market, P/E and value risk premium (Panel D of Table 9).
Market, P/E and leverage premium (Panel E of Table 9).
All other three factor models were not capable of explaining cross sectional variations in equity
returns in India as their adjusted R2 values have been found to be very low (see Panel F to Panel J of
Table 9).
Moreover among the above mentioned three factor models, the model having market, size and
value premium as independent variables produced the best results as adjusted R2 values of this model
were higher for all 20 portfolios than any other three factor model or two factor model. This factor
model (based on market, size and value premium) is the famous Fama-French multifactor asset pricing
model. Moreover none of the intercept values (i.e. 'a' values) of this model are statistically significant
while all slope coefficients of market premium, size premium and value premium have been found to
be statistically significant. Hence we conclude that the three factor model (based on excess market
return, size premium and value premium) works very well in explaining cross sectional variations in
equity returns in Indian stock market.
The results of various four factor models are presented in Panel A to E of Table 10.
It can be clearly seen that the four factor model based on market, size, P/E and value premium
(Panel A of Table 10) provides the best results here although adjusted R2 values have improved only
marginally as compared to the three factor model based on market, size premium and value premium
(Panel B of Table 9). This might be due to the overlapping effect of value and P/E risk premium in
Indian context.
218 International Research Journal of Finance and Economics - Issue 29 (2009)
Table 10: Four Factor Model Regression Results
Panel A: Market, Size, P/E & Value
R pt − R ft = a + b(R mt − R ft ) + s(SMTt ) + p(LMH t ) + h (HML t ) + e t
Finally, the results of the five factor model have been provided in Table 11. It is clearly visible
that the five factor model is not any substantial improvement in explaining cross sectional
improvement in explaining cross sectional variations in equity returns in India over three or four factor
models, as adjusted R2 values have improved only marginally with the inclusion of two additional
factors (P/E risk premium and leverage premium).
Table 11: Five Factor Model Result Market, Size Value, P/E and Leverage
R pt − R ft = a + b(R mt − R ft ) + s(SMB t ) + p(LMH t ) + h (HML t ) + l (LEVG t ) + e t
The empirical results regarding April Seasonality effect and January Seasonality effect are
presented in Table 12 and 13 respectively. It is clearly visible that none of the slope coefficients of the
International Research Journal of Finance and Economics - Issue 29 (2009) 221
dummy variable i.e. 'b values' are statistically significant. Moreover all intercept values or 'a' values are
very high and statistically significant. Hence we may conclude that none of the seasonality effects
(April or January) has been present in equity returns in India over the study period.
i. There existed a statistically significant negative relationship between company size (Market
Capitalisation) and equity returns in India over the study period. The smallest stocks portfolio
(PIMC) outperformed largest stocks portfolio and provided the investors with an extra risk
adjusted return of 3.06 percent per month (t value 2.573) as against 0.63 percent per month (t
value 1.329) on P5MC i.e. largest stocks portfolio. The size premium (i.e. the return differential
between smallest and largest stocks portfolios) has been found to be 2.32 percent per month (t
value 5.800) over the study period which is quite robust.
ii. There existed a statistically significant negative relationship between P/E ratio and equity
returns in India over the study period. The lowest P/E ratio stocks portfolio (PIPE)
outperformed the highest P/E stocks portfolio (P5PE) and provided the investors with an extra
risk adjusted return of 2.17 percent per month (t value 2.879). The P/E risk premium (i.e. the
return differential between PIPE and P5PE) has been found to be statistically significant over
the study period (1.68 percent per month with t value 3.111).
iii. There existed a statistically significant positive relationship between BE/ME ratio and equity
returns in India over the study period. The highest BE/ME stocks portfolio outperformed the
lowest BE/ME stocks portfolio. The highest BE/ME stocks portfolio (P5BEME) produced an
extra risk adjusted return of 2.23 percent per month (t value 2.957) as against 0.67 percent per
month (t value 1.434) on P1BEME i.e. the lowest BE/ME stocks portfolio. The HML premium
or value premium (i.e. the return differential between P5BEME and P1BEME) has been found
to be 1.57 percent per month (t value 2.492) which is also statistically significant.
iv. There existed a statistically significant positive relationship between D/E ratio and equity
returns in India over the study period. The highest D/E stocks portfolio (P5DE) outperformed
the lowest D/E stocks portfolio (PIDE) and provided an extra risk adjusted return of 1.86
percent per month (t value 2.845) as against 0.61 percent per month (t value 1.186) on lowest
D/E stocks portfolio i.e. PIDE. The leverage risk premium has been found to be statistically
significant at 1.31 percent per month (t value 2.673) over the study period.
v. The investment strategies based on size, P/E ratio, BE/ME ratio and D/E ratio would have
provided the investors with statistically significant extra risk adjusted returns of 2.43% (t value
2.273), 1.71% (t value 3.157), 1.56% (t value 2.474) and 1.25% (t value 2.502), respectively
over the study period. It shows that opportunities are available for Indian investors to earn extra
returns on a risk adjusted basis by following investment strategies based on company
fundamentals.
vi. More frequent rebalancing of portfolios did not produce any drastically different results in
Indian context and hence we may conclude that frequency of portfolio rebalancing does not
affect the results in any significant way.
vii. Excess market return has been found to be an important factor in explaining cross sectional
variations in equity returns in India although it is not capable of explaining all such variations.
It implies that other company fundamentals should be added to the asset pricing model in order
to explain cross-sectional variations in equity returns in India in a better way.
viii. None of the company fundamentals, in isolation, could explain cross sectional variations in
equity returns in India in any significant way.
ix. The three factor model based on market, size premium and value premium (Popularly known as
Fama-French Multifactor asset Pricing Model) explained cross-sectional variations in equity
returns in India in a much better way than the single factor CAPM or any two factor model.
x. Four factors or five factors models did not improve the results regarding cross-sectional
variations in equity returns in India in any significant manner and hence we may conclude that
the three factor Fama-French model works well in Indian context.
xi. None of the seasonality effects (April or January) had been found to be present in equity returns
in India over the study period.
International Research Journal of Finance and Economics - Issue 29 (2009) 223
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