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Ane Empiric Cal Inve Int Estigati The Indi Ionoft Ian Sto The Prof Ock Mar Fitabilit Rket Ty Anom Maly
Ane Empiric Cal Inve Int Estigati The Indi Ionoft Ian Sto The Prof Ock Mar Fitabilit Rket Ty Anom Maly
n Journal of F
Finance & Acccounting
ISSN 19946-052X
2012, Vol. 4, No. 2
An E
Empiriccal Inveestigatiion of the
t Proffitabilitty Anom
maly
in the
t Indiian Sto
ock Marrket
S anjay Sehgaal,
Professor of
o Finance, Departmen
nt of Financial Studies,
Univerrsity of Delh
hi, India
Srivid
dya Subramaaniam(correesponding author),
a
Assistaant Professoor, Departm
ment of Econ
nomics,
SGTB Khalsa
K Colllege, Univerrsity of Delhi, India
E-mail: sriividyadse@
@gmail.com
Abstract
This stuudy examinnes the profiitability anoomaly for th he Indian sttock markett using dataa for 493
compannies on the BSE from January 19996 to Deceember 2010 0. A negativve relation between
b
profitabbility and reeturns is em
mpirically cconfirmed which
w is in contrast too prior reseearch for
mature markets. Fuurther the ob bserved relaationship iss robust to choice
c of pro
rofitability measure.
m
The finndings can be explaineed by the ffact that more m profitab
ble firms teend to givee higher
dividennd payouts and
a are therrefore perceeived to be less risky by b investorss resulting in i lower
returns.. A positivee relationshiip between profitability y and payou uts and a neegative relaationship
betweenn payouts annd beta is obtained
o connfirming our argument.. The three ffactor Famaa French
model is able to explain reeturns on pprofitability y sorted portfolios whhich was not n fully
explained by CAPM. Thus the profitabillity anomaly y does not pose
p seriouss challenge to asset
pricing in the Indiaan context. Our findinggs have stro ong implicaations for accademicianss as well
as portffolio managgers. The sttudy contribbutes to equ uity markett anomaly lliterature esspecially
for emeerging markkets.
Keywords: Profitaability, Diviidend payouuts, Beta, CA
APM, Famaa French moodel
JEL codde: C22, C333, G12, G1
14, G15
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1. Introoduction
The liteerature on stock
s markeet anomaliees is extensiive and gro owing. Schw wert (2003)) defines
anomalies as emppirical results which aare inconsiistent with maintainedd theories of asset
pricing.. The CAPM M which posits
p a possitive and linear relation betweenn beta and security
returns was the acccepted paraadigm in thhe finance liiterature forr a long tim me. Howeveer in the
late 19770s, empiriical work appeared
a thhat exposed d the shortccoming of tthe CAPM. It was
observeed that that much of th he variationn in expecteed return is unrelated tto market beta b and
various company characterist
c tics could aaffect stock returns vizz. size, bookk to markett equity,
earninggs to price, past
p returnss, leverage aand momen ntum (Famaa & French,, 1992)1.It was w then
well esttablished thhat beta is inadequate
i tto explain returns
r and thus there is need to develop
multifacctor asset pricing modeels. Fama annd French (1993)
( deveeloped a thrree-factor model
m for
expecteed returns, which
w suggeests that exppected returrns on a porttfolio in exccess of the risk-free
r
rate aree explained by sensitiviity to markeet, size and d value factoors. The addditional risk
k factors
i.e. sizee and value are firm sppecific, yet tthey have proven
p to haave an imprressive explanatory
power in explainiing major anomalies of the CA APM for in nstance sizee, book to market,
earninggs to price, leverage.
Howeveer recent sttudies havee found thaat even the Fama and d French (11993) modeel is not
withoutt weaknessees. For instaance, the m
model fails to
t explain returns
r on pportfolios so
orted on
momenntum (Famaa & French,, 1996), acccruals (Sloaan, 1996), net n stock isssues (Loug ghran &
Ritter, 1995), (Ikeenberry, Laakonishiok & Vermaeelen, 1995))) and proffitability (F Fama &
French,, 2008). Fam ma and Freench (2008)) point out that
t the moodel fails too explain retturns on
portfoliios sorted onn accruals, momentum
m m and net sto
ock issues in
n all size grooups.
Asset ppricing anoomalies prim marily mom mentum, acccruals and d net stockk issues hav ve been
heavily researchedd for the dev veloped cappital marketts. It is the profitabilityy anomaly which
w is
comparratively lesss explored. Existing
E liteerature on profitability
p anomaly esstablishes a positive
relationnship betweeen profitabiility and retturns. Haug gen and Bak ker (1996) fifind more prrofitable
firms hhave greater expected returns. T They constru uct a modeel of expeccted returns which
includes various accounting,
a market annd past retu urn variablees and repoort that ev ven after
controllling for theese variablees more proofitable firm ms tend to have
h greateer expected returns.
They reelate profitaability of a firm to its growth potential and posit that ccurrently prrofitable
firms hhave greateer potential for futuree growth. This T indicates the proobability fo or faster
(slowerr)-than-averrage future growth in a stock’s earnings
e and
d dividendss. Cohen, Gompers
G
and Vuuolteenaho (2002)
( also
o find that m more profittable firms provide higgher averag ge stock
returns.. Fama and French (20 006) concluude that giv ven BM and d expected investmentt, higher
expecteed profitabillity impliess higher exppected returns. Fama and a Frenchh (2008) rep port that
the profitability annomaly exits only in tthe case off small stoccks. In thiis case they y find a
positivee relation between profitability annd returns and a presencce of signifi ficant hedgee returns
althouggh the hedgee portfolio returns
r are nnonexistentt in the casee of big stoccks, tiny sto
ocks and
market as a whole. Fitzpatriick and Oggden (2009)) find that the lowestt future retu urns are
associatted with thee lowest pro ofit quintilee and vice versa.
v Artmann, Finter and Kempf (2011)
1
Banzz (1981),Stattm
man(1980), Basu
B (1983), Bhandari (1988),
( De Bondt and Thaaler, (1985, 1987)
1 and
Jegadeessh and Titmann (1993).
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V (1)
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Rmt – Rft is the exccess market return i.e reeturn on maarket factor minus
m risk ffree return,
et is the error term,
a (interccept) is a measure
m of ab
bnormal proofits and
b is the sensitivity coefficient of market ffactor.
The CA APM impliees that exceess returns on a portfo olio should be fully exxplained by y excess
market returns. Hence,
H the expected value of a (the interrcept term)) should be b 0. A
significcantly positiive (negativ
ve) value off ‘a’ (interceept) impliess extra-norm
mal profits (losses).
If theree is a signiificant positive or neggative intercept in thee CAPM sppecification, then a
CAPM anomaly exxists.
3.4 Relaation betweeen beta and
d payouts
The purrpose of esttimating thee relation beetween betaa and payouts is to evalluate if high
h payout
firms aare perceiveed to be leess risky byy investors. We first estimate sttock beta for f each
individuual firm by regressing a firm’s exxcess month hly stock return againstt the excesss market
return uusing rollinng three yeear regressioons over thhe entire tim
me period. The variab ble beta
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measurees the co movement of securityy return wiith the market returnn and is caalled the
systemaatic risk of the
t equity security
s of ffirm i. The value
v of βi is obtained from the fo
ollowing
time serries regressiion for each
h firm in thee sample as follows
Yi = α +βi X (4)
where Yi is the exccess monthly return of a firm i ,
X is thee excess maarket return,
α the inntercept andd βi (beta) is the stock bbeta for firm
m i.
Once thhe value of beta is avaailable for eeach firm ov
ver the entire sample pperiod, we estimate
the relaation betweeen beta and payouts usiing panel OLS in the fo
ollowing eqquation
beta i,t = γ0 + γ1 payoutts i,t +ε t (5)
where bbeta is the estimated
e yearly beta ffrom equation 4 and γ0 is the inteercept. The value of
γ1 in thiis equation shows
s the relationship between beeta and payo
outs. To connfirm our reesults on
relationnship between beta and d payouts, w we construccted porttfolios on thhe basis of payouts
and calcculated the average bettas of the coorner portfo
olios.
3.5 Asseet pricing teest-Fama French
F (FF) model
If a CA
APM anomaaly exists th hen we atteempt to evaluate if the excess retuurns of the stylized
portfoliios that are missed by CAPM cann be explainned using th he three facctor model of
o Fama
and Freench (1993) specified as
a follows. .
The FF Model is given by:
Rpt – Rft = a + b (Rmt - Rft) + s(SMBt )+ h(LMHt )+
) et (6)
Where SMBt is thee monthly reeturn on thee size mimiccking portfo
olio,
LMHt is the monthhly return on
n the price-tto-book mim
micking porrtfolio,
s and h are the senssitivity coeffficients of SMBt and LMH
L t
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2
Constrruction methoodology for size
s and valuue factors hass been adopteed from Sehggal, Subramaniam and
Morandiiere(2012).
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P1 P2 P3 P4 P5
Mean t- Mean t--stat Meean t-statt Mean t-stat Mean t-
stat stat
0.023 2.461 0.017 2.205 0.0 14 1.927
7 0.017 2.459 0.015 2.197
Panel B
B. ROA sorrted portfolioos
P1 P2 P3 P4 P5
Mean t- Mean t--stat Meean t-statt Mean t-stat Mean t-
stat stat
0.026 2.789 0.032 3.141 0.0 21 2.554
4 0.019 2.648 0.015 2.215
ROE ROA
β0 t(β0) β1 t(β1) β0 t(β0) β1 t(β1)
0.255* 38.475 0.032*
* 3.2222 0.24
44* 18.16 0.2231* 2..074
3
The eqquation has been estimated
d using fixedd effects paneel OLS metho
od, which hass been chosen
n over the
random eeffects methood based on Wu-Hausman
W statistic.
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29.67 %%( 31.14% %). Corporaate dividendd policy ten nds to varyy directly w
with currentt profits.
Currentt profits maay contain informationn about futu ure profits and hence large payouts may
send a ppositive signnal leading to stock priice appreciaation.
Table 3. Empiricall results based on one ffactor CAPM
M
Panel a. ROE sorteed portfolioss
CAPM results (Taable 3) show w that the eextra normaal returns (aafter adjustinng for mark ket risk)
on ROE E sorted porrtfolios is 1..2% per moonth for less profitable stocks
s and 00.6% per month
m for
more prrofitable stoocks. The siignificant inntercepts off corner porttfolios conffirm the presence of
a profittability anom maly within n the CAPM M frameworrk. We how wever find thhat the marrket beta
for lesss profitable stocks(P1) is higher aas compared d to more profitable
p sttocks(P5), showing
s
that lesss profitable firms aree more riskky. The beeta coefficieent of bothh portfolioss is also
statisticcally significant which means thatt the market return factor is imporrtant in cap pturing a
large am mount of vaariation in co ommon stocck returns. WeW find thaat the alphass of P1 and P5 have
soberedd down duee to the con ntribution off beta. Resu ults on ROA A sorted poortfolios aree in line
with thaat obtained for ROE. The T extra noormal return n (after adjuusting for m
market risk) is 1.4%
per month for less profitablee stocks andd 0.4% perr month forr more proofitable stoccks. The
interceppt of the loower profitaability portffolio (P1) is i statisticaally significcant confirm
ming the
presencce of a profi fitability ano
omaly withiin the CAP PM framewo ork. We recconfirm thatt market
factor iss able to exxplain part of
o the profit ability anom
maly. Thesee results aree in line with Louge
and Meerville (1972) who find d negative rrelation bettween profitability andd beta. They y reason
that invvestors perceive profiitability as an “inversse surrogatee” of businness risk. Previous P
findingss of Scherrrer and Maathison (19996), Gu and d Kim (200 02) and Leee and Jang g (2006)
indicateed a negativve relationsh hip betweenn profitabiliity and systematic risk.. From an in nvestors
perspecctive who iss developin ng a tradingg strategy a highly pro ofitable firm
m is less riisky and
hence should proviide less retu urns.
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0.967* 20.949
9 --0.074* -3.235 0 .002
The FF results (Taable 5) show w insignificcant interceppts for loweest profitabiility portfollios(both
ROE annd ROA) owingo to contribution oof both sizee and valuee factors. FFF regression ns show
that botth SMB andd LMH coeffficients aree higher forr P1 as comp pared to P55 confirming g role of
size annd value factors
f in explaining profitabilitty based returns.
r Thhe alpha of P1 is
predomminantly capptured by vaalue factor aand marginaally by sizee factor. Hennce the threee factor
model aabsorbs thee profitabilitty sorted reeturns that are
a missed by CAPM.. Further FF F results
are robuust to choice of profitab
bility proxyy i.e. ROE and
a ROA.
4
The eequation has been estimateed using randdom effects panel
p OLS meethod, whichh has been cho
osen over
the fixedd effects methhod based on Wu-Hausmann statistic.
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When w we investiggate the aveerage size aand P/B5 foor the profittability sortted portfolio
os (both
ROE annd ROA) we w find thaat P1 is acttually smalll size and low l P/B viis-a-vis P5 i.e. less
profitabble firms arre relatively
y distressed and smalleer in size (ffor use of PP/B as a measure of
relativee distress see
s Chan and a Chen( 1991)). Sinnce less prrofitable fiirms are reelatively
distresssed and smaall in size, it
i is found that small sized comp panies and llow P/B companies
give lowwer dividennd payouts and
a hence arre perceived d to be more risky by innvestors.
Next wee try to devvelop a risk story
s for sizze and valuee factors.
Table 66. Empiricall results of panel
p OLS regression of size on dividend
d paayouts and value
v on
dividennd payouts
Size i,t = γ0 + γ1 payyouts i,t +ε t
P/B i,t = γ3 + γ4 payyouts i,t +ε t
γ0 t(γ0) γ1 t(γ1) A
Adj γ3 t(γ3) γ4 t(γ4) Adj.R2
R2
22.817 609.45 0.125 1.96 0 .001 3.13 3.904 0.989 0.782 0
Our paanel OLS reesults (table 6) show weak posiitive relatio onship betw ween firm sizes and
payoutss and a weaak positive relationshiip between P/B and payouts. Exaamining thee corner
portfoliios formed ono the basiss of size andd P/B it is observed
o th
hat small and nd low P/B firms
f do
exhibit lower payoouts vis-a-v vis big and high P/B firmsf (averaage payoutss for small firms is
19.17 %%and for big firms is 30.15%.
3 Avverage payo outs for low
w P/B firms is 20.26 % and for
high P/B B firms is 30.64%).
3 Hoowever in thhe absence of o any statisstically signnificant relaationship
one migght infer thaat there cou
uld be other reasons forr the risk sto ory leading to these facctors for
instancee small firmms are expoosed to highh operation nal, financiaal risks owin ing to the nature
n of
their buusiness and more liquiddity risk owwing to investor neglectt. Low P/B stocks on the t other
hand reepresent relaatively distrressed firmss as show byb weaker track
t recordd of their paast sales
and earnnings growtth rates (seee Fama and French (19 995)).
5. Summary and Conclusion
C ns
Prior reesearch has confirmed a positive rrelation bettween profittability andd returns forr mature
marketss (see Famaa and French h (2008)). TThese resultts can be ex
xplained if w we look at the
t issue
from enntrepreneur’’s perspectiv
ve thus treaating profits as a reward
d for risk beearing.
Our ressults howevver confirm a negativee relation beetween profitability annd returns whichw is
robust tto choice off profitability measure.. This could d possibly be
b explainedd by examining the
problemm from inveestor’s persp pective. Moore profitable firms tennd to pay hiigher divideends and
thereforre are perceeived to be less risky by investorrs. Thus a negative
n rellation is po
ostulated
betweenn dividend payouts
p and d firm betass. In other words
w more profitable ((and higher payout)
firms shhould provvide lower returns.
r It is equally important to t know w whether proffitability
based aanomalous pattern
p in reeturns couldd be explain dard asset ppricing models. One
ned by stand
5
For ROOE (ROA) soorted portfolio
os the averagge values of market
m cap (siize) for P1 iss 22.42 (22.53
3) and for
P5 is 22.53(23.92).Foor ROE (ROA A) sorted porrtfolios the av
verage values of P/B for PP1 is -0.87(-0.88) and
for P5 is 8.09(8.81).
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factor C
CAPM is partially able to expplain the allphas on profitability
p y sorted po ortfolios.
Dividennd payouts confirm thee risk argum ment for thee market factor as a neegative relaationship
betweenn payout annd beta is em
mpirically coonfirmed.
It is fuurther foundd that the FF
F size andd value based factors absorb the profitabilitty based
returns that are misssed by CAPM. Hencee the profitab bility anommaly does noot pose an em
mpirical
challengge to multtifactor assset pricing framework k in Indian n context. These risk k factors
howeveer do not bear signifficant relattionship wiith payout ratios, thuus suggestiing that
alternattive explanaations mightt be neededd to justify th
heir risk preemiums.
The stuudy has stroong implicaations for aacademician ns who are searching ffor a ration nal asset
pricing theory that can explain n prominentt equity maarket anomalies and hass a universaal appeal.
There aare also im mplications for investm ment managgers who are
a continuoously in pu ursuit of
profitabble style bassed trading strategies.
The preesent researrch contribu
utes to asseet pricing an
nomaly literrature especcially for em
merging
marketss.
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