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Literature Review On Earnings And Returns

The aim of the research is to find the effect of size and book factors on the earnings and returns. For the purpose of this research textile industry is chosen along with its sectors weaving spinning and composite. Different companies from these sectors along with their closing value taken from the business recorder are taken into consideration.

The research is based on the findings of Fama and Fench who stated that the ratio of Book equity to the market equity is the main player in determining the major essence of the average stock returns. Further more if this ratio is considered along with the size than they also play a major role in minimizing the risks in the construction of portfolios. Higher ratio of book equity to market equity yields poor earnings and its lower ratio generates higher earnings. (Fama and Fench, 1990)

When conducting research it is necessary that when stocks grouped to size and book equity to market equity ratio should indicate the clear differences in profitability .On summarizing the above point it can be concluded that those firms which have high return on growth usually have low book equity to market equity ratio and vice versa.

Besides this there is also a relation between size and profitability. Stocks are directly proportional to the earnings, smaller the size of the stocks smaller the earnings generated by the firms. Size usually effect earnings due to the low profits on stocks and these points were proved in 1981. (Vishny, 1981)

Before 1980 there was a very little or no relation between the size and profitability. But the recession which occurs in the early eighties generates the depression of small stocks prohibiting its participation in the boom period of mid eighties. In this regard different theorists have given different point of views.

According to Penman when portfolios of book equity to market equity are generated for the tenure of five years firms which have low ratio become healthier in terms of profits and vice versa. (Penman, 1980)

According to the theory presented by Lakonishok Shleifer and Vishny

growth rates don’t have any effect on the size of firms and they become same in the coming years after the portfolio formation regardless of high and low book equity to market equity of stocks.

The explanation behind their statement lies in the fact that those firms which have low book equity to market equity ratio generates low returns on the stocks and thus the weakness lies in the generation of future earnings growth ability of the firm which becomes weaker than the market. Same is the case with the firms with high book equity to market equity ratio because their ability of future generation of earnings become stronger than the market. In summarizing their theory that firms with higher book equity to market equity ratio have higher returns on earnings and thus they verify the irrational pricing. (Lakonishok, Shleifer and Vishny.1987)

Main point that should be kept into consideration is that this analysis does not cater asset pricing issue. The earnings by the firms in different ratios of the size of book equity to market equity groups occupy the place in the market in the same manner as their stock returns. The routes occupy by the factors like market and size can be distinguished clearly by their position in returns. Besides this detail analysis there is a weakness that can be seen in asset pricing model and it lies in the fact that book equity to market equity in earnings is responsible for driving this ratio in returns.,

Basically asset pricing Model was developed in relation with the Capital Market Theory in order to show the balance between risk, return on assets and uncertain future payments. It was in early nineties when Fama and Fench discovered that Beta does not describe clearly the differences in stock returns. and thus in order to conduct a meaningful study they considered three variables size, Book equity to market equity in explaining the clear variations and ups and downs in stock returns. In the three factor models Fama and Fench were able to minimize the anomalies that were creating disruptions in the capital asset pricing Model. (Fama and Fench, 1980)

The anomalies that were arising in the Capital Asset Pricing Model was because of its lack of ability in taking into account the systematic risk, neglecting some important attributes of the firm ,biased interpretation of information and the statistical and other errors involve in feeding the computer data. In the late nineties Daniel and Titman argued that firm’s traits are responsible for showing the ups and downs and differences in the stocks average returns. DT also argues that even under the controlled circumstances the average return does not necessarily have the positive relation with the three factors. (Daniel and Titman, 1999)

In 2000 Pastor and Stambaugh elaborate this view through their research on a mean variance efficiency portfolio by doing a comparison between the risk based model developed by Fama and Fench and the firm trait based model developed by Daniel and Titman .After conducting research they came to the conclusion that both models are similar and give rise to same portfolios when considered for investment purposes. The crux of this research lies in the point that many factors are responsible for capturing the detail analysis of stock returns. (Stambaugh, Daniel and Titman, 2000)

In the late nineties Miller also collaborate in this view. He said though since many decades single beta was used to explain the depth of the stock returns but base on recent study more than one factor is required to get the deep insight about the stock returns. In 1999 Malkiel found that risk management requires more empirical tests. (Miller and Malkei, 1999)

To check the multifactor model Chui and Wei in 1998 perform the empirical tests to check the validity on Asian region data. After conducting research they came to the conclusion that there is a weak bond between the average stock return and the market. Beside this they also concluded that Fama and Fench three factor characters are associated with each other. (Chui and Wei,1998).

Drew and Veeraraghavan also confirmed that multifactor approach developed by Fama and Fench provides a deep insight in examining the cross sectioning of returns and explaining the strong relationship between size, book equity to market equity ratio and stock returns. However in Chinese market is still lacking in finding the relationship between the three factors defined by the Fama and Fench. . (Drew and Veeraraghavan, 2000)

In order to gain insight about all the tests proving the relationship between the size, book equity to market equity ratio and stock returns developed by the Fama and Fench it is necessary that they should pass through bias hypothesis proposed by kothari,Shanken and Sloan and the other hypothesis given by Black in 1995. This challenge can be respond in a better way through the statement given by Halliwell, Heaney and Sawicki. According to them repetition of the same result in any stock market suggests that there is a strong persuasive asset pricing effect. (Halliwell, Heaneyand Sawicki, 1995)

The point of the debate in conducting the research is that asset pricing model explains the ups and downs in a better way than the CAPM. To prove this, markets of different countries are taken in to account. Firstly china is taken into consideration because its analysis is difficult as compare to the other markets .Secondly multifactor effect can be explained in a better way through seasonal effect. On conducting the research following conclusions were obtained.

Very low cost portfolio for size will generate a positive result of 0.9273% per month.

Book to market equity effect is not as prominent as it should be in United States market.

Basic findings of this research were that value firms which are defined as the firms who have high book equity to market equity ratio give prominent results. Besides this research does not apply on the changes that occur because of seasonal effects like New Year and Christmas particularly in the data of January. Other major point that can be taken into account is that investors in China are quasirationals and non beta risk is also attached with the factors found in three factor model. Furthermore beta is not efficient enough to explain in detail about the average stock returns. This research is applicable on both the type of investors’ i-e. risk aversive and risk taker.(Drew and Veeraghavan,2000).

The research done on Shanghai Stock market provides an incentive to those investors who are interested in taking advantage of extra benefit in the form of extra returns. These investors should shape their portfolios in accordance with the book equity to market equity ratio and thus by doing so they can expose their portfolios to the risks. According to Cochrane

Anomalies are applicable in the small and valuable ratio only when the investors are knowledgeable about distressed and ill liquid stocks. If the strategies are not working than it is essential for the investor to work in the opposite direction. (Cochrane, 1999)

The major findings of the research conducted on the Chinese stock market were that further tests on the three factor model developed by Fama and Fench are required. Beside this distinction between the different classes of stocks are also necessary and the economic factors associated with the three factor model also need to be determined. The main finding of this research is that expected returns are not always the result of firm’s aggregate risk it is sometimes the investor’s misevaluation that gives rise to it thus it can be said that compare to the capital asset pricing model, market risk are in a better position to explain the behavior of stock returns. (Sharpe, Lintner and Black, 1972)

To check the validity of three factor model developed by Fama and Fench, it was also applied on the Indian Stock market. The issues that gave rise to this debate were related to economic and financial concerns. Its impact can not only be seen on economic science but world business and financial sectors have also shown some great variations. According to Sharpe and Lintner that expected returns are directly proportional to the risks and market beta is the sole factor in explaining in detail about the ups and downs in average stock returns. It was explained in a better way by Fama and Fench and in order to prove it in a better way they use NASDAQ and American Stock Exchange (AMEX) (Sharpe, 1965)

According to the research conducted by Fama and Fench it was found that beta alone is not capable enough to explain the changes in the stock returns. Beside this they also concluded that two factors play a very important role in finding out in detail about the stock return .These factors include size and book equity to market equity ratio.

The hypothesis developed by Fama and Fench was also seconded by Chui (1991).Wei (1978) and Daniel after taking this research further by testing it on Japanese market. The findings of their research include that Beta is not associated with the average stock return. According to the research conducted by the other prominent investors on the United States stock markets average returns have a direct relationship with the firm book equity to market equity ratio. However in the later years Keim came up with an argument. According to him the identified variables can be considered as different scales to gather the required information. (Keim, 1990).

Other findings of the research include that size effect does not occur in a systematic manner in the emerging markets. Beside this return factor in twenty rising market is similar to those of developed markets. Thus small stocks perform better than the large stocks and value stocks perform better than the growth stocks. (Rouwenhorst, 1998)

India has been chosen as a country for research because of its rapid growth in various sectors including market capitalization and trading value. The research conducted on the Indian stock market is an extension of the hypothesis presented by Chui and Wei .Indian emerging market sectors cement, textile, pharmaceutical and automobile were chosen for research. On conducting research it was found that there is a negative relation between size and average returns. Beside this the role of size is overshadowed by the market equity to the book equity. It can be said that market to book equity is the major player in determining in detail about the average returns. (Chui and Wei, 1999)

The main purpose of Fama and Fench of conducting research was to analyze in detail the effect of leverage on security returns and as a result of this they discarded all the financial firms. However there research was finally concluded on the point that the strongest indicators are book equity to market equity in finding out the effect on the stock returns.

During their research they also concluded that financial and non financial firms exhibit similar behavior in returns. Both these firms have certain and distinct type of size and book to market ratios. According to them it difficult to say that those financial and non financial firms differ in the two mentioned characteristics. Beside this the two characteristics size and book to market equity relate in the same manner when associate with the security returns. (Fama and Fench, 1981)

In conducting research it is also necessary to consider the biases that are involve in data selection .These biases are basically responsible for overstatement and understatement of the two factors developed by Fama and fench which are size and book to market equity ratio. These are then responsible of creating biases according to financial and statistical point of view.

CAPM theory by FAMA AND FRENCH suugest that stocks beta alone is sufficient to explain ite average return.CAPM uses only single factor beta to compare portfolio with the market but for the better results FAMA AND FRENC added two other factors and the model later called three factor model.In three factor model they used beta, risk free rate of return and market risk.They drawn a conclusion that if return increases with book/price then stocks with a high book to price ratio must be more risky than average. They found that high book to price ratio means that stock is distressed and selling at low price because future earnings are doubtful.

FAMA AND FRENCH model like CAPM can also be used to explain the performance of portfolios through linear regression and two extra factors will give additional axes and instead of a simple line regression is a big flat in fourth dimension. The three important points of this model are as follows:

Stocks tends to beat the bonds in long term by the amount known as “equity risk premium” and so the amount of stocks in the portfolio is the first factor to determine the long term returns.

Small companies tends to beat the larger companies by the amount known as “small company premium” so the size of portfolio is the second factor that will determine the long term return.

Cheap companies outperform more expensive companies over the long term by amount known as “Equity risk premium” so the stock is the third factor that will determine long term average return.

There is a theory known as Agency Theory that concerns about the relationship between a shareholder (principal) and an agent of the principal or company’s manager. This theory involves the cost of resolving conflict between an agent and the principal. The primary agency relationship in business is between stockholders and managers and between debt holders and stockholders.

However in order to this statement research was conducted. According to Lane assumptions of agency theory does not apply to the decisions involving strategic and corporate relationships because managerial behavior is indicated clearly by the steward theory. (Lane et al, 1998)

According to the steward’s theory it is the duty of manager to have a positive attitude towards the organizations goals and stock holders have the limited information regarding the strategic issues and decisions thus they are influenced at minimum by the corporate diversification

The main point of this theory was that different corporations have different perspectives. These perspectives give rise to the conflicts regarding level of hierarchy and corporate diversification. The troubles basically lie among the interests of shareholders and managers who have different interests depending upon their needs. In this way it can be concluded that these factors chained with the corporate diversification which indicates the nature of agency problem and equity ownership is linked with magnitude of agency problem. (David J. Denis, Diana K. Denis and Atulya Sarin, 1999).

Another theory that creates a conflict with the stock returns is the Efficient Market Hypothesis theory says that the financial markets are informational efficient and already reflect all information that is available and keep on changing to reflect new information. So according to this theory it is impossible to perform the market by using the information that the market has already. The efficient market hypothesis was developed by FAMA and many other researchers also worked on this model to get better results.

According to this theory organizations have sufficient information and this information can be reflected through the securities they possess in the form of bonds, stocks and property. This fact creates a difficulty for the organization and creates hurdles in the outperformance with the market information. There are three forms in which this hypothesis can be stated:

In weak form efficiency hypothesis firms future prices cannot be predicted using the trends in the past. Firm lacks the ability to earn higher return in the future using historical data and predictions. In this regard there is no pattern that can be seen in asset prices and thus they follow a random pattern.

According to semi strong form efficiency hypothesis prices have the ability to mold themselves to the information and there are no biases that can be found in this regard .Here fundamental and technical analysis have the ability to produce higher returns in the future.

Strong form efficiency hypothesis deals with the fact that share prices reflect both type of information private and public and a barrier can be seen in earning higher returns. Strong form efficiency hypothesis is applicable only in the condition where private information has the ability to become public and this hypothesis becomes inapplicable where trading laws are involved. This hypothesis can be tested for its validity in the market where investors lacks the ability to earn higher returns in the long run.

This hypothesis has faced many criticisms. According to the behavioral economists this hypothesis contains many cognitive biases like overconfidence, overreaction information bias and various human errors in reasoning arguing and processing. (Daniel Kahneman, Armos Tversky)

Strong form efficiency hypothesis does not have any empirical evidence. According to Dreman those stocks which have low P/E generate higher returns and thus they result in higher beta. (Dreman, 1995)

Another important theory given by Fama and French is the Portfolio Theory. Portfolio theory is series of tools which are used to minimize the risk of portfolio in investment. This theory says that the portfolio assembled out of dissimilar assets will have lower level of risk than one made in similar ones. This is due to the fact that dissimilar assets respond differentially to each other and economic environment is also different for these assets in market. The first problem arises is how exactly you define the risk and it was found that the risk can be defined through a statistical measure that is standard deviation which is the measure of how returns deviate from their average. This method is quite simple to calculate the risk and has advantage

Basically portfolio theory deals with the set of tools whose purpose is to lower the risk of portfolio and at the same time aims to target a certain amount of required return. According to this theory a portfolio that contains the diversified assts tend to have a lower risk as compare to the portfolio that has similar assets. The reason of this point lies in the fact that diversified portfolios have the ability to deal with the environmental threats differently.

The main point that can be considered in this theory is the amount of risk that is involved in the investment. Its definition was given by Harry Markowitz in the form of a new theory called standard deviation of returns. It resulted in the failure of portfolio theory given by Fama and French. This theory is based on the measure of deviation of stock return from its measure using the statistical tools.

(Henry Markowitz, 1952)

Standard deviation is the factor that was pointed out as one of the greatest measure of risk .beside this it was easy to calculate and give accurate results when tested on the valid set of assumptions. The type of risk that is used in the modern portfolio theory is volatility more commonly known as standard deviation. Researches done on this type of hypothesis basically deals with the fact that rational investors are those whose actions are based on the prices and for the diversified portfolio expected return should have the positive correlation with the amount of risk taken.

Another type of risk that should be considered is the Compensated risk. It is the type of risk that persists even when all the other type of risk present is diversified that can’t be paid.

The idea of compensated risk was tested by the Fama and French.In order to do this they develop the Capital Asset Pricing Model (CAPM).In this model cash flows are discounted using a calculated amount of risk known as beta. Basically it is a measure of a risk involved in the security as compare to the average return. In the journal cross section of expected stock and returns Fama and French used regression analysis to test their hypothesis.

During their research they identified the various factors which are responsible of generating high and low returns .in concluding their research they found out that the factors contributing largely are company size, company price, company earnings, sales book value or other dimensions of book value

Keeping in view the company size and company "value" together. It proves better in predicting the return from the basket of stocks with quite higher precision and accuracy than beta and the CAPM, Fama and French devised the "Three Factor Model" of portfolio returns.

The research conducted on this model is fairly simple and easy to understand. According to this model expected return of a portfolio depends upon the three factors

Stocks have the ability to beat bonds over the long term by an equal amount known as the "equity risk premium", so the quantity of stocks vs. bonds in a portfolio is the fore most factors that will determine expected return for the long term.

Smaller companies usually have the ability to perform better than the larger companies over the long term by an amount known as the "small company premium", At this point a bias is need to be considered known as size bias. Size bias of the portfolio is the second dominant factor that has the ability to affect the portfolio's long term expected return.

Cheap companies tend to perform in a better way as compare to the more expensive companies over the long term. They tend to do this by an amount known as the "value premium", so the portfolio's allocation toward cheap ("value") vs. expensive ("growth") stocks is the third factor.

Beta was one and only factors tested by Fama and French, but once the effects of size and value were taken into consideration this factor disappeared.  In other words, beta failed where company size and value usually works..  In their research Fama and French concluded and considered that beta which was considered as a risk measure had been made obsolete.(Fama and French, Cross section of Stocks and returns, The journal of Finance)

It is assumed that higher returns are found at the places where payments while assuming risks are necessary. Here the three factors are considered prominent and identifiable as symptoms for risks.  They are also a source to generate and yield a higher return on the condition if investors are risk taker and have the ability to expose themselves to the risks of the portfolio.

Stocks usually have high amount of risk as compare to the bonds. In this scenario stockholders are paid a return only on the condition after employees and creditors are paid what they are owed, so being last in line means that stockholders assume more risk.  This risk factor is uncontroversial. 

Small companies tend to be more susceptible to economic downturns than large and this is visible in the volatility of their profits and the rates at which they go bankrupt.  The small company factor, once verified by other researchers looking at samples of data outside the one used by Fama and French, was also uncontroversial.

Fama and French caused more of a stir with the value factor, because for a long time investors like Warren Buffett and Ben Graham had been claiming that cheap companies outperform but that this was due to mispricing, not risk.  Of course using circular logic one could argue that the companies wouldn't be cheap unless there was something wrong with them to make them out of favour, and therefore they aren't mispriced at all.  This never really satisfied a lot of investors though, and the concept of a "value risk" has divided researchers ever since with distinct camps of "efficient markets" believers vs. those who believe markets are not efficient, most notably researchers interested in how investor psychology can distort prices, these are the researchers in the field of "behavioural finance".

There is now, after 16 years of research, an impressive body of work by both the "value premium is a risk premium" theorists and the "value premium is caused by the market consistently making mistakes" theorists.  Fama and French initially threw their lot in strongly with the "risk" side, however in the last few years have produced a number of papers supporting the idea that the value premium is at least in part driven by mispricing.  The consensus, to the extent that one could be said to exist, is that the value premium is probably a combination of mispricing by the market systematically paying too much for glamourous "growth" companies and too little for dull or out of favour "value" companies, and in part a risk factor attached to a lot of shaky unprofitable companies with doubtful futures which also reside in great numbers among cheap companies.


Cost of capital model by FAMA AND FRENCH commences with Modigliani and Miller who uses arguments to model the effect of leverages on firms cost of equity and weighted average cost of capital. Several other models were developed to find this effect including CAPM (sharpe,1964),Linter and Mossin (1965,1966),Arbitrage theory of pricing(1976) and Fame and French model (1997).This model says that any sensitivity coefficients in the model must be related to the firm’s leverage.


This model states the whether stock prices properly reflect differences in the evolution of profitability when stocks are grouped on size and BE/ME. With the help of simple rational pricing model FAMA and FRENCH found that BE/ME is related to persistent properties of earnings. It was found that high BE/ME signals low earnings on book equity high BE/ME stocks are less profitable than low BE/ME stocks. It was found that the firms having low BE/ME were the firms with high average returns on capital whereas the firms with high BE/ME were the firma with low average returns on capital.[ Fama,1995]

The study on the evolution of profitability and earning /prices ratios in relation to size and book to market equity is consistent with rational pricing. Further analysis shows that the common factors in returns signals common factors in earnings suggests that market, size and book to market factors in the earnings are the source of corresponding factors in return. The weak links in rational pricing models suggests that the book to market factors in earning drives the book to market factors in returns. The test centre on six portfolios formed on ranked values of size and BE/ME for individual stocks. The I and II section describes the portfolios and measures of profitability, III section determines the behavior of earnings for the 11 years around portfolio formation. Section IV examines the profitability in chronological times to show the performance of different size and book to market combinations. Section V examines price/earning ratios, earning growth rates and stock returns. Section VI argues that there size, market and BE/ME in shocks to earnings. Section VII examines link between returns and common factors in returns.

FAMA and FRENCH (1992) document a significant relation between firm sizes, book to market ratios and security returns for non-financial firms. Some financial economists remain unconvinced about the robustness of relation and argue that the documented anomalies are simply a result of data snooping by academics,(eg:Black (1993) and McKinley (1995).In this research the authors has tested the data snooping hypothesis by analyzing the relation between firm, size to book market ratios and security returns for sizeable sample. Later it was found out that financial and non financial firms have very similar patterns. Financial firms are those firms with standard industrial classification codes (SIC) ranging from 6000 to 6999 and remaining firms are classified as non financial firms .In order to test the data snooping hypothesis potential for data selection was also considered as described by Kothari, Shanken, and Sloan (1995).The result of this study indicates that the size and book to market ratio for financial and non financial firms have similar meaning as they relate to security returns.

It was found in the recent studies that size and book to market ratio has the power for cross section of stock returns but it was found that size and book to market equity ratio effects also exists in the bonds return. This research suggested that size and book to market are correlated with the risks that are priced in both stocks and bonds. It was found that size has dominant effect in bonds returns and book to market equity has dominant effect in stock returns.

Further studies shows that the test allows for both variables, the negative relation between the size and average return is less significant the inclusion of market to book equity seems to absorb the role of size in selected stock returns.

The traditional capital asset pricing model (CAPM) developed by Sharpe (1964) Linter (1965) and black (1972) states that the expected returns on stocks are positively related to their risk and market betas are the only risk factors to explain the cross sectional variations of expected returns. American stock exchange (AMEX) and NASDAQ during the 1963 to 1960.FAMA and FRENCH found that the variations of cross sectional stocks returns can be captured by two firm characteristics firm size and book to market equity. Chan al (1991),Chui and Wei (1998) and Daniel et al (1997) also found that book to market equity plays a significant role in explaining the cross sectional variations in Japanese market and these studies suggested that market beta is not related to stocks. Overall studies concluded that the risk factors capture to a certain extent the return behavior observed in international stocks.Rouwenhorst (1998) showed that the return in 20 markets are qualitatively similar to those documented for many developed markets.FAMA and FRENCH (1998) and Patel (1998) documented a premium for small firms and value stocks in 17 emerging market economies. Chui and Wei (1998) showed that book to market equity can explain the cross sectional variation in expected stock returns in three out of five pacific markets.

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