Fundamentals and Stock Returns in Japan

Presented By:Ambu GyawaliAnita K. LuitelAyush Nepal

Barsha ShresthaBidur Koirala

Introduction• Cross sectional differences in returns in Japanese stock.

• The study uses four variables: • Earnings Yield ,• Cash Flow Yield , • Size(market capitalization of equity),• Book to Market Ratio (of equity )

• The research uses Univariate Analysis of returns & Fundamental Variables Regression.

• Researcher also used sensitivity analysis for the SUR model and last section is summary and conclusion.

Literature Review• Fama (1991) points out any correlations observed between

fundamental variables and returns could be consistent with market inefficiencies or with the fundamental variables proxying for omitted risk factors. Academic interest in Japanese market is relatively recent phenomenon.

• Hamao (1991) and Hamao and Ibbotson (1989) characterize the Japanese capital markets by presenting summary statistics.

• Elton and Gruder (1989) analyzed the relationship between exceptional data and actual stock performance.

Purpose & Significance

• To explore the cross sectional predictability of equity returns in Japan • Using variables such as:

• Earnings Yield, • Cash Flow Yield,• Size• Book to market ratio.

• To provide compact summary of the relationship between:

i. Stock Returnsii. Fundamental Variables (i.e. Earnings Yield, Cash Flow Yield, Size

& Book to market ratio.)

Methodology• Study is based on the analysis of the relationship between stock returns

and fundamental variables • Analysis conducted at the portfolio level where the portfolio are

constructed under different grouping schemes.• Alternative statistical specification and various estimation methods

applied for comprehensive & high quality data set that extends from 1971 to 1988.

• The sample includes both manufacturing and non manufacturing firms, companies from both section of the Tokyo Stock Exchange, and also de listed securities.

• The study employs the Seemingly Unrelated (SUR) model to adjust portfolio risk and test for the significance of the fundamental variables.

• The SUR methodology assumes that the beta for the portfolios is constant over time.

ModelRpt – Rft = α0 + βp1 (RWt – Rft) + βp2(REt – Rft) + α1(E/P) pt + α2(LS)pt + α3(B/M)pt + α4(C/P) pt + ept ………..(1)

Where, P= 1…..64, t=1….210.

Dependent variable• Return on Portfolio P in the month t, rpt less the risk free

rate in the month t. • RWt, Rft and REt are the returns on the value weighted and

equally weighted indexes in the month t.

• The fundamental variables analyzed in each month t includes:

• (E/P) pt, • Average Earning Yield for portfolio P;

• (LS)pt, the average of natural logarithm of market capitalization for firms in portfolio;

• ( B/M)pt, the average book to market value for portfolio P and• (C/P)pt, the average cash flow yield for portfolio P.

• It provides a compact summary of the relation between stocks returns and fundamental variables.

• Prior research indicates that the relationship between equity returns and fundamental variables is different in US for January versus Non January months.

• This issue is addressed by introducing dummy variables for January and non January months into equation (2):

Rpt – Rft= α0 Djt + α0r (1-Djt) + βp1j (RWt – Rft)Djt + βp1r (RWt – Rft) (1 – Djt) + βp2j (REt – Rft) (1 – D jt) + βp2r

(REt – Rft) (1 – Djt) + α1j( E/P) pt Djt + α1r(E/P)pt ( 1 - Djt) + α2j(LS)pt Djt + α2r(LS)pt (1 – Djt) + α3j(B/M)pt Djt + α3r(B/M) pt (1 – Djt) + α4j (C/P)pt Djt +α4r (C/P) pt (1–Djt)+ ept

where P= 1,…..64; t=1,….210 Djt is a dummy variable where it takes the value of 1 in the month of January and 0 otherwise.

• The other variables are defined as in equation (1).

• The study also apply the Fama-MacBeth (1973) Methodology where this procedure update betas periodically.

• The basic model for month t is Rpt – Rft = α0t + b1t βp1 + b2t βp2 + α1t(E/P) pt + α2t(LS) pt + α3t(B/M) pt

+ α4t(C/P)pt + ept………………….………….(3)Where,

• Rpt – Rft is the excess return on portfolio (security) P,• βp1,βp2 are beta for two factor model with factors being excess return on

value and equally weighted indexes. • E/P and C/P are the earning yield and cash flow yields, respectively. • LS is the natural logarithm of market capitalization, and B/M is the book

to market ratio.

Data Analysis & Findings

Conclusion• This study is based on cross-sectional differences in returns on Japanese stocks to the underlying

behavior of four fundamental variables; earnings yield, size, book to market ratio, and cash flow yield.

• This study reveals a significant relationship between fundamental variables and expected returns in the Japanese market.

• The book to market ratio and cash flow yield has the most significant positive impact on expected returns.

• A cash flow yield has a positive and in general highly significant impact on expected returns. • Earnings yield and size have been the sole focus of cross-sectional studies on the Japanese market. • It is hardest to disentangle the effect of the earnings yield variable. • In the context of the full model, earnings yield has a negative impact on stock returns and is in some

cases reliably negative. • E/P has a positive and nearly significant impact on stock returns.• Due to failure in application of the SUR methodology, the economic hypothesis predicts that relative

values of their fundamental variables, the failure to perform this adjustment results in a mis-specified model.

• There are no essential differences between the results using individual securities and those using portfolios.

• This study does not enable us to determine unambiguously whether the predictability in returns is a result of market inefficiency in the asset pricing model.

Limitations• In contrast to the voluminous research in the U.S. relating stock

returns to such fundamental variables as firm size, earnings yield, cash flow yield and book to market value, there has been only very limited research relating to the Japanese market.

• Moreover, the available Japanese evidence suffers from methodological problems and a limited data base.

• Information on delisted companies was not available in previous studies; hence, the studies also suffer from a survivorship bias.

• Japanese regulations do not allow companies to use different reporting methods for tax purposes and for public financial statements.

• There is no guarantee that relationships uncovered from historical data will prevail in the future.

Critical Appreciation & Future Scope

• This study helps to fill this void by exploring the relationship between equity returns and fundamental variables.

• The results provide evidence on which fundamental variables (if any) are at work in the Japanese market.

• Firms with large capital investments tend to have substantially understated earnings.

• This studies help to deal with anomalous price behavior on the Tokyo Stock Exchange.