Firm quality and stock returns: Evidence from India

ABSTRACT

Using data for 1 848 companies, we find that quality increases, not quality, drive stock returns in India. Profitability and safety seem to be relevant attributes for measuring quality. Our cross-sectional tests show that the role of quality in predicting returns is partially subsumed by momentum in short holding periods. Rational sources are not able to explain quality premiums. We find that quality premiums result from investor overreaction. At the same time, momentum profits are an outcome of investor underreaction, suggesting that investors pay more attention to fundamentals than past price trends. High investments by institutional investing may account for such behaviour.

KEYWORDS:

• quality increases
• asset pricing
• behavioural mispricing
• momentum
• India

JEL CODES:

• C13
• C22
• G11

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 NSE is the leading stock exchange in India which was established in 1992 as the first electronic exchange providing dematerialised trading in the country.

2 Capital Line Database provides capital market data for over 35 000 listed and unlisted companies in India which are classified under more than 300 industries.

3 Our hedge portfolio implies a long-short strategy wherein one buys P10 stocks and finances the same by short-selling P1 stocks.

4 We observe momentum profits starting from a six-month period in order to capture an early reaction of investors through past price-based information.

5 Apart from the Fama-French Five Factor model, Asness, Frazzini and Pedersen’s Five and Six Factor models (Mohanty, 2018) have also been used in the recent literature. However, we have taken the Fama-French Five-Factor model as a robustness test as it is one of the most applied asset pricing models in recent literature.