Value and Size Anomalies: A Study of Indian Stock Market

Abstract

Asset pricing continues to be one of the most investigated topics in finance. The path-breaking contribution in that area was the development of Capital Asset Pricing Model (CAPM). Though CAPM continues enjoying popularity with practitioners, the empirical examinations showed that value stocks and small-sized stocks were commanding excess return that could not be explained by the overall market risk factor. This resulted into posing a serious challenge to the Efficient Market Hypothesis (EMH). In response to it, Fama and French (1993) developed a three-factor model, which conceptualized the size and value as additional factors for explaining the realized returns. However, they inferred the risk from the realized returns, and thus designated the excess return as ‘value premium’ and ‘size premium’. Another group of researchers tried to examine the value and size effect by using the combined measure of risk-return like the Sharpe ratio to investigate any disproportionately higher returns in value stocks and small-sized stocks. This approach not only results into inconsistent findings, but also does not allow comparing the levels of return and risk separately. Since the study of value anomaly and size anomaly is a matter of bifurcating stocks based on the discriminating parameters, the Discriminant Analysis (DA) can be a powerful tool to know whether the excess returns on value stocks and small-sized stocks are due to proportionately associated higher risks that can be labelled as ‘risk premium’ or simply a manifestation of the ‘pricing anomaly’. The analysis of data is carried out based on two different perspectives, namely the market perspective, and the investors’ perspective. The market perspective shows mixed results as far as the difference of mean return is concerned. The return remains an important factor to discriminate value and growth stocks. However, the risk turned out to be the important factor in discriminating the small-sized and large-sized stocks. As far as the investor’s perspective is concerned, there is excess return on the value stocks in majority of the cases and there is excess return on small-sized stocks in some cases, which is not explained by the associated risk. As such, any excess return may not be only for excess risk (i.e. premium) or only a pricing anomaly. This study goes a step forward in showing that what part of return on value stocks can be attributed to the associated higher risk and what part can be taken as an unmixed bless. This is a unique contribution of DA, which is lacking with other two popular approaches that conclude about the state of market efficiency in a binary way. Another important contribution of this work is the identification of an optimum holding period. Here, on average 3 to 4 years turns out to be an optimum holding period for the investors to yield higher returns in case of value stocks as well as small-sized stocks. Thus, contribution of this study lies not only in finding the fact objectively, but also in making the application of Discriminant Analysis for the first time in the study of pricing anomaly