INTERNATIONAL JOURNAL of ACADEMIC RESEARCH

Vol. 4. No. 1. January, 2012

SIZE, LEVERAGE AND STOCKS RETURNS: EVIDENCE FROM PAKISTAN

Faisal Khan , Dr. Arshad Hassan , Shahid Ali
1 2 1 2 3

Quaid-e-Azam College of Commerce University of Peshawar, Muhammad Ali Jinnah University Islamabad, 3 Institute of Management Sciences Peshawar (PAKISTAN) E-mails: faisalkhan_sub@yahoo.com, aarshad.hasan@gmail.com, shahid.ali@imsciences.edu.pk ABSTRACT

The theme of this study is to examine the effect of size on the basis of market capitalization and leverage with high and low debt-to-equity ratios on identified portfolios required rate of returns listed at Karachi Stock Exchange (KSE). Multivariate regression has been used to identify the relationship among market premium, size premium, debt to equity premium and portfolio returns. The sample has been selected from 21 sectors consisting 200 listed-Pakistani firms for the period of January 2001 to December 2007. The p-value at 95% confidence level shows the relationship with CAPM and the size premium is positive and significant related to portfolio returns (P1 to P5), while the leverage premium (DER premium) is positively insignificant. It has been observed that the firms with high market capitalization outperform the firms with low market capitalization. The 2 proposed multi-factor model increased the explanatory power of size premium by almost 40% at P1; the value of R indicated that the contribution of size premium was high as compared to the leverage premium. Therefore the security analysts, institutional investors, fund managers and other stakeholders should consider the size premium (SMB) as an important factor for determinant of required rate of returns. Key words: Market premium; Size premium; leverage premium 1. INTRODUCTION This study argues that many of the capital asset pricing model (CAPM) average return anomalies are interrelated. The CAPM has been one of the most frequently used, but today many empirical studies have pointed out some deficiencies in the model, as an explanation of the link between risk and return. CAPM is weak as it based on Efficient Market Hypothesis, which means: transparency; no transaction costs; no significant restriction to investment; investors rational behavior and expectations. There is mixed support for a positive linear relationship between required rates of return and systematic risk for portfolios of stock. Some recent evidence indicated the need to consider the additional risk variables or different risk proxies. Today lot of empirical studies have shown the accessibility of extra required rate of returns by using active investment strategies based on a number of firm's variables such as size (Banz, 1981), leverage (Bhandari, 1988), price earnings ratio (Basu, 1977), book to market ratio (Stattman, 1980); Rosenberg, Reid and Lanstein, (1985), etc. These evidences, since inconsistent with the CAPM, are popularly known as CAPM anomalies. The assetpricing model of Sharpe (1964), Linter (1965) and Black (1972) has long shaped the way academics and practitioners thought about average required rate of returns and risk. There are several empirical contradictions of the Sharpe-Linter-Black (SLB) model. The most important is the size effects of Benz (1981) that market equity (market capitalization) adds to the explanation of the cross-section of average returns provided by market betas. The average return on small firms (low ME) stocks is too high than average returns on large firms (high ME), given their estimates. Another contradiction of the Sharpe-Linter-Black (SLB) model is positive relation between leverage and return documented by Bhandari (1988). It has been brought into the account that the leverage is associated with risk and expected return. The most influential work of Fama-French (1992) three factor model in which they add two variables besides the market return, the returns on small minus big stocks (SMB) and the returns of high book to market value minus low book to market value stocks (HML). This particular study discussed the three-factor model that includes two variables other than market premium i-e the returns with high leverage stocks minus the low leverage stocks (Debt/equity ratio) and the returns on small minus big stocks (SMB). Size and leverage effects are the most important assets pricing anomalies. There are different explanations of the documented size effect. One viewpoint is that small firms are inherently riskier than large firms due to differences in their operating, financial and liquidity risk characteristics. The prices of small firms stocks tend to be more sensitive to changes in the economy as they are less likely to survive adverse economic conditions. The recognition of the size effect leads the researchers to investigate its possible causes, as its presence implies that either the CAPM is miss-specified or that market is inefficient. The leverage ratio of the firm that was identified in this study was high and it has been argued that the small firms typically do not have nearly as much collateral as large firms and would not have the same ability to raise external funds. Therefore, small firms would be more adversely affected by lower liquidity and higher short-term interest rates. This study tests the size and leverage ratio effect in Pakistan stock market over a long period of seven years. The statistical trend of the calculated portfolios on the basis of size report that the stock behavior of the identified portfolios is inefficient that is the general theoretical phenomena is that the companies with small size have high risk adjusted high return; such concept was supported by Benz (1981). But this particular study

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empirically shows that the firms with low market capitalization (ME) have high risk than the firms with high market capitalization but here the large firms (high market capitalization) out perform the small firms (with low market capitalization). The findings reveal a positive and significant relationship between size and expected returns. The same result supported by Sehgal and Tripathi (2005) in Indian stock market. The financial leverage is source of corporate financing and is supposed to have both positive and negative attributes as a debt-financing instrument. Bhandari (1988) concluded in his study that the expected returns on common stocks are positively related to the debt to equity ratio. This particular study examines how the stock price of a firm reacts to the overall change of its leverage ratio. It is an important question because the choice of capital structure is arguably one of the most important decisions managers face, and a change in the leverage ratio can affect a firms financing capacity, risk, cost of capital, investment and strategic decisions, and ultimately shareholder wealth. The descriptive statistical trend of the calculated portfolios on the base of leverage ratio also follow the abnormal behavior as the general theoretical phenomena is that the firms with high debt to equity ratios have high risk adjusted high return, but this particular study has reported the high volatility in low debt to equity ratio in compare to the high debt to equity ratio. The required rate of return of the firms with low debt to equity ratio (P1 to P5) is high and there is an increasing trend, while there is decreasing trend in the firms with high debt to equity ratio. The findings reveal a positive and insignificant relationship between leverage premium and expected returns. The same result supported by Ho et al (2006) in Singapore. The balance of the study has being organized as follows; literature review, methodology, data description, data analysis, results and conclusion respectively. 2. LITERATURE REVIEW Empirical studies have shown the accessibility of extra normal required rate of returns by using active investment strategies based on a number of firm variables such as size (Banz, 1981), leverage (Bhandari, 1988), price earnings ratio (Basu, 1977). These evidences, since inconsistent with the CAPM, are popularly known as CAPM anomalies. Size effect is by far the most strongly documented and widely researched upon CAPM anomaly in US and other mature markets. Banz (1981) was the first to document the size effect in U.S market (NYSE). He defined firm size by the market value of the firms common stocks and concluded that a statistically negative relationship exists between firm size and stock returns. Sehgal and Tripathi (2005) examined size effect in Indian stock market that created a strong size premium using six different measures of company size, i-e market capitalization, enterprise value, net fixed assets, net annual sales, total assets and net working capital. There study conclude that although the size premium is substantially high when market-capitalization is used, but it remains positive and statistically significant with the use of other non-market based size measures such as net fixed asset, net sales, total assets and net working capital. Fama and French (1992) reported that average returns on small stocks are too high with given estimated beta, while average returns on large stocks are too low. Their study found out that size & beta of size portfolios were highly correlated (- 0.988, in their data) so problem arose to separate the effect of size and beta on average return. When portfolio was formed alone on size, there is strong negative relationship between size and average return. Imperfect capital market theory predicts very different effects on small and large firms risk with the changing credit market conditions. Gabriel and Timmernannn (2000) analyzed the implication of size in context of a flexible econometric model & found that the small firms has displayed the highest degree of asymmetry in their risk in recession & expansion states. Their study reported that economy in recession has strongly affected the small firms risk by worse credit market conditions. The small firms have low collateral in compare to large firm, so the ability to raise the external funds are not same, therefore the small firms will be highly affected by higher short-term interest rate. Fama and French (1996) argued in their study that the small stocks tend to have higher returns than big stocks and high-book-to-market stocks have high returns than low BE/ME stocks. Moreover, stocks with low longterm past returns tend to have positive SMB & HML slopes and higher future average return. Chan et al (1991) conducted a study in Tokyo stock market; their findings revealed a significant relationship between the fundamental financial variables (earnings yield, size, book to market ratio, and cash flow yield) and expected returns in the Japanese market. Their findings confirmed the existence of a "size effect"; small firms tend to outperform larger firms, after adjusting for market risk and the other fundamental variables. Guan et al (2007) conducted a study in USA and concluded that the presence of idiosyncratic variables (size, book-to-market & price earning) indicated that an average cross-sectional return was not inconsistent with a valid CAPM. The study reported that idiosyncratic variables might be correlated with expected returns. Chan and Chen (1991) found that because of the difference in production efficiency, difference in leverage, and perhaps the resultant difference in accessibility to external financing, small firms tend to be riskier than large firms. The evidence also suggested that investors who were willing to invest in small marginal firms were compensated with higher average returns over time. Bhandari (1988) proposed to use Debt/ Equity ratio as an additional variable to explain to explain the stock returns. He argued in his paper that an increase in debt/ equity ratio of a firm increases the risk of common equity. It concluded in his paper that the debt/ equity ratio has a significant positive effect on the expected common stock returns. J. Choi (2009) reported that the large positive alpha from the high - book - to - market portfolios came from financial leverage. When the risk premium was high, book to market firms equity beta tends to increase more than those of low book to market firms. Their study showed that the book to market changes driven by changes in market leverage. Nishat (2000) concluded in his study that in Pakistan, industry leverage is high, hence there were negative and significant relationships between return and volatility change. Odit, Chittoo (2008) conducted empirical study in Stock Exchange of Mauritius and found relationship between leverage and investment. There study has investigated the two types of firms, namely: (I) high-growth firms; and (II) low-growth firms; It has shown that the leverage has a significant negative effect on investment. The firms with low growth; relationship between

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leverage and corporate value is negative and statistically significant, while as the firm with high growth; relationship between leverage and corporate value was negative and statistically insignificant. Maroney, Naka and Wans (2004) conducted a study in the context of 1997 Asian financial crisis; it included six Asian countries (Indonesia, South Korea, Malaysia, the Philippines, Taiwan, and Thailand), they considered leverage as a key feature for financial crisis that the firms were highly levered with dollar denominated debt. The devaluation in currency resulted in increase in leverage and interest payments. Leverage increased with exchange rate depreciation caused equity betas to rise; investors suffered capital losses because the equity they hold became more risky. The positive correlation between exchange rates and local returns were consistent with leverage linked to exchange rate. The local returns have positive correlation with exchange rate changes because they were associated with capital gains and losses in local market. The increased leverage contributes to the rise in equity beta and raises expected returns. Hull (1999) analyzed whether the stock value was influenced by how a firm changed its leverage ratio in relationship to its industry leverage ratio norm. He found out in his study that the stock returns for firms moving "away from" debt-to-equity norms were significantly more negative than return for firms moving "closer to" these norms. Cai, Zhang (2008) examined how the stock price of a firms reacts to the overall change of its capital structure. The study documented significantly negative effect of the change in leverage ratio on the portfolio returns. There was a significant, negative effect of the change in long-term and short-term debt leverage on stock returns, but a weaker effect for the change in short-term debt leverage. Their study reported that an increase in leverage ratio lead to lower investment in future, that is a negative effect of leverage change on future investment. 3. METHODOLOGY An asset pricing model based on the idea that an asset's returns can be predicted using the relationship between that same asset and many common risk factors. In 1976 by Stephen Ross, create the theory that predicts a relationship between the returns of a portfolio and the returns of a single asset through a linear combination of many independent macro-economic variables. It is often viewed as an alternative to the capital asset pricing model (CAPM), since the APT has more flexible assumption requirements. Whereas the CAPM formula requires the market's expected return, APT uses the risky asset's expected return and the risk premium of a number of macroeconomic factors. The basis of arbitrage pricing theory is the idea that the price of a security is driven by a number of factors and can be calculated by deriving the following formula: r = rf + 1f1 + 2f2 + 3f3 +.. nfn. The three-factor model is an extension of a single factor CAPM; lot of literature today supports other additional factors beside the traditional beta. Fama & French have done extensive research in this area and found factors describing value and size to be the most significant factors, outside of the market risk. A primary implication of the three factor model use in this study is that investors can choose to weight their portfolios such that they have greater or lesser exposure to each of the specific risk factors, and there fore can target more precisely different levels of expected return. In order to test the model, we follow the traditional multivariate regression framework and transform the above equation into a simple time series model represented as follows: R = R+ (Rm-R) + s (SMB) + h (DER Premium) This study constructs two factors; SMB address size risk and debt to equity ratio address leverage risk. SMB stands for small minus big, ie, the firm with small market capitalization and the firm with high market capitalization while leverage premium is the difference of the ratio with high and low debt to equity. Where R present the return on portfolios, it is the dependent variable that is to be predicted, (Rm-R), (SMB) and (DER Premium) are the independent variables that is use to predict it, , s and h are the coefficients or multipliers that describe the size of the effect the independent variables has on dependent variable. 4. DATA AND VARIABLES The financial data collected from the financial data published in the Karachi stock exchange web site (www.kse.com.Pk), covering a period from 2001 to 2007. The sample includes 200 listed-Pakistani firms at Karachi Stock Exchange among the identified sample ie 21 sectors which is almost equal to 60%, from 2001 to 2007, the monthly data on closing price, turnover and KSE index collected from the www.brecorder and Ready Board Quotations issued by KSE at the end of each trading day, which are also available in the files of Security and Exchange Commission of Pakistan (SECP). Treasury bill from the state bank of Pakistan has been considered as risk free rate of return. The procedure to create a sample size from the identified population is to select those 200 companies that are traded eight (8) months a year at least while as the companies that has been traded less than eight months a year has been excluded, the analysis of the relationship between stock returns and the identified variables is conducted at the portfolio level. Information to find out the market capitalization of the sorted company to evaluate the size variable, the outstanding shares is obtained from the annual report of the companies. The process of sorting was on the basis of ascending order and the same process was repeated each year. The companies with low market equity have been placed in small while as the companies with high market equity has been placed in large. The values of debt and equity were obtained from the annual report of the companies. The

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treasury-bill rate is used as risk free rate and KSE Index as the return rate of market. The data on treasury-bill rates are taken from Monthly Billiton of State Bank of Pakistan. The financial sector including banks, insurance and leasing etc; are excluded from the total selected sample, as most of the studies have been conducted by excluding the financial sector due to highly differentiated risk profiles, Fama and French (1992). 4.1. Portfolio Returns Stock returns are calculated as; Rit = log (Pit+1/ Pit) Where Pit is the stock price of the i-th firm in time period t and the average return of this stock is the return of portfolios that has been regressed as dependent variable on three factors namely market premium, size premium and leverage premium. 4.2. Market Premium (RM-RF) It represents excess return that investor could earn if he invests in market portfolio instead of investing in a risk free asset. Return of market is calculated as; Rm = log (KSE Indexit+1/ KSE Indexit) Market premium (Rm-Rf) is calculated as, the difference between the return on KSE index and T-bill yield. 4.3. Size Premium (SMB) Size premium (SMB) is calculated as, the difference of the portfolio 1 with low market capitalization and the firms placed in portfolio 5 with high market capitalization. SMB = Small firms (low ME) big firms (high ME). 4.4. Leverage Premium (Der Premium) Leverage premium, is measured as the difference between the firms with high debt to equity ratios and the firms the low debt to equity ratios. Leverage premium (DER premium) is computed as; Total Liabilities DER = -------------------------------------Total Equity Leverage Premium = High DER last 30% Low DER top30% The firms were sorted into five portfolios, with portfolio one (P1) having the lowest leverage ratio and portfolio five (P5) having the highest leverage ratio. The firms in Pakistan are highly levered; the average equity is 35% while the average debt is 65% of the identified population that contain approximately 400 companies. 5. EMPIRICAL RESULTS 5.1. Evidence on size effect st The data has been classified in to three different groups, 1 group consist of whole entire period that is from nd 2001 to 2007, the 2 sub group consist of time period from 2001 to 2003 and the last sub group consist of time st period from 2004 to 2007. The 1 portfolio (P1) is the lowest while the last portfolio (P5) represents the highest value on the base of market capitalization. The size of the firm gradually increases by moving from P1 to P5. The empirical result of all the three period is that the large firms out perform as compare to small firm and the standard deviation of large firms are low as compare to small firms. In all the three periods there is high variation in small firms that empirically shows the inconsistency of performance of small firms in Pakistani stock market. Especially in nd the 2 sub period (2004 to 2007) high variation is found in weighted returns in small firms. Today, the performance of stock markets is viewed in terms of economic indicators, which are many. These variables can be divided in two nd groups: macroeconomics and firm- specific variables. Pakistan face lot of unfavorable economic condition in the 2 sub period (2004 to 2007), few macro factors that are inflation, interest rate and exchange rate shows that all of the macro factors in the period of 2004 to 2007 increases at increasing rate that empirically show the unfavorable effect. It is not easy for small firms to outperform in such stage. Gabriel and Timmernannn (2000) found the small firms display the highest degree of irregularity in their risk in recession & expansion states. They argue in their paper that economy in regression strongly effect the small firms risk by worse credit market conditions. The small firms have low collateral in compare to large firm, so the ability to raise the external funds are not same, therefore the small firms will be highly affected by higher short-term interest rate. The coefficient of variation also suggests the risk averse investors to invest in the firm with high market capitalization that is denoted by P5. It indicates portfolios manager that to earn dollar one ($1) return in both P1 and P5, the risk for P5 (3.85) is low in relation to P1 (13.1).

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5.2. Evidence on leverage effect st Table 5.1 shows the descriptive statistical trend of the calculated portfolios on the base of leverage. The 1 portfolio (P1) present the firms with low debt to equity ratio and the last portfolio (P5) present the firms with high debt to equity ratio. It reports the high volatility in low debt to equity ratio in compare to the high debt to equity ratio. Table 5.1. Descriptive Statistics of portfolios sorted on size and leverage ratio (2001 to 2007)
SIZE Standard Deviation 0.10 0.07 0.06 0.07 0.08 0.02 LEVERAGE Standard Deviation 0.08 0.07 0.07 0.06 0.07 -0.01

P1 P2 P3 P4 P5 PREMIUM

Mean 0.01 0.01 0.01 0.02 0.02 -0.01

R.R 13.10 9.49 5.45 4.03 3.85 9.30

Mean 0.01 0.01 0.01 0.01 0.01 0.00

R.R 11.21 4.55 5.56 4.34 8.96 -2.24

At extreme level the expected return of the firm with high debt to equity ratio is high than the firm with low debt to equity ratios. The reason for such behavior is due to the industry effect that the firms in these portfolios mostly belong to textile spinning, sugar and chemical industry. The trading volumes in these industries are low in st this particular period that may miss priced the securities. The 1 sub group follows almost the same behavior. The effect of industry is found in both P3 and P5. The P5 present the most high leverage ratios because of the textile spinning industry. Most of the firms belong to textile sector has negative equity that result in low trading and that also result in low returns (Table 5.2). Table 5.2. Descriptive Statistics of portfolio sorted on size and leverage ratio (2001 to 2003)
SIZE Standard Deviation 0.102 0.068 0.070 0.084 0.100 0.003
nd

P1 P2 P3 P4 P5 PREMIUM

Mean 0.015 0.014 0.014 0.026 0.029 -0.014

R.R 6.919 4.960 5.121 3.281 3.413 3.505

Mean 0.013 0.024 0.021 0.025 0.020 0.007

LEVERAGE Standard Deviation 0.099 0.075 0.078 0.066 0.081 -0.018

R.R 7.687 3.196 3.648 2.611 3.972 -3.714

Table 5.3 presents the 2 sub group (2004 to 2007) which contains that there is a high variation in mean of the firms with high debt to equity ratio in portfolios as compare to other identified periods, even in some cases their trend is negative (P5, see Table 5.3) which indicate the industry factor followed by P5 as most of the companies in these portfolio belong to textile spinning and sugar. In this particular time large numbers of textile companies were de listed from KSE. There may some macro economic indicator also involve in this particular period that is the interest rate, exchange rate and inflation rate increase at increasing rate. Table 5.3. Descriptive Statistics of portfolio sorted on size (2004 to 2007)
SIZE Standard Deviation 0.09 0.07 0.06 0.07 0.06 0.03 LEVERAGE Standard Deviation 0.06 0.06 0.06 0.06 0.06 0.00

P1 P2 P3 P4 P5 PREMIUM

Mean 0.00 0.00 0.01 0.01 0.01 -0.01

R.R 54.50 26.66 5.82 5.09 4.23 50.28

Mean 0.00 0.01 0.01 0.01 0.00 0.00

R.R 21.93 7.39 11.25 9.98 -49.24 -27.31

5.3. Multivariate Regression Analysis The regression use the natural logs to found out the empirical link between the risk and return of portfolios that is the market premium, in other word to test the CAPM that is most frequently used. The P-value at 95% confidence level shows that the relationship between market premium and each portfolio (P1 to P5) is highly 2 positively significant (see table 5.4). A higher value of R is associated with more explanatory power of a model but the table suggests space for other variables also. The table 5.4 shows that as the size of firm increase the value of 2 R is also increasing, which indicates that validity of CAPM for the firm with high market capitalization is high as compare to the firm with low market capitalization.

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Table 5.4. CAPM P1 to P5 (2001 to 2007)
P1 0.62 4.94 0.00 0.23 P2 0.51 5.67 0.00 0.28 P3 0.54 7.05 0.00 0.38 P4 0.75 10.28 0.00 0.56 P5 0.98 21.64 0.00 0.85

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Rm-Rf t Stat P-value 2 R

nd

In table 5.5, 2 variable (SMB) is regressed along with the market premium (two factors are regressed with 2 portfolio return). Its P-value is highly significant at 95% confidence level. The value of R is high that indicate the high contribution of size. Table 5.5. Regression Market Premium and Size Premium P1 TO P5 (2001 TO 2007)
P1 0.28 2.89 0.00 0.63 9.00 0.00 0.61 P2 0.31 3.89 0.00 0.36 6.23 0.00 0.51 P3 0.40 5.44 0.00 0.26 4.96 0.00 0.52 P4 0.62 8.77 0.00 0.23 4.54 0.00 0.65 P5 0.94 19.56 0.00 0.08 2.34 0.02 0.86

Rm-Rf t Stat P-value SMB t Stat P-value 2 R

rd

By adding the 3 factor (leverage premium) the multivariate regression predict that the dependent variable is more effected by the size (SMB) as compare to leverage premium (DER premium), the P-value at 95% confidence level is highly significant at both market and size premium but almost positively insignificant at leverage premium (see Table 5.6). Table 5.6. Regression Market Premium, Size and Leverage Premium P1 to P5 (2001 to 2007)
P1 0.26 2.35 0.02 0.61 7.75 0.00 0.05 0.48 0.63 0.62 P2 0.22 2.51 0.01 0.29 4.62 0.00 0.20 2.36 0.02 0.55 P3 0.29 3.75 0.00 0.19 3.27 0.00 0.23 2.96 0.00 0.57
st

Rm-Rf t Stat P-value SMB t Stat P-value HML t Stat P-value 2 R

P4 0.58 7.28 0.00 0.20 3.47 0.00 0.10 1.27 0.21 0.66

P5 0.89 16.89 0.00 0.05 1.27 0.21 0.09 1.84 0.07 0.87

The table 5.7 by regressing market premium for the 1 sub period (2001 to 2003) resulted positively highly significant at each portfolio. Table 5.7. CAPM P1 TO P5 (2001 TO 2003)
P1 0.56 3.26 0.00 0.24 P2 0.47 4.56 0.00 0.38 P3 0.55 5.78 0.00 0.50 P4 0.78 8.69 0.00 0.69 P5 1.08 19.80 0.00 0.92

Rm-Rf t Stat P-value 2 R

nd

By the regressing of 2 factor (Size premium) along with market premium, it indicates that contribution of size premium does exist on portfolio returns (Table 5.8). Table 5.8. Regression Market Premium and Size Premium P1 TO P5 (2001 to 2003)
Rm-Rf t Stat P-value SMB t Stat P-value R2 P1 0.36 2.52 0.02 0.55 4.67 0.00 0.54 P2 0.36 3.99 0.00 0.30 3.97 0.00 0.58 P3 0.46 5.26 0.00 0.24 3.34 0.00 0.62 P4 0.68 8.81 0.00 0.27 4.17 0.00 0.80 P5 1.04 19.03 0.00 0.09 1.96 0.06 0.93

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Almost same behavior is followed by regressing 3 factor (leverage ratio premium) for the period of 2001 to 2003 that is the market and size premium is highly significant at 95% confidence level, while the leverage premium is insignificant (Table 5.9). Table 5.9. Regression Market Premium, Size and Leverage Premium P1 to P5 (2001 to 2003)
P1 0.37 2.33 0.03 0.56 4.30 0.00 -0.04 -0.22 0.83 0.54 P2 0.29 2.93 0.01 0.24 3.04 0.00 0.17 1.72 0.09 0.62 P3 0.40 4.13 0.00 0.19 2.47 0.02 0.16 1.61 0.12 0.65 P4 0.68 7.73 0.00 0.26 3.70 0.00 0.01 0.14 0.89 0.80 P5 0.99 16.99 0.00 0.05 1.06 0.30 0.12 2.02 0.05 0.94

Rm-Rf t Stat P-value SMB t Stat P-value HML t Stat P-value 2 R

nd

In 2 sub period (2004 to 2007) lot of variation has been experienced in Pakistan economy that is the interest rate, inflation rate and foreign exchange rate increased by increasing rates. Some industries were highly st nd affected thats why result varies more than proportionally in 1 sub group. The CAPM in 2 sub period (Table 5.10) 2 predict that it is highly significant at 95% confidence level. But the value of R is low as compare to the CAPM st applied in 1 sub group (see table 5.7).
Table 5.10. CAPM P1 TO P5 (2004 to 2007) P1 0.69 3.63 0.00 0.22 P2 0.55 3.59 0.00 0.22 P3 0.51 4.07 0.00 0.26 P4 0.68 5.69 0.00 0.41 P5 0.83 11.72 0.00 0.75

Rm-Rf t Stat P-value 2 R

nd rd

By regressing the 2 and 3 factor (size premium and leverage premium) for the period of 2004 to 2007 (Table 5.11 & Table 5.12), it indicates the high contribution size variable. Table 5.11. Regression Market Premium and Size Premium P1 TO P5 (2004 to 2007)
P1 0.08 0.57 0.57 0.76 9.20 0.00 0.73 P2 0.18 1.24 0.22 0.46 5.11 0.00 0.51 P3 0.26 2.03 0.05 0.31 3.87 0.00 0.45 P4 0.49 3.80 0.00 0.24 2.93 0.01 0.51 P5 0.72 9.38 0.00 0.12 2.56 0.01 0.78

Rm-Rf t Stat P-value SMB t Stat P-value R2

Table 5.12. Regression Market Premium, Size and Leverage Premium P1 to P5 (2004 to 2007)
Rm-Rf t Stat P-value SMB t Stat P-value HML t Stat P-value 2 R P1 -0.03 -0.23 0.82 0.69 7.43 0.00 0.21 1.57 0.12 0.74 P2 0.04 0.25 0.80 0.37 3.70 0.00 0.26 1.84 0.07 0.54 P3 0.08 0.57 0.57 0.19 2.27 0.03 0.34 2.86 0.01 0.53 P4 0.35 2.50 0.02 0.15 1.67 0.10 0.26 2.04 0.05 0.55 P5 0.67 7.73 0.00 0.09 1.65 0.11 0.10 1.24 0.22 0.79

6. CONCLUSIONS This study relates cross-sectional differences in returns on Pakistan stocks to the underlying behavior of two variables i-e size and leverage ratio other than market premium. It has been experienced that there exist lot of variation in Pakistan equity returns as in other developing countries. The empirical estimation is based on a crosssectional regression analysis of the relationship between stock price in form of portfolios and the firm size and debt to equity ratio. The data has been regressed for the whole entire period (2001 to 2007) that concluded almost

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positive significant relationship between market premium, size premium and portfolio returns, while 3 independent variable (Leverage ratio premium) has positively insignificant relationship. st The data has been further classified into two-sub group for more precise examination. The 1 sub group nd (2001 to 2003) follows almost the same behavior for all the identified variables. But the 2 sub period that consists nd of the period for 2004 to 2007 experience lot of variation in their behavior. In 2 sub group there is lot of variation in mean in several portfolios as compare to other identified periods, even in some cases their trend is negative, the nd 2 identified period was effected by macro factors (inflation, interest rate and exchange rate). There is high variation in small firms that empirically shows the inconsistency of performance of small firms in Pakistani stock market. The descriptive statistical trend of the calculated portfolios on the base of leverage follow the abnormal behavior as the general theoretical phenomena is that the firms with high debt to equity ratios have high risk adjusted high return, but this particular study report the high volatility in low debt to equity in compare to the high debt to equity. The regression uses the natural logs and conclude that the CAPM (market premium) and the size premium is positively significant at each portfolio (P1 to P5), while the leverage premium (DER premium) is 2 positively insignificant. The value of R in all the three tables in the period of 2001 to 2007 clearly suggest that the market and size factor does exit contribution towards the stock returns, while the leverage ratio dose not affect the stock returns in identified period and time. We recommend that investment strategy based on size and not leverage effect economically feasible in context of Pakistan equity market (KSE) as they provide positively significant and extra normal required returns. It has positive implication for mangers, financial institution as well as individual investors and mutual fund mangers. The analysts may simply follow ranking rule on the base of size sorted portfolios instead of technical analysis. REFERENCES 1. Alex, Marcus, Robert, (1985), Debt Policy and the Rate of Return Premium to Leverage, The Journal of Financial and Quantitative Analysis. 2. Banz, (1981) The relationship between return and market value of common stocks, Journal of Financial Economics. 3. Basu, Sanjoy, (1977), Investment performance of common stocks in relation to their price-earnings ratios: A test of the efficient market hypothesis, Journal of Finance 32, 663-682. 4. Bill, Iftekhar, Sharma, Leverage, Growth and Managerial Compensation. 5. Black, F (1972). "Capital Market Equilibrium with Restricted Borrowing," Journal of Business, Vol 45, No 3. 6. Chan, Chen and Nai-Fu, (1991) Structural and Return Characteristics of Small and Large Firms, Journal of Finance. 7. Cheng, Shamsher, Nasir, (2008) Earnings Announcements: The Impact of Firm Size on Share Prices, Journal of Money. 8. E F. Fama and French, (1996), Multifactor Explanations of Asset Pricing Anomalies, Journal of Financial. 9. E F. Fama and French, (2006), Dissecting Anomalies. 10. Fama and French, (1992), The cross-section of expected stock returns, Journal of Finance. 11. Gaberiel and Timmermann, (200), Firm size and cycle variations in stock returns. 12. Garry and Smith, (2000),Portfolio Diversification, Leverage, and Financial Contagion; IMF Staff Papers, Vol. 47, No. 2 pp. 159-176 13. Jaewon Choi, (2009),The Impact of Financial Leverage on Asset Pricing (Job Market Paper). 14. James M. Gahlon and James A. Gentry, (1982) On the Relationship between Systematic Risk and the Degrees of Operating and Financial Leverage; Financial Management, Vol. 11, No. 2, pp. 15-23. 15. Jie Cai, Zhe Zhang, (2008), Leverage change, debt capacity, and stock prices; 16. K. C. Chan and Nai-Fu Chen, (Sep., 1991) Structural and Return Characteristics of Small and Large Firms; The Journal of Finance, Vol. 46, No. 4, pp. 1467-1484 17. L. C. Bhandari, (1998)Debt/Equity Ratio and Expected Common Stock Returns: Empirical; The Journal of Finance. 18. Liming Guan, Don R. Hansen, Shannon L. Leikam, J. Shaw, Stable betas, size, earnings-to price, book-to-market and the validity of the capital asset pricing model. 19. Louis, Yasushi Hamao and Josef, (Dec., 1991), Fundamentals and Stock Returns in Japan; The Journal of Finance, Vol. 46, No. 5, pp. 1739-1764. 20. Markowitz, Harry, (1959), Portfolio selection: Efficient diversification of investments. 21. Merton H. Miller, (Jun., 1991) Leverage; The Journal of Finance, Vol. 46, No. 2, pp. 479-488. 22. Mohammed Nishat (unpublished), The Systematic Risk and Leverage Effect. 23. Mohun Prasadsing Odit, Hemant B. Chittoo, (2008), Financial Leverage And Investment; The Case Of Mauritian Firms. 24. Neal, Naka and Wansi, (Mar., 2004), Changing Risk, Return, and Leverage: The 1997 Asian Financial Crisis; The Journal of Financial and Quantitative Analysis, Vol. 39, No. 1, pp. 143. 25. Otavio Ribeiro de Medeiros, Paulo Roberto Barbosa Lustosa, Jose Alves Dantas, (unpublished), The Impact of the Degree of Operating Leverage on Stock Returns: An Empirical Study in the Brazilian Market; 26. R. Burt Porter, (2005) Connecting Optimal Capital Investment and Equity Returns; Financial Management, Vol. 34, No. 2, pp. 63-98.

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27. R.W. Faff, R. D. Brooks, Ho Yew Kee, New Evidence On The Impact Of Financial leverage On Beta Risk: A TIME SERIES APPROACH. 28. Robert M. Hull, (2008), Leverage Ratios, Industry Norms, and Stock Price Reaction: An Empirical Investigation of Stock-for-Debt Transactions. 29. Rosenberg, Barr, Kenneth Reid, and Ronald Lanstein, 1984, Persuasive evidence of market inefficiency, Journal of Portfolio Management 11, 9-17 30. Ross Stephen A, (1976), The arbitrage theory of capital asset pricing, Journal of economics theory. 31. Sanjay and Tripathi, Sources of Size Effect: EVIDENCE FROM INDIAN STOCK MARKET. 32. Sehgal and Tripathi, (2005), Size Effect in Indian stock Market: Some Empirical Evidence, The journal of business perspective. Vol. 9. No. 4. 33. Sharpe (1964), Capital asset prices: A theory of market equilibrium under condition of risk, The journal of finance, Vol 19 Issue 3, 425 442. 34. Stattman, D. (1980), Book Values and Stock Returns, The Chicago MBA - A Journal of Selected Papers, 4, pp. 25-45. 35. Ulf Axelson, Per Strmberg, Michael S. Weisbach, Leverage and Pricing in Buyouts: An Empirical Analysis: 36. Wong K.A. and M.S. Lye, (1990), "Market Values, Earnings Yields and Stock Returns", Journal of Banking and Finance. 37. Yew Kee Ho, Mira Tjahjapranata, Chee Meng Yap, (2006), Size, Leverage, Concentration, and R&D Investment in Generating Growth Opportunities, Journal of Business, vol. 79, no. 2.

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