An Empirical Analysis of the Relationship between Fundamentals and Stock Returns in Sri Lanka

This study investigates the ability of market beta, book-to-market equity, leverage, and earnings-price ratio to explain the cross-sectional variation in expected returns in the stock market of Sri Lanka. The sample of the study consists of a total of 88 companies which are listed on the Colombo Stock Exchange, and covers a six-year period from October 1991 to September 1997. The informal tests examine average returns and averages of fundamental variables for portfolios formed on the basis of size alone, beta alone, and size and beta. The formal asset-pricing tests use the Fama-MacBeth (1973) cross-sectional regression procedure. In the formal tests, returns are regressed on beta, size, book-to-market-equity, leverage, and earnings-price ratio, both individually and jointly, in every month in the cross-section. The results show that, inconsistent with the central prediction of the Capital Asset Pricing Model, the relation between average returns and beta is strongly negative. Earnings-price ratio shows a reliable positive relation with average returns. Market beta and earnings-price are strongly related to returns jointly as well. Firm size, BE/ME, and leverage are not related to average returns in any significant manner.The negative beta-effect and positive E/P-effect found in this study have practical implications for investor in the Sri Lankan stock market. The most important message is that higher market risk may not result in higher average returns. On the contrary, stocks of firms with low market risk may produce higher average returns. This implies that fundamental analysis that is based on the widely used positive relation between market risk and returns may not work in Sri Lanka. The positive E/P-effect implies that stocks with higher earnings-price ratio tend to produce higher average returns