Quality factors explaining returns on the FTSE/JSE All-Share

Master Thesis


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University of Cape Town

The research done on style 'anomalies' such as the book-to-market and the size effect have found that these idiosyncratic factor s explain returns better than Beta. These findings have led has to an increased importance of idiosyncratic factors in explaining returns, which is contrary to the popular Capital Asset Pricing Model (CAPM). CAPM only considers Beta or systematic risk in explaining returns and disregards idiosyncratic risk. This paper has an even greater focus on idiosyncratic factors, by testing company specific factors with no reference to market valuation. These are defined as 'quality' factors for the purposes of this paper. The paper done by Asness, Frazzini, and Pedersen (2013), found that quality stock s earned excess returns in 23 of the 24 countries that they tested. This paper followed a similar approach with respect to the definition of quality and tested whether these 'quality' factors have explanatory power on the FTSE/JSE All-Share. The explanatory power of the 'quality' factors are then combined and compared with some of the style 'anomalies'. The results found that nine of the quality factors from the single regression analysis, over the entire period from the 1st of January 1994 until the 1st of November 2014 were significant at a 95% level of confidence. The following 'quality' factors were found significant and are ranked according to the absolute t-statistics:: Accruals ratio (ACCRUALS), cash flow return on equity (CFROE), 12-month growth in earnings per share (EPS12M), 12-month growth in cash flow return on equity (CFROE12M), 24-month growth in cash flow return on equity (CFROE24M), 12-month growth in EBITDA margin (EBITDAMARG12M), 36-month growth in cash flow return on equity (CFROE36M), interest coverage before tax (ICBT), return on total capital (ROC). In the single regression results the ACCRUALS ratio ranked higher than the book-value-to-market and the earnings yield. The CFROE also exhibited a higher level of significance than the earnings yield. In the multiple regression analysis for all factors, the following factors which are ranked according to absolute t-statistics were found to be significant : book-value-to-market, cash flow return on equity (CFROE), 12-month growth in earnings per share (EPS12M), 18-month volatility in return on equity (ROEVOL18M) and the accruals ratio (ACCRUALS). Finally the cumulative payoff results are consistent with the results found in the regression analysis. In terms of cumulative payoff the ACCRUALS factor ranked first and the CFROE factor ranked fifth. The ACCRUALS and CFROE factors also had the highest and fifth highest Sharpe ratio respectively. A single 'quality' factor composite of the significant factors found may have an important role to play in asset pricing, due to the high explanatory power and stable positive relationship with returns on the FTSE/JSE All-Share.