Explaining the Cross-section in Excess Returns

Magnus Seerup Jensen

Student thesis: Master thesis

Abstract

The purpose of this thesis is to explore how well selected economic variables explain the excess return on the Danish stock market. The purpose is formulated in the following problem formulation: “What has been the determining factor of high-performing stocks on the Danish stock market between 2008- 2018?” According to the CAPM, the beta value alone should be sufficient to explain stock returns. However, the conceptual framework and literature review show that the beta value is not entirely adequate for accounting for the cross-section in stock returns. Based on a review of related work, multiple economic variables that have previously been linked to stock returns are selected. In order to answer the problem statement above, quarterly stock data for the KAX Index between 2008 and 2018 is extracted from Bloomberg. The 20 percent stocks with the highest cumulative CAPM-adjusted return are assigned to a winner portfolio. It is the average excess return of this portfolio that function as the dependent variable. A multiple regression is set up for the sample period as well as two subperiods. The study finds a significant relationship between the average excess return and five of the nine variables considered – they are, FCF-yield, firm size, financial leverage, interest rate and ROIC. Especially the interest rate and FCF-yield are strongly related to the excess return. This thesis detects a zero correlation between firm size and the excess return; it can, however, not be rejected that a nonlinear relationship exists. Furthermore, the paper only finds very limited support that value investing can explain the excess return. The evidence from this thesis indicates that the market at the beginning of the sample period is lowpriced and normalizes towards 2018 just as the observed correlations seem to be dependent on the portfolio composition, i.e. there is a bias towards stocks that have been less affected by the financial crisis rather than cheaper stocks which would do well when economic fundamentals are improving The thesis concludes that the Danish stock performance between 2008 and 2018 in particular seems to be determined by the economic conditions, including the interest rate level. Based on this study, there seems to be no advantage in investing in stocks with certain characteristics, such as low P/E ratios or high leverage.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2019
Number of pages120