The Journal of Developing Areas

Volume 51 No. 4 Fall 2017

TESTING STOCK MARKET EFFICIENCY AND

THE ASSET PRICING MODEL: SOME
EVIDENCE FROM SRI LANKA
Ravi Dilantha Rathnasekara
The University of Huddersfield, UK

ABSTRACT

This paper examined the Price-Earnings anomaly and the Capital Asset Pricing Model (CAPM) for
the Colombo Stock Exchange (CSE) in Sri Lanka over the period 2004 to 2013. Stock market
anomalies inevitably challenge the validity of the Efficient Market Hypothesis and the accuracy of
the asset pricing model used in measuring stock returns. Therefore, the accuracy of the asset pricing
model used to measure stock returns is in the centre of the market efficiency debate, and the CAPM
is an extensively applied asset pricing model in the Sri Lankan capital market. A stochastic version
of the CAPM time-series regression was therefore adopted in this study to estimate portfolio
abnormal returns as measured by Jensen’s Alpha. The analysis found systematically high abnormal
returns from portfolios of stocks with a low Price-Earnings ratio relative to the portfolios consisting
of stocks with a high Price-Earnings ratio. This suggests anomalous pricing behaviour in capital
market operations in Sri Lanka. Price-Earnings anomaly hypothesises either the CAPM is mis-
specified and/or capital markets are inefficient. If the CAPM appears to be a correctly specified asset
pricing model that accurately explains stock returns in response to their true level of systematic risk,
Price-Earnings anomaly evidently undermines the semi-strong form stock market efficiency. To shed
light on this joint hypothesis problem, the study investigated the accuracy of the CAPM. Results of
a two-pass regression approach similar to Black, Jensen and Scholes (1972) and Fama and Macbeth
(1973) empirical work indicated that the CAPM-beta does not appropriately explain stock returns in
Sri Lanka. As such, it appears that the CAPM suffers from omitted variable bias problem and hence
mis-specified. In the absence of statistically significant evidence to constitute accuracy of the CAPM,
Price-Earnings anomaly observed in this study appears to have been produced either by measurement
inconsistencies of the mis-specified CAPM or by a combined effect of both CAPM-misspecifications
and capital market inefficiency. From the policy front, market efficiency is an important attribute and
the accuracy of the asset pricing model is a vital strand in market efficiency tests. An investigation
of market anomalies using alternative asset pricing models such as Fama-French (2015) five-factor
model might be a potential area for future research. Asset pricing models are being constantly
investigated and these studies may find further specifications in the contemporary asset pricing
model.

JEL Classifications: B23, E5

Keywords: Cyclically-Adjusted-Price-Earnings Ratio, Price-Earnings Anomaly, Capital Asset
Pricing Model, Efficient Market Hypothesis, Portfolio Differential Returns (Jensen’s Alpha)
Corresponding Author’s Email Address: rdilantha@gmail.com
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INTRODUCTION

Accuracy of the asset pricing model used to measure stock returns is in the centre of the
market efficiency debate. Adherents of market efficiency hypothesis ascribe stock market
anomalies to the misspecifications of the asset pricing model. Mis-specified asset pricing
models are likely to conceal model defects in abnormal returns. As such, market anomalies
should be ideally tested using a correctly specified asset pricing model to shed light on
stock market efficiency. In Sri Lanka, there is a greater emphasis on the Capital Asset
Pricing Model (CAPM) in predicting stock returns. It is therefore one reason to use the
CAPM in this study over the contemporary asset pricing models evolved in the recent past
to estimate stock returns and test its effectiveness empirically. Stock market anomalies
inevitably challenge the validity of the Efficient Market Hypothesis and the accuracy of
the asset pricing model used in measuring stock returns. This is simply because abnormal
returns may derive from market inefficiency and/or misspecifications of the asset pricing
model used to measure stock returns. If the asset pricing model deployed in measuring
stock returns is incorrectly specified, market anomalies appear to have been produced
either by measurement inconsistencies of the mis-specified asset pricing model, or by a
combined effect of both model misspecifications and capital market inefficiency. Hence,
the test results on market efficiency would be inconclusive due to this joint hypothesis
problem. This research therefore intends to address this dilemma in a scientific approach.
There is an extensive literature considering stock market anomalies and asset
pricing models, but mostly in distinct research work. This means that earlier empirical
studies on these two strands have been carried out in isolation using different sets of data
in different time periods. Using the same set of data, this research paper investigates the
Price-Earnings anomaly and the accuracy of CAPM specifications to shed light on the
semi-strong form stock market efficiency in Sri Lanka for the period 2004-2013. In this
way, it is expected to reveal much precise evidence on the joint hypothesis problem in
market efficiency contention. The paper is in seven sections of which this is the first that
presents an introduction to the study. Section 2 presents a review of the literature on Price-
Earnings anomaly and the CAPM. Section 3 describes the data collection process. Section
4 explains the research design and methodology in examining the Price-Earnings anomaly.
Section 5 presents empirical results and a discussion. Section 6 specifies the CAPM testing
methodology and discusses empirical findings of the CAPM investigation. Section 7
concludes the paper highlighting potential areas for future research.

LITERATURE REVIEW

A large body of research on numerous market anomalies has evolved over the recent few
decades and challenged the market efficiency hypothesis. Basu’s (1977) Price-Earnings
anomaly and Banz’s (1981) size anomaly are such irrefutable findings in the literature.
Basu (1977) gave birth to the price-ratio hypothesis as he documented significantly higher
risk-adjusted abnormal returns from portfolios consisting of stocks with a low P/E ratio
than those from portfolios consisting of stocks with a high P/E ratio during 1957-1971 in
the US stock market. Price-Earnings (P/E) or Earnings to Price (E/P) anomaly appears to
have masked by the firm-size effect in subsequent work. Reinganum’s (1981) work
suggested the supremacy of the firm-size effect over the E/P effect as stock returns were
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controlled for firm-size, E/P anomaly had disappeared. Banz and Breen (1986) too
confirmed Reinganum’s (1981) results as they were unable to trace an independent E/P
effect. Nonetheless, Basu (1983) argued that it is the E/P effect that subsumes the size
effect when both variables are jointly considered. Goodman and Peavey (1986) concurred
with Basu (1983), asserting a strong P/E effect from their study. Jaffe, Keim and
Westerfield (1989) found that firm-size and E/P ratio jointly explain stock returns
extensively. Lakonishok, Shleifer and Vishny (1994) found superior performance from
value stocks over glamour stocks.
The Sharpe-Lintner CAPM implies that the differences in market beta among
different securities comprehensively explain the differences in stock returns across
securities. Recent empirical findings on stock market anomalies have challenged the
central theme of the CAPM. Some scholars have attributed market anomalies to the failure
in CAPM to capture the underlying systematic risk comprehensively (Chan and Chen,
1991; Bhandari, 1988; Friend and Blume, 1970; Banz, 1981). Banz (1981) found abnormal
returns from small-cap stocks. Chan and Chen (1991) ascribed that small firms bear higher
risk of distress which is not contemplated in the CAPM in explaining returns pertaining to
small-firm stocks. Bhandari (1988) found that high levered stocks had earned extra returns
over the level indicated by the market beta. Friend and Blume (1970) documented non-
zero differential returns which were inversely related to their respective risk levels
estimated by the CAPM-beta. Samarakoon (1997) found that the relationship between
average stock returns and beta in Sri Lanka is negative and it was statistically significant
during the study period from 1991 to 1997.
Fama and French (1992) observed a positive but statistically insignificant
relationship between stock returns and beta, and hypothesised that the ‘beta is dead’.
Consequently, a three-factor-model was proposed by Fama and French (1993) as a superior
asset-pricing model in substitution of the single-beta CAPM, encompassing factors relating
to firm-size and book-to-market equity in addition to the overall market risk factor in the
CAPM. Subsequently, Cahart (1997) introduced the momentum effect in addition to the
three factors in Fama-French (1993) model. A five-factor asset pricing model was proposed
by Fama and French (2015) infusing a measure based on profitability of firms and a
measure related to firms’ new net investments to their previously proposed three-factor
model. Hou, Xue and Zhang (2015) proposed their own versions of firm-size differential,
investments-to-assets differential and profitability differential between portfolios together
with the market excess return factor in their q-factor asset pricing model built on the
neoclassical q-theory of investment.

DATA COLLECTION

Share price data for this study were collated from the data files uploaded in the Colombo
Stock Exchange (CSE) data library and earnings statistics were extracted from the Annual
Reports of companies that were listed in the CSE. Data were gathered for 115-months from
June 2004 to December 2013. The test period reasonably covers a bear-market period (the
period from May 2007 to May 2009) and a bull-market period (the period from June 2009
to October 2010) that prevailed respectively before and after the war-end in Sri Lanka.
Firms with more than one type of traded stocks, investment trust funds and highly illiquid
stocks and stocks with negative P/E ratios were excluded from the sample. This filtering
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process resulted in sorting out 92 stocks for the study sample, which were trading on 1st
June 2004 in the CSE. Cyclically-Adjusted-Price-Earnings (CAPE) Ratios were computed
for each security in the sample using market prices prevailed at each period-end as the
numerator and immediately preceding 5-years’ average Earnings per Share (EPS) as the
denominator. Immediately preceding 5-years’ average EPS was used to smoothen out
earnings surprises of any particular one year. Campbell and Shiller (1988) used multi-year
earnings averages on the total stock index and suggested that annual earnings could be
noisy as a measure of fundamental value.

RESEARCH DESIGN AND METHODOLOGY

CAPE ratios were computed for each stock in the sample on 1st June 2004. Five portfolios
were formed (A=highest-CAPE, B, C, D, E=lowest-CAPE) and all securities in the sample
were allocated among these five portfolios in a manner that each portfolio comprises of 18
stocks (the odd number was equally allocated between the highest and the lowest CAPE
portfolios). Monthly portfolio returns were then computed assuming an equal initial
investment in each security in a portfolio and a buy-and-hold investment strategy. This
process is defined as a mutual fund scheme where each portfolio is acquired on 1 st June
2004, holding them for one year and reinvesting the disposal proceeds in the same class for
another one year. The process was repeated until 31st December 2013.

Portfolio Return Measures

Monthly portfolio returns (Rpt) were estimated using the following formula.

n
R pt   Ri xWi (1)
i 0

Where;
Ri – Monthly returns on ith stock in a portfolio at month-t
Wi – Weight of ith stock in a portfolio
n – Number of stocks in a portfolio

Portfolio Performance Measures

Jensen’s, Sharpe’s and Treynor’s portfolio measures were used in this paper to assess
portfolio performance. These measures estimate portfolio returns relative to their
underlying risk, which is an important attribute in capital market performance evaluation.

Jensen’s Alpha

The following stochastic version of the CAPM time-series regression as depicted in

equation-(2) was adopted to estimate portfolio differential returns (abnormal returns) as
measured by the intercept estimate (Jensen’s Alpha-αpt).
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R pt  R ft  ˆ pt  ˆ pt ( Rmt  R ft )   pt (2)
Where;
Rft – Monthly risk-free return at month-t
Rmt – Monthly return on the market portfolio at month-t
εpt – Independent error term
̂ pt – Estimated intercept (Jensen’s Alpha, the measure of differential returns)
ˆ pt – Estimated slope coefficient (Portfolio Beta, the measure of systematic risk)

Monthly excess returns on the market portfolio (Rmt – Rft) were regressed on
monthly excess portfolio returns (Rpt - Rft) in an Ordinary Least Squares (OLS) model. The
All-Share-Price-Index (ASPI) in the Colombo Stock Exchange was used as a proxy for the
market portfolio and three-month Treasury bill interest rate in Sri Lanka was used for the
risk-free rate of return in the above time-series regression equation-(2).

EMPIRICAL RESULTS AND DISCUSSION

Table-1 below depicts portfolio performance indicators including time-series regression

results of all CAPE-sorted portfolios formed on 1st June 2004. Portfolio betas (as measured
by regression slope coefficients) and differential returns (as measured by regression
intercepts) were estimated from time-series regressions using 115-monthly observations
from June 2004 to December 2013.

TABLE 1: PORTFOLIO PERFORMANCE INDICATORS (JUNE 2004-

DECEMBER 2013)

Portfolio Class A B C D E
Median CAPE ratio 29.07 14.15 10.18 7.23 3.94
Average monthly portfolio returns (Rp) 1.83% 1.91% 2.10% 2.13% 2.49%
Average monthly excess portfolio returns (R'p) 0.97% 1.05% 1.24% 1.28% 1.63%
Portfolio Beta (βp) 1.03 0.93 0.95 1.07 1.02
Treynor's measure (Tp) 0.95% 1.13% 1.31% 1.20% 1.60%
Sharpe's measure (Sp) 12% 15% 16% 14% 19%
Jensen's Alpha (αp) – differential returns 0.27% 0.41% 0.59% 0.55% 0.93%
t-statistic of αp 0.668 1.431 1.760 1.173 1.986†
Coefficient of correlation: ρ(R’p,R’m) 0.86 0.91 0.88 0.83 0.82
test-statistic of Augmented Dickey-Fuller (ADF) -9.181 -8.653 -8.982 -8.827 -7.861
unit root test in ‘level’
Coefficient of 1st order serial correlation: -0.119 -0.009 0.077 0.026 0.074
ρ(εpt+1,εpt) – Breusch-Godfrey test
LM-statistic of Breusch-Godfrey test 1.594 0.009 0.677 0.077 0.629
LM-statistic of White’s heteroscedasticity test 8.375† 0.967 3.738 1.552 2.959
FGLS estimates of αp (t-statistic in parenthesis) 0.26% No indications of heteroscedasticity
(0.680)

†Statistically significant at the 5% significance level

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Median CAPE ratios indicate the dispersion of stocks among five different CAPE-
sorted portfolio classes. The significance of coefficient of correlation (>0.80) between
excess portfolio returns and excess market returns implies a well-diversified nature of all
portfolios. By using stock returns data instead of price data in OLS estimations, a potential
non-stationarity problem was reasonably mitigated. However, the time series data were
tested for non-stationarity using a formal unit root test - Augmented Dickey-Fuller (ADF)
test. As reported in table-1, no indications of non-stationarity were found as testified by
low ADF test statistics than the critical value at the 5% significance level. First order serial
correlation is low for all portfolios indicated by low coefficients in Breusch-Godfrey test,
except a marginal increase in portfolio ‘A’. Rather than adjusting for consistency in
standard errors, a Feasible Generalised Least Squares (FGLS) approach was adopted to
correct for heteroscedastic errors in portfolio ‘A’ and a modified intercept estimate
(Jensen’s Alpha) was presented together with its t-value.
Table-1 shows that average monthly portfolio returns increase as one moves from
the highest-CAPE portfolio to the lowest-CAPE portfolio (i.e., from portfolio ‘A’ to ‘E’).
Differential returns as measured by Jensen’s Alpha (αp) indicate risk-adjusted abnormal
returns above the level implied by the CAPM. The low-CAPE portfolios show higher
differential returns than those from the high-CAPE portfolios. Portfolio ‘A’ (the highest-
CAPE portfolio) has reaped a 0.26% monthly abnormal return in excess of the level implied
by the CAPM-beta. However, the significance test given by the t-statistic is not substantial
to confirm that the abnormal returns earned from portfolio ‘A’ is statistically significant at
the 5% significance level. In contrast, portfolio ‘E’ (the lowest-CAPE portfolio) has earned
a 0.93% monthly abnormal return above the level implied by the CAPM and it is
statistically significant. Therefore, at the 5% statistical significance, there is overwhelming
evidence to confirm the superior performance of the lowest-CAPE portfolio relative to the
highest-CAPE portfolio. This superior performance from the lowest-CAPE portfolio
(portfolio ‘E’) compared to the highest-CAPE counterpart (portfolio ‘A’) is not related to
a higher level of risk attached to the lowest-CAPE portfolio. In fact, portfolio ‘E’ has a
slightly lower beta (1.02) than portfolio ‘A’ (1.03).
Figure-1 exhibits that excess portfolio returns have located above the CAPM line
and consequently positive abnormal returns (as indicated by a positive intercept, α p) have
appeared from all portfolios. The difference in abnormal returns between the highest-
CAPE portfolio (portfolio ‘A’) and the lowest-CAPE portfolio (portfolio ‘E’) is 0.67% per
month (annualised to 8.0%). This means that after allowing for differences in the level of
systematic risk of the two portfolio classes, the investors who chose portfolio ‘E’ (the
lowest-CAPE portfolio) earned an 8.0% higher return annually over those investors who
chose portfolio ‘A’ (the highest-CAPE portfolio). This runs contrary to the market
efficiency theory as it offers the investors to embrace an investment strategy to earn higher
risk-adjusted abnormal returns by mere ranking of stocks based on their P/E ratios and
investing in portfolios consisting of stocks with a low P/E ratio.
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FIGURE 1: AVERAGE MONTHLY EXCESS RETURNS OF CAPE-SORTED

PORTFOLIOS (JUNE 2004-DECEMBER 2013)

1.80%
Portfolio E - the
1.60% lowest CAPE
1.40%
M R
E Portfolio C
o e 1.20%
x
Portfolio B Portfolio A Portfolio
- D
n t 1.00%
c the highest
t u CAPE
e 0.80%
h r
s Excess returns
l n 0.60%
s predicted by the
y s 0.40% CAPM
0.20%
0.00%
0.9 0.95 1 1.05 1.1
Portfolio Beta

Treynor’s and Sharpe’s measures too suggested superior performance of low-

CAPE portfolios over the high-CAPE counterparts during the period of this study. Under
the assumptions of market efficiency and a correctly specified CAPM, differential returns
(Jensen’s Alpha) should not be significantly different from zero for all portfolios.
Therefore, the perceived Price-Earnings anomaly is a result of either capital market
inefficiency or a serious misspecification problem inherited in the CAPM in measuring
portfolio returns. If the CAPM is accurately specified, then Price-Earnings anomaly
evidently emphasises stock market inefficiency in Sri Lanka. Therefore, it is imperative to
test the validity of the CAPM to shed light on the market efficiency.

TESTING CAPM SPECIFICATIONS

It is noteworthy to emphasise empirical difficulties in testing the CAPM. As Roll (1977)

argued, the true market portfolio contains all types of assets in the universe not only stocks,
making it infeasible to define in an empirical research. In light of this, the ability to test the
CAPM perfectly is never possible. However, Stambaugh (1982) revealed that a test of the
CAPM is not sensitive to expanding the market proxy beyond common stocks primarily
due to the dominance of common stocks in determining volatilities of market returns. Fama
and French (2004) posited that a market proxy that lies on the minimum-variance-frontier
which reasonably describes the differences in stock returns may well be sufficient for the
purpose. Moreover, owing to the measurement error bias in beta estimations, the OLS
estimators may suffer from errors in variable problem. To minimise the biasness of beta
measurement errors, the portfolio approach was adopted. Portfolio betas better define the
systematic risk than individual stock betas. However, due to a small number of stocks in
 324

the sample, the study suffered from an inherent drawback in forming perfect portfolios in
a manner that minimises the idiosyncratic risk. The CSE being a small stock exchange in
terms of size is subject to higher volatilities that generally require a large number of
securities in portfolios to minimise unsystematic risks.

CAPM Testing Methodology

Consistent with Black, Jensen and Scholes (1972) and Fama and Macbeth (1973)
methodology, a two-pass regression approach was adopted in this research to test the
CAPM. The results are also discussed in the context of findings by Fama and French
(2004). As such, individual stock betas were estimated in the first stage from time series
regressions in accordance with equation-(2) using a prior period data-set (i.e., an
immediately preceding 2-year period from 1st June 2004). Based on individual stock betas
so estimated, stocks were grouped into ten beta-sorted portfolios (1=the lowest beta
portfolio, 10=the highest beta portfolio) on 1st June 2004. Monthly returns on each of these
10 beta-sorted portfolios were computed assuming an equal initial investment in each
security within portfolios and a buy-and-hold investment strategy. Monthly excess returns
on the market portfolio (Rmt - Rft) were then regressed on monthly excess returns on each
of these beta-sorted portfolios (Rpt - Rft) over 115-months period (from June 2004 to
December 2013) using the time-series regression equation-(2). This process produced
portfolio betas (as measured by slope coefficients) and differential returns (as measured by
intercept estimates). It is reasonably assumed that this procedure mitigated both errors-in-
variable and measurement-error-bias problems by first estimating individual stock betas
using a prior period data-set (i.e., prior to 1st June 2004) to group stocks into beta-sorted
portfolios on 1st June 2004 and then conducting time series regressions to estimate portfolio
parameters. The following cross-sectional regression model was used in the second stage
to test the CAPM specifications.
R p  ˆ  ˆ p   (3)
Where;
R’p - Average excess portfolio returns (Rp - Rf)
βp – Portfolio betas estimated from pass-one regressions
Ҫ – Independent error term
̂ - Regression intercept
ˆ – Slope coefficient of βp
Testing Hypotheses

The null hypothesis and the alternative hypothesis were constructed as follows.

Null Hypothesis – The CAPM is not mis-specified

If the CAPM is a correctly specified asset pricing model that explains stock returns
accurately, which means that the CAPM-beta is a complete measure of systematic risk,
then,
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- the intercept (µ) of the above cross-sectional regression equation-(3) should not
be significantly different from zero :-
t-value of deviation ~ critical value of the test statistic t0.95,(N-1) and,
- the slope coefficient (δ) should be statistically significant and it should not be
significantly different from excess returns on the market portfolio (Rm – Rf) :-
t-value of deviation ~ critical value of the test statistic t0.95,(N-1).

This means that when portfolio betas (βp) are regressed on average excess portfolio returns
(Rp – Rf) in a cross sectional regression, the above two conditions should be satisfied in
order to confirm the CAPM specifications under the null hypothesis.

Alternative Hypothesis – The CAPM is mis-specified

For the acceptance of the null hypothesis, it is required to satisfy both the conditions in
significance tests, which means that a statistically significant beta coefficient (δ) and
statistically insignificant deviations of slope (δ) and intercept (µ) estimates from the
theoretical parameters implied by the CAPM. Accordingly, if t-values of deviations from
the theoretical parameters are statistically significant or the t-value of the beta coefficient
(δ) is not statistically significant at the 5% significance level, it will lead to rejection of the
null hypothesis that the CAPM is not mis-specified.

Empirical Test Results of the CAPM

Pass-one Time Series Regression Results

Table-2 below depicts the empirical results of 10 beta-sorted portfolio classes derived from
pass-one time-series regressions.

TABLE 2: PASS-ONE OLS TIME-SERIES REGRESSION RESULTS OF 10

BETA-SORTED PORTFOLIOS (JUNE 2004-DECEMBER 2013)

Beta Coeffici Test- Coefficient of LM

sorted βp R’p αp t(αp) ent of statistic first order statistic
portfolio correlati of ADF serial of
class on unit root correlation White’s
ρ(R’p, test in ρ(εpt+1, εpt)– heterosce
R’m) ‘level’ (LM statistic of dasticity
B-G test in test
parentheses)

1 0.44 1.62% 1.32% 2.230† 0.44 -10.640 -0.156 (2.54) 0.37

2 0.66 1.25% 0.80% 1.151 0.53 -10.033 -0.069 (0.54) 0.83
3 0.80 0.61% 0.06% 0.162 0.83 -9.194 -0.021 (0.05) 8.23†
4 0.90 0.65% 0.04% 0.107 0.84 -9.169 -0.090 (0.92) 33.30†
5 0.98 1.03% 0.36% 0.697 0.78 -9.648 -0.047 (0.25) 1.11
6 1.06 0.75% 0.02% 0.070 0.90 -9.555 -0.167 (3.20) 5.59
7 1.13 1.27% 0.50% 1.333 0.90 -8.714 0.054 (0.33) 8.43†
8 1.20 1.30% 0.49% 1.128 0.88 -8.575 0.045 (0.23) 1.94
9 1.29 2.01% 1.13% 2.157† 0.85 -8.803 -0.034 (0.13) 2.85
10 1.51 1.98% 0.95% 1.401 0.83 -8.511 0.072 (0.60) 22.31†

†Statistically significant at the 5% significance level

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Portfolio risk measured by portfolio beta ranges from 0.44 (assigned to portfolio
1) to 1.51 (assigned to portfolio 10). ADF test was used to investigate non-stationarity and
no evidence of non-stationarity was found. A reasonably higher level of coefficient of
correlation between excess portfolio returns and excess market returns indicates a well-
diversified nature of portfolios. Even though portfolio 1 and 2 show a lower level of
coefficient of correlation, there were no indications of persisting non-stationarity,
autocorrelation and heteroscedasticity in those two portfolios. Coefficients of first order
serial correlation are low and statistically insignificant for all portfolios. OLS parameter
estimates of the following portfolios were corrected for heteroscedasticity through
weighted least squares approach using an FGLS model.

Portfolio Class FGLS Estimates (t-values in parentheses)

αp βp
3 0.08% (0.226) 0.78
4 0.03% (0.085) 0.92
7 0.49% (1.351) 1.14
10 0.96% (1.561) 1.58

As depicted in Figure-2 below, portfolio differential returns as measured by

Jensen’s Alpha show consistently positive values. The CAPM implies a zero intercept
when market-beta entirely explains excess portfolio returns, as given by; αp = (Rp – Rf) –
[βp(Rm – Rf)] = 0.

FIGURE 2: PORTFOLIO DIFFERENTIAL RETURNS (AS MEASURED BY

JENSEN’S ALPHA) OF BETA-SORTED PORTFOLIOS (JUNE 2004-
DECEMBER 2013)

1.40%
D
i 1.20%
f
R 1.00%
f
e
e 0.80%
t
r
u 0.60%
e
r
n 0.40%
n
t
s
i 0.20%
a
l 0.00%
0.40 0.60 0.80 1.00 1.20 1.40 1.60
Portfolio Beta
 327

Non-zero differential returns therefore indicate departures from the theoretical

returns implied by the CAPM. If stock markets are assumed to be efficient, such deviations
indicate the CAPM’s imperfection to accurately estimate stock returns in relation to their
true level of risk. However, the t-values in significance tests are not conclusive to constitute
such departures from theoretical estimates are significant at the 5% significance level as
only two portfolios (portfolio 1 and 9) indicate statistically significant differential returns.
These t-statistics may perhaps be understated due to imperfect grouping of stocks into
portfolios, which was an inherent limitation in this study.

Pass-two Cross-sectional Regression Results

Portfolio betas estimated from pass-one time series regressions were used as the
explanatory variable in pass-two cross-sectional regressions to test the accuracy of the
CAPM. Instead of estimating a single cross-sectional regression, year-by-year cross-
sectional regressions of portfolio betas on excess portfolio returns were estimated. The
average of slope coefficients and intercepts together with their mean standard errors were
used to test the accuracy of CAPM specifications. Results are depicted in table-3 with t-
values in parentheses.

TABLE 3: PASS-TWO CROSS-SECTIONAL REGRESSION RESULTS (JUNE

2004-DECEMBER 2013)

Regression Parameter CAPM’s theoretical Standard t-value of deviation

Parameter estimates of cross specifications error
sectional
regressions

Intercept (µ) 0.0059 (0.4536) Zero 0.0130 0.4536

Slope (δ) 0.0091(0.7329) 0.0068 (monthly 0.0124 0.1843

average excess
returns on the
market portfolio)
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FIGURE 3: AVERAGE MONTHLY EXCESS RETURNS OF BETA-SORTED

PORTFOLIOS (JUNE 2004-DECEMBER 2013)

2.50%
A
v
e 2.00%
r
R
a
e
g 1.50%
t
e
u
r 1.00% Linear
E A hypothetical
n relationship
x flatter
s found in this
c study relationship
e 0.50% found by Fama
Excess returns and French
s
predicted by the (2004, p.33)
s CAPM
0.00%
0.10 0.30 0.50 0.70 0.90 1.10 1.30 1.50 1.70
Portfolio Beta

Figure-3 depicts the actual excess return regression line together with the
theoretical line estimated by the CAPM. The empirical relationship between excess
portfolio returns and portfolio beta indicates a non-zero intercept. Fama and French (2004)
found a flatter relationship between portfolio betas and differential returns than the
theoretical line predicted by the CAPM. Their finding is hypothetically depicted by a dash-
line in figure-3 for comparison purpose. During the period of this study, average monthly
excess returns on the market portfolio was 0.68%. This was derived by subtracting average
monthly risk free rate of 0.86% from average monthly returns on the market portfolio of
1.54%. The average of slope coefficients of year-by-year cross-sectional regressions
indicates 0.91% as reported in table-3. However, the t-value of the deviation of average
slope coefficient from the theoretical slope coefficient is insignificant. The average of
intercept estimates of cross-sectional regressions indicates 0.59%. A non-zero critical
intercept runs contrary to the CAPM. However, the t-value of the intercept deviation is not
statistically significant. Under the null hypothesis, there is no overwhelming evidence to
confirm that the parameter estimates significantly depart from the CAPM’s theoretical
parameters. However, more importantly, the t-value of beta coefficient is not statistically
significant to confirm that the relationship between excess portfolio returns and portfolio
beta is significant as implied by the CAPM. In view of this, the evidence found in this paper
is consistent with the notion of ‘powerless beta’ (Fama and French, 2004) in explaining a
cross-section of portfolio returns in Sri Lanka. Consequently, the null hypothesis that the
CAPM is not mis-specified is rejected.
 329

CONCLUSIONS

Findings of this paper in relation to the Price-Earnings anomaly in Sri Lanka is consistent
with Basu’s (1977) price-ratio hypothesis, confirming the low P/E portfolios’ ability to
generate higher risk-adjusted abnormal returns than those from the high P/E portfolios.
This predictability nature of stock returns based on the P/E ratio confronts the semi-strong
form stock market efficiency in Sri Lanka. However, a precise conclusion on stock market
efficiency can be inevitably established if the asset pricing model used to measure stock
returns is evidently proved as correctly specified. Price-Earnings anomaly documented in
this paper posits the joint hypothesis dilemma. That is, if the CAPM holds correct, the
price-ratio hypothesis clearly disrupts the Efficient Market Hypothesis. If the CAPM is
incorrectly specified, Price-Earnings anomaly appears to have been produced either by
measurement inconsistencies of the CAPM that used to measure stock returns, or by a
combined effect of both CAPM-misspecifications and capital market inefficiency.
Therefore, the accuracy of the asset pricing model plays a vital role in market
efficiency tests. In this context, this study did not find substantial evidence to confirm the
accuracy of CAPM specifications in Sri Lanka. The CAPM-beta did not demonstrate a
strong explanatory power in explaining a cross-section of portfolio returns. As such, it
appears that the CAPM suffers from omitted variable bias problem and the P/E ratio seems
to have a reasonable explanatory power on a cross-section of portfolio returns than the
single market-beta. Therefore, the perceived Price-Earnings anomaly could not be fully
accredited to stock market inefficiency in the absence of conclusive evidence to confirm
the accuracy of the CAPM. It is hence concluded that the Price-Earnings anomaly found in
this study is a result of either misspecifications of the CAPM or a combined effect of both
stock market inefficiency and CAPM-misspecifications. An investigation of market
anomalies using contemporary asset pricing models such as Fama-French (2015) five-
factor model might be a potential area for future research.

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