Usefulness of book-to-market ratio and strength of future residual incomes to predict future stock returns

In the past academic research have displayed strong evidence that stocks with the relatively low valuation earn higher future returns than stocks with relatively high valuation. This kind of value anomaly seems to exist for example between firms with high and low book-to-market ratio. In addition there is a lot of evidence that future stock returns can be predicted by analyzing past financial information. Especially the value relevant fundamentals which are usually the main components of equity valuation models seems to consist useful information about the future stock prices. In this thesis it is investigated if the investment strategy based on book-to-market valuation ratio and the main fundamental components of residual income valuation model can generate abnormal future stock returns. Strategy focuses on high book-to-market firms which past financial information indicates strong future residual incomes for these firms. These pieces of information are recognized by analyzing the return on equity and expected return on equity which are the main components of residual income model. The results shows that investment strategy based on book-to-market ratio and strength of future residual incomes generates higher mean returns than equally weighted market portfolio in the U.S markets during the years 1970–2010. Furthermore the strategy outperforms high book-to-market portfolio by mean return margin of 11.5%-points. Strategy seems to be quit robust across time as well when it is outperforming equally weighted market and high book-to-market portfolios almost 80% of the time. The returns appears to be highest among firms with the smallest market value and lowest among the large-sized firms. However the benefits of using fundamental based screening are stronger among medium-sized firms which indicates that superior return performance of the investment strategy is not driven by small firm effect. It seems also that the superior returns are not at least fully compensation for extra risk. Actually the strategy prefers the stocks with the low earnings variability and leverage together with high liquidity which are argued to be appropriate proxies for risk. Also the explanation of Fama and French (1992) which argues that abnormal returns of high book-to-market firms are due high distress of these firms is not supported by results presented in this thesis. In fact the strategy prefers firms with low distress and still generates higher mean returns than high book-to-market firms on average. This indicates that there could be undervalued stocks in the market which are successfully identified by investment strategy based on valuation ratio and analyzing past financial information