Stock Returns Predictability Using Financial Ratios in Malaysia

Abstract

Stock return predictability is important to maintain confidence and liquidity in a stock market. The conventional theory on stock price behaviour, the Efficient Market Hypothesis, posits that stock return predictability is not possible. This study considers the Adaptive Market Hypothesis to explain the predictability of stock returns in Malaysia using financial ratios as predictor variables. The Adaptive Market Hypothesis is gaining prominence to explain stock behaviour. However, studies have been mixed and limited. This study contributes to the empirical evidence on the relationship of financial ratios to return of stock in emerging markets, specifically Malaysia. Purposive sampling is employed to select the listed companies from the Malaysia Stock Exchange, which are then filtered based on three criteria to arrive at a sample of 392 companies. For predictor variables, seven financial ratios have been identified for their predictive strength to stock returns. This study employs panel data to formulate the multiple predictive regression. The regression model determined is the fixed effects regression with robust standard error. Results show that the relationship to stock returns is significant for the predictor variables of earnings yield, dividend yield, book-to-market ratio, return on assets, current ratio and assets turnover. The relationship between debt-to-equity ratio and stock returns is not significant. The findings show that financial ratios have predictive strength to stock returns in the Malaysia market. To improve on the explanatory strength, it is suggested for future research to incorporate external factors such as GDP, inflation or other economic factors such as interest and exchange rates.