Predicting Stock Returns in a Cross-Section: Do Individual Firm Characteristics Matter?

It is a common wisdom that individual stocks’ returns are difficult to predict, though in many situations it is important to have such estimates at our disposal. In particular, they are needed to determine the cost of capital. Market equilibrium models posit that expected returns are proportional to the sensitivities to systematic risk factors. Fama and French (1993) three-factor model explains the stock returns premium as a sum of three components due to different risk factors: the traditional CAPM market beta, and the betas to the returns on two portfolios, Small Minus Big (the differential in the returns on stocks of small and big companies) and High Minus Low (the differential in returns on the of companies with high and low price-to-book ratio). The authors argue that this model is sufficient to capture the impact on returns of companies’ accounting fundamentals, such as earnings-to-price, cash flow-to-price, past sales growth, long term and short-term past earnings. Using a panel of stock returns and accounting data from 1979 to the end of 2008 for the companies listed on NYSE, we show that this is not the case, at least at individual stocks’ level. According to our findings, fundamental characteristics of companies’ performance are of higher importance to predict future expected returns than sensitivities to the risk factors. We explain this finding within the rational pricing paradigm: contemporaneous accounting fundamentals may be better proxies for future sensitivity to risk factors, than sensitivities, estimated from historical data.