**1. Introduction**

Asset pricing models are used to evaluate risk and return structure of stocks, and facilitate individual investors and institutions in planning and managing their portfolios. A list of models is available to assist investors and financial managers in predicting the expected return for their targeted stocks. However, two models are alternatively and widely used for this purpose. The first one is the Capital Asset Pricing Model (CAPM), developed by Sharpe (1964), Lintner (1965) and Mossin (1966). The second one is the three-factor model proposed by Fama and French (1993).

CAPM measures the sensitivity by a single factor: security's beta coefficient with a mean-variance coefficient of the market portfolio. In the early 1970s, CAPM, with its single factor to measure risk for a security, was widely used to facilitate the investors. Later, studies related to intertemporal asset pricing models (Merton 1973; Breeden 1979), arbitrage pricing theory (Ross 1976), size effect (Banz 1981; Reinganum 1981; Keim 1983), and book to market (value) effect (Rosenberg et al. 1985) and (Chan et al. 1991), highlighted some other variables having considerable effect on the relationship between average returns and systematic risk, that had remained unconsidered employing the single factor model, CAPM. These contributions helped to identify systematic risk empirically, which would not have been possible with the former abstracted and theoretical model.

The empirical validity of CAPM was struck down by the Fama and French (1992), which suggested that beta (β) is unable to fully capture the variations in cross-sectional expected returns. Later on, size (SMB) and book-to-market (HML) factors were also added as an extension of the CAPM (Fama and French 1993). It has been discussed that the three-factor model provides a better explanation as compared to CAPM in many countries.

Recently, Fama and French (2015) proposed a five-factor model which added investment (CMA) and profitability (RMW) as new factors into the existing three-factor model. However, the model is reportedly unable to explain the low average returns on small stocks, the returns of which are similar to those of firms with low profitability but high investment level. Elliot et al. (2016) discussed that such stocks are only a small fraction of the US market, but the case is different across global markets. They demonstrated that the newly added factors have limited explanatory power for these stocks. Moreover, the contribution of the value factor has been significantly diluted by the two new factors in terms of explaining the average returns; therefore, it has been suggested that the three-factor model generally fits well with Shanghai stock exchange (SSE) A-share market (Xie and Qu 2016).

The economic rationale (risk-based interpretation) behind the newly added factors (i.e., investment and profitability factors) has been criticized in recent studies (Ülkü 2017) and (Ali and Ülkü 2018). It has been explained that factors generally represent risk attributes (e.g., SMB and HM), while CMA and RMW are derived from the dividend discount model. Further, these factors capture mispricing away from 'value', caused by noise trading and the weekend sound-mind effect. Kubota and Takehara (2017) examined the five-factor model for the Japanese market. They concluded that the Fama-French's five-factor model is not the best benchmark for stocks traded at the Japanese stock market. Thus, the paper focuses on the three factors; size premium, value premium and the market risk premium.

In the context of Pakistan, Iqbal and Brooks (2007) analyzed the Fama-French three-factor model and CAPM for the stocks traded at Karachi stock exchange (KSE). They discussed that risk factors in the three-factor model are more significant. Mirza and Shahid (2008) deployed a multivariate framework to test the validity of the three-factor model. They included the stocks of financial firms as well; the results generally supported the three-factor model.

The Fama-French three-factor model has been widely applied to most of the developed and emerging markets; however, the model has been least applied to the emerging south-Asian market, Pakistan. This might be due to the small size of the market and the difficulty in assembling enough stocks to construct the underlying portfolios of this model in earlier decades. For instance, prior studies on KSE such as Iqbal and Brooks (2007), Mirza and Shahid (2008) and Javid and Ahmad (2008), which used a fixed number of stocks, ranging between 49 and 90 stocks, may have suffered from small sample problems. Moreover, the sample period in these studies either includes only bull rally between 2003 and 2007 or includes Asian-crises (1997), political instability in Pakistan (1999) and US-Afghan war (9/11); due to these events investment behaviors remained alert and risk averse. Hence, their results cannot be considered robust.

Fama-French excluded financial firms from their series of studies. They stated that "the stocks of financial firms are thinly traded and the financial firms tend to have higher financial leverage, but for non-financial firms, high leverage has a different meaning and can be considered as financial distress" (Fama and French 1992). Most of the studies followed the same approach and excluded the stocks of financial firms while empirically testing the three-factor model on various stock markets.

Pakistan shares the 'typical characteristics' and features of an emerging market, such as thick tails accompanied with excess kurtosis in the return distribution, high return with excessive volatility, and low market capitalization but high trading volume (Khwaja and Mian 2005). The special characteristics of financial firms in Pakistan, such as liquidity, active participation, and a large fraction of the market value of these firms to total market value of the index are rarely discussed in the literature. These characteristics are different as compared to the US and other developed stock markets discussed in Fama and French (1998, 2017), where stocks of financial firms are thinly traded and do not make up a large fraction of the total market value of the index.

Modigliani and Miller (1958, 1963) explain in theoretical language that the risk profile (beta) of the firm can be affected by leverage but it does not invalidate the fundamental principal of the asset pricing model. Therefore, it is better if the pricing model is generally applied, rather than restricted to nonfinancial firms only. Motivated by the Modigliani-Miller theory, Baek and Bilson (2015) assessed the size and value factors to measure the cross-section of expected stock return in financial and non-financial firms of US stock market. The empirical results suggested that size and value premiums commonly exist in both financial and non-financial firms. Therefore, we include both (financial and nonfinancial firms), as we believe that exclusion of financial sector firms is not justified in the case of Pakistan.

For the application of the three-factor model, factors formation methodology plays the most important role. In this regard, Xu and Zhang (2014) document the empirical evidence and identify some drawbacks that arise in the application of the three-factor model to Chinese stock returns. In order to evaluate the effect of several special features in China, they experiment with different ways to construct the three factors. Their results illustrate that the construction of the three factors can have a significant impact in empirical studies that apply the Fama-French's three-factor model. Further, Vo (2015) and Xie and Qu (2016) also discussed the applicability of the three-factor model by considering the special features of the Australian stock market and the SSE (A shares) China, respectively.

However, in the context of the Pakistani stock market, it is still unclear whether the portfolio construction should be based on Fama-French (i.e., to exclude the stocks of financial firms), or on adapting the strategy of keeping fixed number of stocks, similar to the previous studies on KSE, or on including stocks of both financial and non-financial companies as well as new firms.

To adjust for the small sample problem, a unique feature of KSE and the investment behaviors across the diverse economic conditions, this article uses a larger dataset (2002–2015) as compared to any previous study on KSE. A comparatively larger dataset containing all the liquid stocks to avoid the illiquidity factor (zero returns), is expected to improve the power of the tests and will capture variation in stock returns beyond any previous study on KSE. The paper argues for the importance of the special features in the Pakistani market and compares three different factors construction methodologies which may significantly affect the performance of the three-factor model. The three different constructed baskets of stocks are: 'fixed basket', 'non-financial basket' and 'variable basket'. The fixed basket includes only those stocks which survive the entire sample period, the non-financial basket and variable basket include (exclude) companies into (from) the basket every year upon meeting (differing from) the sample selection and criteria limitations. The variable basket includes all the stocks, whilst the non-financial basket only includes non-financial stocks.<sup>1</sup>

The summary statistics, reported in Table 1, confirm that the monthly returns on the factor portfolios in three different scenarios are somewhat different from each other. For example, the fixed basket generates approximately 5.66% per annum size premium, whereas the non-financial and variable baskets generate approximately 9.14% and 9.15% per annum, respectively. The value premium for the fixed basket is approximately 11.25% per annum, whereas the non-financial and variable baskets generate approximately 15.04% and 12.27% per annum, respectively. The significance of these factors also varies. The value premium is significant at a 5% level in each of the portfolio construction methodologies. Conversely, SMB is statistically insignificant for the fixed basket, significant at 10% level for the non-financial basket, and significant at 5% level for the variable basket.

<sup>1</sup> See Section 3.4 of this paper for further details.


**Table 1.** Descriptive statistics: comparing three different methods of constructing factors.

Note: Authors calculation. The table reports the comparison of descriptive statistics of size (SMB) and value (HML) premiums between the fixed basket, non-financial basket and variable basket. The sample period is 2002:01–2015:12, \*\*\* and \*\* indicate significance at 10 and 5% level, respectively. Source: the official website of the Pakistan stock exchange (https://www.psx.com.pk/) and the official website of the State Bank of Pakistan (http://sbp.org.pk/).

Liew and Vassalou (2000) analyzed the relationship between future economic growth and the Fama–French three-factor model. Their findings sugges<sup>t</sup> that size and book-to-market factors are positively related to future economic growth. Vassalou (2003) and Petkova (2006) observed a moderated explanatory power of the Fama–French factors in the existence of macro-economic risk. The findings by Boamah (2015) provide a further indication of the relevance of SMB and HML to future economic growth.

There is no known study that has observed the predictive ability of these risk factors for future economic growth in the GDP of the Pakistani economy. However, Javid and Ahmad (2008) examine a set of macroeconomic variables in addition to market risk premium (single factor). The results support the proposal that a few economic variables play an additional role in explaining the variation in stock returns and this variability has some business cycle correlations.

The paper offers several pioneering contributions. It: (1) constructs and compares the risk factors and the three-factor model under three different methods; (2) examines the robustness of the model across different risk regimes and subsamples; (3) analyses the performance of the term structure premium augmented four-factor model; and (4) links the information content of the Fama–French factors and the business cycle variables to predict future economic growth of Pakistan. The evidence will enhance our understanding of whether or not these factors relate to underlying economic risk factors.

Our results show that: (1) size and value premiums exist in the KSE. In terms of returns, small size firms outperform big size firms while value stocks (high book-to market equity ratio) outperform growth stocks (low book-to-market equity ratio); (2) the three-factor model can explain the variations in average stock returns on six size-B/M portfolios, the average adjusted R squared meaningfully increased by including two additional factors into the model; (3) the three-factor model by constructing portfolios in different ways, is applicable to KSE, as all the models capture size and book-to-market effects significantly; (4) the significance of the regression coefficients are time variant. However, the existence of these factors is stable across the three sub-periods; (5) the three-factor model captures the size and book-to-market effects significantly for the six risk-based (categorized based on market beta) portfolios; (6) loadings on the term structure premium (TSP) mostly remain statistically significant but do not improve the explanatory power of the augmented four-factor model, contrarily it increases the significance of the intercept. However, SMB and HML remain robust in the presence of the TSP; and (7) the market and SMB factors possess the predictive ability for one-year ahead growth of the Pakistani economy and remain robust in the presence of the business cycle variables.

This paper proceeds as follows. Section 2 provides a related literature review of prior studies, Section 3 describes the data and the methodologies used in the paper. Section 4 discusses empirical results and analysis. Section 5 investigates the relevance of the risk factors to predict future economic growth. Section 6 summarizes the research findings and concludes the paper.

#### **2. Prior Related Studies**

Success of the Fama-French three factor model is, basically, a divergence in CAPM and emerged as a most popular explanation for the ongoing argumen<sup>t</sup> on asset pricing. However, several studies in the financial literature (e.g., Groenewold Fraser 1997; Beltratti and Tria 2002; Drew and Veeraraghan 2002; Mirza and Shahid 2008; Guo et al. 2008; Lischewski and Voronkova 2012; Cakici et al. 2013; Minovi´c and Živkovi´c 2014; Baek and Bilson 2015; Boamah 2015; Ceylan et al. 2015; Zaremba and Konieczka 2015; Elgammal et al. 2016; Chung et al. 2016; Xie and Qu 2016; Kubota and Takehara 2017) attribute mixed evidence regarding the existence, significance, augmented versions and time varying behavior of the risk premiums and the three-factor model in the stock markets of USA, Europe, Australia, Asia and Africa by applying various models and portfolio construction methodologies.

Daniel and Titman (1997) examined the Fama and French (1993) and demonstrated that size and book-to-market factors are highly correlated with the average stocks returns but there is no separate distress and most of the co-movement of the value stocks is not due to distressed stocks being exposed to a unique distress factor. They explained that it is characteristics rather than factor loadings that appear to explain the cross-sectional variation in stock returns. Davis et al. (2000) thoroughly studied the characteristics, co-variances and average returns for the period (1929–1997). By dividing the sample into two sub-periods, their findings confirmed that value premium (HML) factor was 0.50% per month in the first sub-period (1929–1963) and 0.43% per month in the second sub-period (1963–1997). The Value premium observed in the first sub-period was statistically significant at (*t* = 2.8) while the second sub-period presented higher significance at (*t* = 3.38). They confirmed a strong relationship between value premium and average stock returns. They discovered that the results of Daniel and Titman (1997) appeared to be supporting characteristics of the model due to the shorter time span.

Connor and Sehgal (2001) analyzed the results of the Fama-French three-factor model and CAPM. Stocks traded at the CRISIL 500 Indian stock market were taken as a sample. The results after using wald statistics showed that three out of six portfolios had significant intercepts for CAPM, whereas, in the Fama-French model all six portfolios had insignificant intercepts. Finally, on the basis of their findings, it was concluded that the three-factor model performs better for the Indian stock market than the CAPM.

In their study of three developed markets, Griffin (2002) found that the three-factor model can significantly explain the variations in the cross-section of expected stock returns in the stock markets of Canada, England and Japan. Drew and Veeraraghan (2002) detected size and value premiums in the Malaysian stock market. De Groot and Verschoor (2002) analyzed the influence of size and value factors on stocks' average returns in five Asian emerging markets. Their findings suggested a strong size effect for all of the markets (India, Korea, Malaysia, Taiwan and Thailand), while value effect only exists in Thailand, Malaysia and Korea.

For the Australian stock market, O' Brien et al. (2008) compared the CAPM with the three-factor model. Their results suggested that the three-factor model explained nearly 70% of the variations in return and led to the formation of an opinion that the three-factor model is a very effective and useful model for explaining the variation in expected stock returns. Brown et al. (2008) detected time-varying value premium in the stock markets of Hong Kong, Korea and Singapore. However, they found a value discount in the Taiwanese stock market.

Malkiel and Jun (2009) studied the Chinese stocks and confirmed the existence of size and book-to-market effects for returns on Chinese stocks. Lischewski and Voronkova (2012) examined the factors determining the stock prices on the Polish stock market (WSE). Findings supported the existence of the size and value factors along with the market risk premium, while liquidity factor was not priced in Polish stocks.

Xu and Zhang (2014) empirically investigated the Fama-French three-factor model and identified some downsides that can arise in the application of the three-factor model to the Chinese stock returns. In order to evaluate the effect of several special features in China, they experiment with different ways to construct the three factors. They concluded that formation of the three factors can have a significant impact in empirical studies that apply the three-factor model to Chinese stock market. In the same way, Vo (2015) examined various approaches to construct portfolios and proposed further evidence for the Australian market.

Therefore, Xie and Qu (2016) performed an empirical study, by focusing on the unique features of the Chinese stock market. Their study consisted of stocks traded at SSE A-share between 2005 and 2012. The findings suggested that size and value premiums are significant for China's stock market (SSE A-share market) and the three-factor model generally fits well. They did not include the investment and profitability factors in the model as these factors dilute the value factor. Similarly, Kubota and Takehara (2017) empirically investigated and rejected the Fama-French's five-factor model as a benchmark for the Japanese stock market.

In a Pakistani context, Iqbal and Brooks (2007) analyzed the conditional Fama-French three-factor model and CAPM for the stocks traded at KSE-Pakistan. The GARCH and EGARCH methods are used on monthly, weekly and daily data of 89 stocks during the period between 1992 and 2006. They illustrated in a graphical analysis that conditioning variables generally result in upward bias. They concluded that the unconditional three-factor model performs better. Mirza and Shahid (2008) deployed a multivariate framework to test the validity of the three-factor model. The sample consisted of 81 stocks traded on KSE from January 2003 to December 2007. The results confirmed the size premium but reported a value discount. Their findings, in general, supported the three-factor model. Javid and Ahmad (2008) examined a set of macroeconomic variables along with the market risk premium on 49 stocks traded at KSE during the period between 1993 and 2004. The results supported that the economic variables play an incremental part in explaining the variation in stock returns and this variability has some business cycle correlations.

Within a broad international analysis Liew and Vassalou (2000) examined the relationship between the Fama–French's three factors and future economic growth in ten countries. The results indicated that SMB and HML are positively related to future economic growth. The predictive ability of the Fama–French factors is found independent on the market factor. They contended that their findings support the risk-based interpretation of the Fama–French factors. Further, a moderate explanatory power of the Fama–French factors for stock returns in the presence of macroeconomic risk factors is noticed by several studies (Aleati et al. 2000; Lettau and Ludvigson 2001; Vassalou 2003; Petkova 2006). Similarly, Boamah (2015) examined the applicability of the Fama-French factors and explore the ability of these factors to predict future economic growth (GDP) of South Africa. The findings show the relevance of small firms and value stocks on the South-African stock market. Additionally, the results show a significantly positive relationship between future economic growth and SMB, HML, and the market factor. The findings remain robust to the inclusion of business cycle variables in the model.

## **3. Data and Methodology**

Emerging markets have their own dynamics, significantly different from developed markets (Bruner et al. 2002). KSE was declared as an open market in 1991 but the pace of the market was stagnant until 2001. However, the market has shown a tremendous growth in recent years; the index has grown by more than 715% in the last eight years (December 2008 to December 2016). Our dataset consists of stocks traded at KSE from January 2002 to December 2015 and GDP growth rates between 2003 and 2016.<sup>2</sup> We start from January 2002 due to a number of reasons, such as: (1) the availably of the data on the official website of the KSE; (2) the stocks remain actively traded at KSE in this period; and (3) in preceding years, the market was illiquid and influenced by other global and regional

<sup>2</sup> Pakistan has three stock markets, the other two stock markets are Islamabad stock exchange and Lahore stock exchange, however all these three markets were merged on 11 January 2016 and renamed as Pakistan stock exchange. Source: https://www.psx.com.pk/.

factors.<sup>3</sup> Thus, it is better to include a lag of a few months to avoid potential bias and begin taking data from January 2002. The study which spans the period of 168 months, including bearish, bull, super bull, recession, recovery and, again, rapid growth in the market, covers all characteristics of market performance and is long enough to ensure stability and efficacy of the model.

#### *3.1. Types and Sources of Data*

Data on stock prices and index closing points are obtained from the official website of KSE.<sup>4</sup> The cut-off yield on the Pakistani Treasury bill rate (T-bill), Pakistan investment bonds (PIBs), and financial statements of financial sector data are obtained from the official website of the State Bank of Pakistan (SBP).<sup>5</sup> The financial daily Business Recorder is used for the data related to number of outstanding shares, market capitalizations and any other missing information.<sup>6</sup> The KSE-100 index is a market capitalization weighted index and is used as the market return, whereas 6 month T-bills cut-off yields are converted into monthly values and used as a risk-free rate, similar to the previous studies on KSE (Iqbal and Brooks 2007; Mirza and Shahid 2008). Overall, more than 630 stocks are carefully observed. However, after screening the stocks as per criteria limitations, the number of stocks included are reduced to 330.<sup>7</sup> Table 2 shows the number of stocks considered in each case. A continuous change in the number of stocks can be noticed across different baskets and this may present different results. We include delisted firms in the sample up to the delisting year to control the survivorship bias. The dataset is modified on December 31 each year. In order to estimate the monthly returns, the closing price of the last day of each month is used.


**Table 2.** Year-over-year sample size (2002 to 2015).

Note: Author's calculation. The table reports the number of companies considered for the reformation of six size and book-to-market (B/M) sorted portfolios each year-end from 2002 to 2015.

#### *3.2. Selection Criteria and Limitations*

For selected companies, monthly price data, market value of equity, book value and other fundamental information should be available; selected stock must survive for a complete year and be traded for at least 85% of the trading days with non-zero returns during the year.

<sup>3</sup> These factors include, but are not limited to Asian crises (1997), political uncertainty in Pakistan (1999) and US-Afghan (9/11) war.

<sup>4</sup> The official website of Karachi stock exchange is www.kse.com.pk (new: https://www.psx.com.pk/).

<sup>5</sup> The official website of the State Bank of Pakistan (SBP) is www.sbp.org.pk.

<sup>6</sup> Source: http://www.brecorder.com/market-data/karachi-stocks/.

<sup>7</sup> See, Section 3.2 for selection criteria and limitations.
