CFA Institute

A Fundamental Analysis of Korean Stock Returns

Author(s): Sandip Mukherji, Manjeet S. Dhatt and Yong H. Kim
Source: Financial Analysts Journal, Vol. 53, No. 3 (May - Jun., 1997), pp. 75-80
Published by: CFA Institute
Stable URL: http://www.jstor.org/stable/4479998
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 A Fundamental Analysis of Korean
Stock Returns
Sandip Mukherji, Manjeet S. Dhatt, and Yong H. Kim

Korea has one of the largest stock markets in the world and is in the process of being
opened to foreign investors. In an investigation of the relations between stock
returns and fundamental variables in Korea, annual stock returns during the 1982-
93 period were positively related to book-market, sales-price, and debt-equity
ratios, negatively related to firm size, and not significantly related to the earnlings-
price ratio or beta. These results add to the growing international evidence that
value stocks outperform growth stocks over long periods. Also for Korean stocks,
book-market and sales-price ratios are more efficient indicators of value than the
earnings-price ratio, and the debt-equity ratio is a more reliable proxy for risk than
beta.

Relations between stock returns and fundamen-
tal variables in the United States have been
studied extensively. In recent years, researchers have
started examining these relations in other countries.
The Korean stock market merits attention because it
is one of the largest in the world and because it is in
the process of opening up to foreign investors.1 For
U.S. investors in particular, the Korean market offers
substantial diversification benefits because the cor-
relation of Korean and U.S. monthly stock returns is
only 0.15 (see Clemente 1994).
Growing recognition of the importance of the
Korean market is reflected in an increasing number
of Korean stock studies appearing in leading
finance journals (for example, Ayadi and Pyun
1994; Dhatt, Kim, and Mukherji 1996; and Kim and
Rogers 1995). Our study fulfills a major need of
analysts and investors for a fundamental analysis
of Korean stock returns.
LITERATURE REVIEW
The capital asset pricing model (CAPM) hypothe-
sizes that investors price only systematic risk, mea-
sured by beta.2 The model predicts a positive
relation between stock returns and beta. Empirical
studies of U.S. stocks, however, have shown signif-
icant relations between stock returns and several
fundamental variables, some of which explain
stock returns better than beta. For instance, Basu
and D/E in explaining U.S. stock returns during the
Sandip Mukherji is an associate professor of finance at period.
1979-91
Howard University. Manjeet S. Dhatt is an assistant
professor of finance at the University of Wisconsin at
Green Bay. Yong H. Kim is a professor of finance at the
University of Cincinnati.
(1977) found that stocks with low price-earnings
ratios (P/Es) have higher average returns than
stocks with high P/Es, even after controlling for
beta. Further, Banz (1981) showed that stocks of
firms that are small in terms of market value of
equity (MVE) have higher beta-adjusted returns
than stocks of larger firms. Bhandari (1988)
reported that stock returns are also positively
related to debt-equity ratios (D/Es), which have
additional explanatory power for stock returns in
tests that include firm size and beta.
Fama and French (1992) indicated that the
book-market ratio (B/M) has the strongest relation
with expected stock returns in the United States.
Furthermore, B/M and MVE combine to capture
the explanatory power of the earnings-price ratio
(E/P), financial leverage, and beta for stock returns.
In follow-up studies, Fama and French (1993, 1995)
provided economic rationales for their findings by
showing that B/M and MVE proxy for stock
returns' sensitivity to risk factors and that these
variables are also related to earnings. Barbee,
Mukherji, and Raines (1996) suggested that the
sales-price ratio (S/P) may be a more reliable indi-
cator of firms' relative market valuation than P/E
or B/M because different accounting methods for
depreciation and inventory affect earnings and
book value of equity but not sales. Unlike P/E and
B/M, S/P is also a meaningful measure of value for
all stocks because it cannot be negative. Barbee et
al. found that S/P absorbs the roles of B/M, MVE,
Evidence is emerging on relations between
stock returns and fundamental variables in interna-
tional markets. Chan, Hamao, and Lakonishok

Financial Analysts Journal * May/June 1997 75

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(1991, 1993) showed that expected stock returns in
Japan are positively related to B/M and cash flow
yield. Capaul, Rowley, and Sharpe (1993) pre-
sented evidence that value (high-B/M) stocks earn
higher returns than growth (low-B/M) stocks in
France, Germany, Japan, Switzerland, the United
Kingdom, and the United States. Roll (1995)
reported that in Indonesia, the mean daily return is
0.1218 percent higher for high-B/M stocks than for
low-B/M stocks, although this difference is not
statistically significant because of a large degree of
noise in the returns.
Our study indicates that Korean stock returns
are positively related to B/M, D/E, and S/P and
negatively related to MVE. Median annual returns
of portfolios with high B/Ms, D/Es, and S/Ps
exceed those with low values of these variables by
22.53 percent, 18.88 percent, and 15.06 percent,
respectively. Low-MVE portfolios have median
annual returns that are 16.28 percent higher than
those on high-MVE portfolios.
These findings add to the growing evidence
that value stocks outperform growth stocks over
long periods by detecting a similar pattern in
Korea. Furthermore, our results indicate that for
Korean stocks, B/M and S/P are more reliable mea-
sures of fundamental value than E/P, and D/E is a
more consistent proxy for risk than beta. We also
found evidence that greater leverage and smaller
size result in higher returns for both value and
growth stocks.
DATA AND METHODOLOGY
We obtained the data from the Pacific-Basin Capital
Markets (PACAP) Databases-Korea compiled by
the PACAP Research Center at the University of
Rhode Island. The database contains stock returns
from 1977 through 1993 for all companies listed on
the Korea Stock Exchange (KSE), but annual
income statement and balance sheet data are avail-
able only from 1981 and only for nonfinancial com-
panies. Accordingly, we examined relations
between fundamental variables and annual stock medium-, and high-value portfolios based on each
returns during an 11-year period from 1982 to 1993
fundamental variable.
for nonfinancial companies listed on the KSE.
Our sample includes only those firms whose
business year ends in December, because most
Korean firms have a December year-end.3 Listed
companies in Korea are required to file their annual
reports with the Korean Securities and Exchange
Commission and the KSE within 90 days of the end
of the business year, and almost all companies do
so. We thus assumed that companies' annual
reports for each December are publicly available by
the following March and examined the relations of
annual stock returns from April through March
with financial data from the previous December.
76 ?Association for Investment Management and Research
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Drawing on the findings of studies of the
United States and international stock returns, we
examined relations between future stock returns
and the following fundamental variables:4
* beta, computed by regressing daily stock
returns against returns on the equal-weighted
market index for the year ending in December,5
* ratio of book value of equity to market value of
equity (B/M),
* ratio of book value of debt to market value of
equity (D/E),6
* ratio of earnings per share to stock price (E/P),
* market value of equity (MVE), calculated by
multiplying the number of outstanding shares
by stock price, and
* ratio of sales per share to stock price (S/P).
At the end of each December (rank period)
during the 1981-91 period, firms were ranked (low
to high) according to values of each of the six
financial variables (beta, D/E, E/P, B/M, MVE,
and S/P). From each rank period, we excluded
firms with negative E/P or B/M because negative
values of these variables do not have meaningful
interpretations.7 Based on a firm's relative rank on
each variable, it was assigned to either a low-,
medium-, or high-value portfolio, with approxi-
mately equal numbers of firms in each portfolio.
The performance of each portfolio was evaluated
for the 12-month period from April through March
of the following year (test period). For each firm,
the 12-month test period returns were computed by
compounding monthly returns, assuming reinvest-
ment of dividends.
We began by studying relations between stock
returns for the first test period, April 1982 through
March 1983, and financial data for the December
1981 rank year and moved forward annually with
data that are similarly related. Stock returns for the
last test period, April 1992 through March 1993, are
related to financial data for December 1991. In all,
we had 11 rank and test periods. In each test period,
median returns were computed for the low-,
EMPIRICAL FINDINGS
Our results are presented in Tables 1 through 5.
Table 1 provides median Spearman rank correla-
tion coefficients of stock returns in the 11 test peri-
ods with beta and logs of other fundamental
variables in the preceding rank years.8 Table 2
shows medians of median annual returns for stocks
with low, medium, and high values of the six fun-
damental variables. Tables 3 through 5 show the
influence of firm size, financial leverage, and mar-
ket risk on returns of portfolios formed on the basis
of B/M,EL/P, and S/P.
Correlations of Stock Returns and
Fundamental Variables
The Spearman rank correlation coefficients in
Table 1 show that B/M has the strongest relation
with stock returns, followed by D/E, S/P, and
MVE. The correlation of E/P with stock returns is
close to zero. Contrary to expectations, the median
correlation of stock returns with beta is negative,
but the correlations are significantly negative in
only 4 years out of 11. Stock returns are correlated
positively with D/E, S/P, and B/M and negatively
with MVE. The relations of stock returns with
fundamental variables are fairly weak. The correla-
tions are, however, significantly positive in 7 out of
11 years for B/M, 6 years for S/P, and 5 years each
for D/E and E/P. Correlations of stock returns with
MVE are significantly negative in 5 years. Among
the explanatory variables, D/E is strongly posi-
tively correlated with S/P. B/M is moderately
positively correlated with S/P, D/E, and E/P and
negatively correlated with MVE. MVE has weaker
negative correlations with E/P, S/P, and D/E than
with B/M.
These results indicate that B/M, D/E, and S/P
are positively related and MVE is negatively related
to stock returns. E/P and beta do not appear to be
reliably related to stock returns. The strong-to-
moderate positive correlations between S/P, D/E,
and B/M suggest that these variables may proxy
for similar factors in stock returns.
Returns on Stocks with Different Values
of Fundamental Variables
Table 2 reports median values of the 11 annual
median returns for portfolios of stocks with low,
medium, and high values of the fundamental vari-
ables. For portfolios formed on the basis of B/M,
S/P, and D/E, median returns are smallest for low-
value groups and largest for high-value groups.9 In
the case of MVE portfolios, median returns are
smallest for high-value groups and largest for low-
value groups. For E/P portfolios, stocks with low
values have the smallest returns, but medium-E/P
stocks have higher returns than high-E/P stocks.10
For beta portfolios, the low-value group has the
largest median returns, whereas the medium-value
group has the smallest median returns.
Among all the portfolios, the median return is
largest for high-B/M stocks (30.39 percent) and
smallest for low-B/M stocks (7.86 percent). The
largest intragroup difference in median returns is,
therefore, in the B/M portfolios, for which the
return on the high-B/M group is 22.53 percent
higher than that on the low-B/M group. By
comparison, the differences between the highest
and lowest median returns for portfolios based on
the D/E, MVE, and S/P are 18.88 percent, 16.28
percent, and 15.06 percent, respectively.
The results in Table 2 indicate that stock returns
are related positively to B/M, D/E, and S/P and
negatively to MVE but are not consistently related

Table 1. Median Spearman Rank Correlation Coefficients for Fundamental

Variables and Annual Stock Returns in Korea, 1982-93

Variable Returns log(B/M) log(E/P) log(S/P) log(MVE) log(D/E)

log(B/M) 0.1678
(213)

[7]
log(E/P) 0.0337 0.3012
(199) (198)

[5] [11]
log(S/P) 0.1017 0.4478 0.2278
(223) (214) (200)

[6] [I1] [8]

log(MVE) -0.0967 -0.3404 -0.2107 -0.2101
(223) (214) (200) (225)

[5] [10] [9] [10]

log(D/E) 0.1354 0.4095 0.0476 0.7956 -0.1389
(223) (214) (200) (225) (225)

[5] [I11] [3] [II] [7]

Beta -0.0927 -0.0183 -0.1464 0.0680 0.0818 0.1174
(269) (182) (170) (190) (190) (190)

[4] [4] [7] [3] [4] [5]

Note: Median sample sizes are given in parentheses, and numbers of years in which the correlation
coefficients are significant at the 10 percent level for the two-tailed t-test, with the same sign as reported,
are shown in brackets.

Financial Analysts Journal * May/June 1997 77

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Table 2. Average Annual Stock Returns for Table 4 indicates a monotonic inverse relation
Portfolios of Stocks with Positive Low, between stock returns and MVE for all three E/P
Medium, and High Values of Funda- portfolios. Furthermore, stock returns are positively
mental Variables related to D/E for low- and medium-E/P firms but

Variable Low Medium High

not for high-E/P firms. The relationship between
beta and stock returns is not clear-cut for any of the
B/M 7.86% 20.69% 30.39%
(70) (72) (71) E/P portfolios. These findings suggest that returns
E/P 14.71 22.65 17.26 on stocks formed on the basis of E/P are systemati-
(66) (67) (67) cally influenced by MVE but not by D/E or beta.
S/P 10.1( 24.42 25.16 Table 5 shows that high-MVE firms have the
(74) (75) (74)
smallest returns for all three S/P portfolios but that
MVE 26.01 18.44 9.73
low-MVE firms have the largest returns only for the
(74) (75) (74)
low-S/P portfolio. D/E is consistently positively
D/E 8.39 20.00 27.27
related to stock returns for all but the low-S / P group.
(74) (75) (74)
Beta 20.73 14.49 18.72 Beta is not systematically related to stock returns,
(90) (90) (89) except for the medium-S/P portfolio, for which the
Note: Data shown are medians of median annual returns of relationship is negative. These results indicate that
portfolios with different values of fundamental variables; the returns of S / P portfolios are influenced in a fairly
median sample sizes are shown in parentheses below the consistent manner by D/E but not by MVE or beta.
average portfolio returns.
Overall, these findings suggest that firm size
to E/P or beta. The variables that have the largest generally has a negative relationship with stock
intragroup differences in stock returns are B / M and returns for portfolios formed on the basis of B/M
D/E. These findings reinforce the correlation results and E/P. D/E generally has a positive relationship
presented earlier: Stock returns are higher for firms with stock returns for portfolios with different B/Ms
that are more undervalued, highly leveraged, and and S/Ps. Beta does not have a consistent influence
smaller. Furthermore, for Korean stocks, B/M and on the returns of portfolios formed on the basis of
S/P are more efficient indicators of value than E/P, B/M, E/P, or S/P.
and D/E is a more reliable proxy for risk than beta.
Table 3. Average Annual Stock Returns for
Portfolios of Stocks with Positive Low,
Effects of Firm Size and Risk
Medium, and High Values of B/M, Cate-
The findings in Tables 1 and 2 show that in
gorized by Low, Medium, and High
Korea, value stocks (high B/M and S/P) substan-
Values of MVE, D/E, and Beta
tially outperform growth stocks (low B / M and S / P);
stock returns are also higher for firms that are riskier Value Low Medium High

(high D/E) and smaller (low MVE) than others. The Categorized by MVE valules
question now is whether firm size and risk are con- Low 18.58% 23.36% 33.74%,
sistently related to returns on stock portfolios (23) (24) (23)

formed on the basis of the valuation variables. Medium 2.85 16.96 27.03
(23) (24) (24)
Tables 3, 4, and 5 provide the medians of
High 5.90 10.56 26.44
median annual returns of stocks with low, medium,
(24) (24) (24)
and high values of B/M, E/P, and S/P, respectively,
Categorized by DIE vallues
categorized by low, medium, and high values of Low -(.88 15.51 24.24
MVE, D/E, and beta. In Table 3, low-MVE firms (22) (24) (23)
have the largest returns and high-MVE firms have Medium 3.82 27.91 28.46
the smallest returns in all cases except the low-B/M (24) (24) (24)

portfolio. Low-D/E firms have the lowest returns, High 16.44 18.80 35.11

and high-D/E firms have the highest returns for all (24) (24) (24)

but the medium-B/M group. The beta categories, Categorized by beta values
Low 4.14 24.73 36.04
however, do not show a consistent pattern. In the
(20) (19) (19)
low-B/M portfolio, high-beta stocks have the largest
Medium -0.65 19.95 30.17
returns, but in the medium- and high-B/M portfo-
(21) (20) (20)
lios, high-beta stocks have the smallest returns and High 20.51 1 1.64 23.86
low-beta stocks have the largest returns.il These (21l) (20)) (19 ))
results indicate that the returns of portfolios formed
Nate: Data shown are medians of median annual returns of
on the basis of B/M are influenced in generally portfolios with different B/M values; median sample sizes are
consistent ways by MVE and D/E but not by beta. shown in parentheses below the average portfolio returns.

78 ?Association for Investment Management and Research

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Table 4. Average Annual Stock Returns for
Portfolios of Stocks with Positive Low,
Medium, and High Values of E/P, Cat-
egorized by Low, Medium, and High
Values of MVE, DIE, and Beta
Table 5. Average Annual Stock Returns for
Portfolios of Stocks with Positive Low,
Medium, and High Values of S/P, Cate-
gorized by Low, Medium, and High
Values of MVE, D/E, and Beta

Value Low Medium High Value Low Medium High

Categorized by MVE values Categorized by MVE values

Low 18.49% 40.49% 27.68% Low 14.29% 23.36% 25.93%
(22) (22) (22) (25) (25) (24)
Medium 16.44 13.06 17.83 Medium 7.71 25.53 30.69
(22) (23) (23) (24) (25) (25)
High 11.32 5.88 5.15 High 0.69 10.78 19.79
(22) (22) (22) (25) (25) (25)
Categorized by DIE Categorized
values by DIE values
Low 3.36 5.55 16.55 Low 6.33 15.16 16.33
(21) (22) (22) (24) (25) (25)
Medium 8.70 20.98 14.05 Medium 6.01 23.25 26.10
(23) (23) (23) (25) (25) (25)
High 27.68 29.71 15.65 High 11.00 30.00 43.35
(22) (22) (22) (25) (25) (24)
Categorized by beta Categorized
values by beta values
Low 15.16 29.21 36.37 Low 16.52 22.37 22.20

(19) (20) (16) (20) (20) (22)

Medium 11.42 11.04 15.44 Medium 1.73 21.44 27.27
(20) (21) (17) (21) (21) (23)
High 18.38 20.38 22.71 High 20.95 19.28 17.47
(20) (21) (17) (21) (20) (22)

Note: Data are medians of median annual returns of portfolios Note: Data shown are medians of median annual returns of
with different positive E/P values; median sample sizes are portfolios with different S/P values; median sample sizes are
shown in parentheses below the average portfolio returns. shown in parentheses below the average portfolio returns.

CONCLUSIONS fundamental value than E/P. Furthermore, D/E is

Fundamental analysis of stock returns in Korea a more reliable proxy for risk than beta

reveals that annual stock returns during the 1982- The positive relationship of D/E with stock
returns persists in portfolios formed on the basis of
93 period were positively related to B/M, S/P, and
B/M and S/P. The negative relationship of firm
D/E and negatively related to firm size but not
size with stock returns is also apparent in portfolios
significantly related to E/P or beta. These results
formed on the basis of B/M and E/P. These find-
are consistent with the findings of recent studies
ings indicate that greater leverage and smaller size
that value stocks outperform growth stocks over
generally result in higher returns for both value
long time periods in several international markets.
and growth stocks.12
Our findings also suggest that for Korean stocks,
B/M and S/P are more consistent indicators of

NOTES

1. The Korea Stock Exchange was the 10th largest stock market
in the world at the end of 1989 (see de Caires and Fletter 1990).
On December 4, 1995, the Korean government unveiled a
sweeping liberalization plan that includes higher stock
ownership ceilings for foreign investors and a four-phase plan
under which fund management and investment advisory
services in Korea will be opened up to foreign concerns.
Under the first phase, foreign fund managers were allowed to
acquire equity interests of up to 50 percent in existing
investment trust companies by the end of 1995. During the
second phase, which became effective in 1996, foreign
managers were permitted to establish branch or joint venture
2.
entities in which they have up to 50 percent equity interest. In
the third phase, foreign fund managers will be allowed to
acquire a 100 percent equity share in existing investment trust
companies by the second half of 1997. From the second half of
1998, foreign fund managers will be permitted to establish
wholly owned subsidiaries and joint venture companies.
Foreign investment advisory concerns were allowed to
open branch operations or acquire equity stakes up to 50
percent in existing firms by the end of 1995. In the second
half of 1997, such companies will be permitted to establish
subsidiaries or joint ventures. From the second half of 1998,
foreign participants will be allowed to acquire 100 percent
equity interest in existing investment advisory firms (see
Aoki 1995).
The CAPM was developed by Sharpe (1964), Lintner (1965),
and Black (1972).

Financial Analysts Journal * May/June 1997 79

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3. The Korea Stock Exchange (1992) indicates that the business
year ends in December for about 77 percent of listed Korean
companies.
4. We could not include cash flow yield among the fundamental
variables studied because cash flow information is not
available in the PACAP data base.
5. To ensure reliability of the estimate, beta was not computed
for stocks that did not have at least 100 daily returns available
during the year.
6. D/E is expected to be an important proxy for risk because
Korean firms tend to be highly leveraged. Kim and Lee (1990)
reported that the average total debt ratio of KSE-listed firms
during the 1977-86 period was 0.80.
7. Among the other variables, only beta can be negative. We
retained negative-beta stocks in the sample because they do
have a meaningful interpretation.
8. Using logs of all fundamental variables, except beta, is
consistent with previous studies; see, for example, Fama and
French (1992).
9. Negative-B/M stocks, which are not included in the table,
have a median return of 17.86 percent, which is close to the
return on medium-B/M stocks; the median size of these
portfolios is 10 stocks.
10. Negative-E/P stocks have the lowest mean return (3.07
percent); the median size of these portfolios is 23 stocks.
11. This finding of a negative relationship between stock returns
and beta for medium- and high-B/M portfolios is contrary
to the CAPM prediction of a positive relation between these
variables, but it is consistent with the argument of Haugen
(1995) that value stocks tend to be less risky and produce
higher returns.
12. The authors thank Jeong Kuk Kim and Chang Seok Oh of the
Korea Securities Research Institute for helpful comments on
an earlier version of this paper. Purchase of data tapes by the
College of Business Administration, University of Cincinnati,
is gratefully acknowledged. Mukherji was supported by a
summer research grant from the School of Business, Howard
University. Kim received partial funding for this study from
the George Scull Fund through the University of Cincinnati
Foundation.

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