Narrow Results

A procedure confirms whether a return-factor correlation is anomalous or results from endogenous simultaneous-equations bias. The identification strategy sorts the cost of capital components for instruments. In the first stage, the initially found factors are regressed on cost instruments. In the second stage, a confirmed anomaly has predicted value significant in returns and exogenous.

Taxes, depreciation and capital structure are strong instruments, affecting 1980–2017 quarterly U.S. stock returns. Size, value and profitability decisions are significant in instruments. Returns increase in fitted profits, but not small size. Actual and predicted values have weaker correlation with returns over time.

The book-to-market ratio’s numerator adds assets and liabilities differing in risk. We propose a test for the value premium and its sources. Individual balance sheet holdings are divided by firm size. When associated risk premium coefficients are equal, an overall book-to-market is appropriate. Otherwise, there are different risks in assets and liabilities.

For U.S. firms, for four decades since 1980, the excess return is regressed on seven ratios relative to size for cash, receivables, tangibles, intangibles, payables, short and long-term debt, and controls. The seven value premiums are not equal. Firms earn higher returns for cash and receivables and lower for short-term debt. Tangible and intangible assets earn no value premium.

Cross-sectional characteristics of stocks such as market value, market-to-book ratio and accumulated past return can be applied to formulate equity portfolios in the stock-picking process to generate good profits in some markets, which relate to the well-known size, value and momentum or contrarian strategies in the literature. Alternatively, income measures in financial statements drive investors in stock markets to buy or sell in an intuitive way that can be also used in the stock-picking process to generate good profits in some markets. This study applies these types of information in the formation period to formulate long-short strategies and investigates both the returns and risk profiles in the holding period afterward and checks whether the measures can be used to generate good profits in the Taiwan markets for the period from January 1980 to June 2020. Given different lengths of the holding period and different equity segments, our empirical analysis shows that strategies filtered by the income measure of gross profitability outperform the counterparts filtered by the operating profitability. Moreover, while the momentum or contrarian effect is not, the size and value effects are helpful to improve the performance of long-short strategies filtered by gross profitability.