Abstract:
This paper tests the validity of the q-factor model on stocks listed on the
Karachi Stock Exchange in Pakistan. The q-factor model is an investment-based
factor model that explains stock returns based on market, profitability, investment
and size factors and it tends to outperform the traditional CAPM, the Fama and
French (1993) three-factor model and Carhart (1997) four-factor model, with some
exceptions. While the model has been tested using data from stock markets in
developed countries, the dynamics of emerging stock markets are significantly
different, warranting a reapplication of the model to average stock returns in a
developing market. We use data from the Karachi Stock Exchange to test the model
in an emerging market context. The results show that, as firms increase their
investment, their stock returns decline. Hence, a firm’s investment is conditional on
a given level of profitability. The size effect is strongly significant for small firms,
but absent for large firms. Finally, the study identifies new factors that give a better
understanding of returns in the context of an emerging economy such as Pakistan.
