Effect of idiosyncratic risks and earnings quality on volatility of stock returns amongst firms quoted at the Nairobi securites exchange

Abstract

Globally, extreme levels of stock return volatility at the capital markets result to inefficiency in capital utilization and reduction in liquidity by firms. Locally, stock returns volatility at the NSE has led to a continuous decline in activity in the market for the past 8 years, as evidenced by continuous decline in the NSE 20 share index from 5,406 points in 2014 to1,672 points in April,2022. The presence of volatility of stock returns at the NSE can be attributed to idiosyncratic risks since the systematic risk is priced in the NSE stocks. Empirical evidence shows that, for investors who do not hold fully diversified portfolios, risks associated with managerial strength, intangible assets, environmental disclosure, firm size, liquidity, dividend policy and cash flow to price all have a significant effect on idiosyncratic volatility of stock returns. However, there is no empirical evidence directly linking idiosyncratic risks posed by capital expenditure, financial gearing and profitability to volatility of stock returns. Hence, this study sought to examine the effect of idiosyncratic risks and earnings quality on firm specific stock returns volatility. Specifically, the study sought to establish the effect of capital expenditure on stock returns volatility, the effect of financial gearing on stock returns volatility, the effect of profitability on stock returns volatility, the effect of earnings quality on stock returns volatility and the moderating effect of earnings quality on the relationship between the idiosyncratic risks and stock returns volatility at the NSE. Efficient Market Hypothesis, Modern Portfolio theory and Fama &French three factor model informed this study. Quantitative approach with correlational research design was employed using secondary data. Using purposive sampling technique, 24 listed firms were sampled yielding 240 firm-year observations from 2010 to 2019. Fixed effects panel data regression model was employed in the analysis of data. The results showed a positive and significant effect of both capital expenditure (CAPIT: β = 0.024737, p = 0.0000); and financial gearing (DCR: β = 0.386707, p=0.0000; AER: β = 0.025187, P = 0.0037) on volatility of stock returns at the NSE. This implies that 1% increase in CAPIT, DCR and AER leads to 2.4737%, 38.6707% and 2.5187% increase in volatility of stock returns respectively. On the other hand, the result showed negative and significant effect of both profitability (EPS: β = -0.006834, p=0.0452; P_E: β = -0.014044, p=0.0001; ROE: β = -0.513469, p=0.0028) and earnings quality (AQ: β = -0.012054, p=0.0003) on volatility of stock at the NSE. This implies that 1% increase in EPS, PE, ROE and AQ leads to a decline in volatility by 0.6834%, 1.4044%, 51.3469% and 1.2054% respectively. Earnings Quality had a positive and significant moderating effect on the overall model and the relationship, increasing R2 from 70.8197% to 82.0373%. The study concludes that capital expenditure and financial gearing are significant positive predictors of stock return volatility; while profitability and earnings quality are all significant negative predictors of volatility of stock returns at the NSE. Earnings quality positively moderates the relationship between capital expenditure, financial gearing and profitability on volatility of stock returns at the NSE. It is recommended that NSE listed firms should optimize their capital expenditure, use more of internal sources of finance and focus more on wealth maximization objective to reduce volatility of stock returns. These findings may be useful to policy makers and academia in designing models which capture idiosyncratic risks in stock pricing to mitigate against volatility of stock returns for firms at the NSE.