Investigating the effect of investor sentiment on stock return sensitivity to fundamental factors: case of JSE listed companies

Fonou-Dombeu, Nyanine Chuele; Nomlala, Bomi Cyril; Nyide, Celani John Article Investigating the effect of investor sentiment on stock return sensitivity to fundamental factors: case of JSE listed companies Cogent Business & Management Provided in Cooperation with: Taylor & Francis Group Suggested Citation: Fonou-Dombeu, Nyanine Chuele; Nomlala, Bomi Cyril; Nyide, Celani John (2024) : Investigating the effect of investor sentiment on stock return sensitivity to fundamental factors: case of JSE listed companies, Cogent Business & Management, ISSN 2331-1975, Taylor & Francis, Abingdon, Vol. 11, Iss. 1, pp. 1-19, https://doi.org/10.1080/23311975.2024.2353846 This Version is available at: https://hdl.handle.net/10419/326288 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Cogent Business & Management ISSN: 2331-1975 (Online) Journal homepage: www.tandfonline.com/journals/oabm20 Investigating the effect of investor sentiment on stock return sensitivity to fundamental factors: case of JSE listed companies Nyanine Chuele Fonou-Dombeu, Bomi Cyril Nomlala & Celani John Nyide To cite this article: Nyanine Chuele Fonou-Dombeu, Bomi Cyril Nomlala & Celani John Nyide (2024) Investigating the effect of investor sentiment on stock return sensitivity to fundamental factors: case of JSE listed companies, Cogent Business & Management, 11:1, 2353846, DOI: 10.1080/23311975.2024.2353846 To link to this article: https://doi.org/10.1080/23311975.2024.2353846 © 2024 The Author(s). Published by Informa UK Limited, trading as Taylor & Francis Group Published online: 04 Jun 2024. Submit your article to this journal Article views: 1577 View related articles View Crossmark data Citing articles: 2 View citing articles Full Terms & Conditions of access and use can be found at https://www.tandfonline.com/action/journalInformation?journalCode=oabm20 Accounting, corporAte governAnce & Business ethics | reseArch Article Cogent Business & ManageMent 2024, VoL. 11, no. 1 , 2353846 Investigating the effect of investor sentiment on stock return sensitivity to fundamental factors: case of JSE listed companies nyanine chuele Fonou-Dombeua , Bomi cyril nomlalab and celani John nyidec aLecturer, Department of Finance and information Management, Durban university of technology, Durban, south africa; bassociate professor, school of accounting, economics and Finance, university of KwaZulu natal, Durban, south africa; csenior Lecturer, Department of Finance and information Management, Durban university of technology, Durban, south africa ABSTRACT this study examines the association between a firm’s fundamental factors and stock returns as well as how investor sentiment influences the association between these variables. the fundamental factors analyzed include accounting variables (earnings yields, change in profitability, and capital investment) and earnings quality measures. investor sentiment is measured using the south African consumer confidence index. A sample of 1 386 firm-year observations from the companies listed on the Johannesburg stock exchange (Jse) between 1990 and 2022 was used. the results show that fundamental factors are related to stock returns, except for measures of earnings quality. Although earnings yields and capital investments cause variation in stock returns, their effects on stock returns are influenced by other variables associated with stock returns. in addition, investor sentiment affects the relationship between fundamental factors and stock returns, suggesting that sentiment influences the outcome of the capital market and the way investors process fundamental information. profitability seems to be more related to stock returns than other fundamental variables. this study sheds light on how sentiment interacts with a set of fundamental factors and their sensitivity to stock returns and highlights the important role of investor sentiment and accounting information in the capital market. 1. Introduction and background traditional finance theory assumes that the capital market is efficient, as such investors are rational and use the information available in the market to make resource allocation decisions. however, behavioral finance theory posits that investors’ psychological states (investor sentiment) influence their investment decisions. consequently, the movement of stock prices is not only affected by a firm’s specific information (fundamental information) and market wide information but also by investor sentiment. investor sentiment is described as investors’ expectations regarding the return and risk related to investment (haritha & rishad, 2020) and/or investors’ psychological state of mind (optimism or pessimism), which guide their investment decisions (park, 2015). investor sentiment may, therefore, be understood as the movement of security prices not affected by fundamental information. since the emergence of behavioral theory, researchers have investigated the association between investor sentiment and outcomes of the capital market, such as share prices and stock returns, and found mixed and inconclusive results. in one hand some studies (chen, 2008; haritha & rishad, 2020; seok et al., 2019) report a positive association between these variables. in other words, these studies revealed that when investors are © 2024 the author(s). Published by informa uK Limited, trading as taylor & Francis group CONTACT nyanine Chuele Fonou-Dombeu [email protected] Department of Finance and information Management, Durban university of technology, Durban, south africa. https://doi.org/10.1080/23311975.2024.2353846 this is an open access article distributed under the terms of the Creative Commons attribution License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. the terms on which this article has been published allow the posting of the accepted Manuscript in a repository by the author(s) or with their consent. ARTICLE HISTORY received 6 February 2024 revised 1 May 2024 Accepted 6 May 2024 KEYWORDS sentiment; accounting information; accrual quality; returns; Jse listed companies REVIEWING EDITOR collins ntim; university of southampton; united Kingdom of great Britain and northern ireland JEL CLASSIFICATION g10; g14; g41; M40; M41 SUBJECTS cognitive psychology; Finance, Business, Management and Accounting 2 n. c. Fonou-DoMBeu etAl. optimistic, their sentiment is high, which leads to an increase in share prices. on the other hand, other studies (Baker et al., 2007) report a negative association between share prices and investor sentiment. these authors argue that the relationship between sentiment and share prices/returns is conditioned by the type of stock or the firm’s characteristics. since both firm-specific information and investor sentiment may affect stock prices, only a few studies (Mian & sankaraguruswamy, 2012) have attempted to link investor sentiment to firmspecific information and share prices. For instance, Mian and sankaraguruswamy (2012) find that investor sentiment has direct and indirect impacts on share prices sensitivity to earnings news. information about a firm’s earnings may affect investor sentiment (seok etal., 2019). in addition, firms that exceed analysts’ earnings forecasts experience a sudden increase in stock prices (chan et al., 2007); for such firms, investors are optimistic; which may in turn influence their decisions. in contrast, firms that fall short of analysts’ earnings forecasts experience a decrease in stock price (chan et al., 2007), which leads to investor pessimism. therefore, the relationship between firm’s specific information and stock returns may be conditioned by investor optimism or pessimism state of mind. this study extends previous work by first examining the relationship between firms’ fundamental factors and stock returns. thereafter, we examine whether investor sentiment affects the relationship between firm fundamental information and stock returns in south Africa, using Jse data. We describe fundamental information as variables related to a firm’s specific information that may lead to changes in stock prices, including accounting variables and earnings quality measures. the accounting variables used are earnings yield, change in profitability, and capital investment. these variables are associated with stock returns (chen & Zhang, 2007). chen and Zhang (2007), argue that earnings yields, change in profitability, and capital investment are related to the expected future cash flow of a firm and are, therefore correlated with stock returns. We also use earnings quality measures as a proxy for a firm’s fundamental information because earnings quality is a good measure of a firm’s performance (Dechow etal., 2010; Fonou-Dombeu etal., 2022). investors use it to forecast future cash flows, which subsequently affect stock returns. the measure of earnings quality used in this study is accrual quality. We specifically focus on accrual quality for to the following reasons. First, accrual is a good measure of earnings quality and predict earnings better than to other measures of earnings quality (chan et al., 2007; perotti & Wagenhofer, 2014). second, accrual is the “primary mechanism through which accountants seek to make financial statements useful” (larson et al., 2018). Finally, the association between accruals and stock returns have provided mixed results. sloan (1996) found that firms with low accruals have higher subsequent stock returns. chan et al. (2007) also documented that accruals are negatively related to future stock returns. this negative association is explained by the fact that accruals are susceptible to manipulation, and a high accrual could signify low earnings quality, which subsequently leads to low returns. however, hirsleifer et al. (2009) find a positive association between accruals and stock returns. this suggests that the relationship between accruals and stock returns are not yet conclusive, and the outcome may depend on the characteristics of the firms or the capital market in which the firm operates. in addition, prior studies that linked accruals to stock returns emphasized that accruals reflect managers’ manipulation of earnings, this is more observed for firms with high accruals (chan etal., 2007; Dechow etal., 2010). the relationship between accruals and stock returns may differ in south Africa’s capital market. in fact, Fonou-Dombeu et al. (2023) showed that the listed firms in south Africa display a low level of accruals, which is an indication of high earnings quality. therefore, the question is: if earnings is of higher quality in south Africa’s listed firms, does earnings quality lead to an increase in stock returns in south Africa? Furthermore, we link investor sentiment to the relationship between firm fundamental information (accounting variables and measures of earnings quality) and stock returns because prior studies found that accounting variables may cause variations in stock prices (chen & Zhang, 2007), and that investor behavior may also affect stock prices/returns (Baker & Wurgler, 2006; Xavier & Machado, 2017). thus, investor sentiment may play a role in the accounting variable-stock return relationship. therefore, the questions are as follows: how does sentiment influence the association between accounting variables and stock returns? Do accounting variables and sentiment jointly influence stock returns? cogent Business & MAnAgeMent 3 We also conjecture that sentiment may influence the relationship between the measure of earnings quality and stock returns since chen (2008) reported that uncertainty influences investor judgement. in fact, the measure of earnings quality may be used as a proxy for information uncertainty because it reflects a firm’s true operational activities (Dechow et al., 2010; Fonou-Dombeu et al., 2023) and firms with high earnings quality are less volatile than firms with low earnings quality (Fonou-Dombeu et al., 2022; rajgopal & venkatachalam, 2011). corollary, firms with high earnings quality will have a stable future cash flow compared to firms with low earnings quality. investors will be optimistic about firms with high earnings quality as it will be easier to forecast the future cash flow of these firms. thus, investor sentiment may influence the relationship between earnings quality and stock returns. therefore, the questions are: how does investor sentiment affect the association between earnings quality measure and stock returns? Do sentiment and earnings quality measure jointly influence stock returns? Furthermore, since the emergence of behavioral finance, investor sentiment has been widely studied in the literature, especially in developed nations, where such studies are in advanced stages (haritha & rishad, 2020). however, in developing nations, studies on investor sentiment are at an early stage (haritha & rishad, 2020). specifically, in south Africa, there is a scarcity of studies that have attempted to link sentiment with firm fundamental information. only a few south African studies on investor sentiment (Dalika & seetharam, 2015; Muguto et al., 2022; rupande et al., 2019), have focused on the effect of sentiment on share prices and/or stock returns. specifically, these studies sought to examine the effect of sentiment at the market level and not at the firm’s level. this study contributes to the literature by shedding light on how a set of fundamental factors influences stock returns in Jse-listed companies. the use of the full set of firms’ fundamental information in this study provides comprehensive and diverse information about stock returns that is concealed when one uses a single variable, accounting variables, or measure of earnings quality separately. the findings also shed light on which factor contributes more or has greater explanatory power for the change in stock returns in south Africa’s capital market. in addition, this study answers the question of whether the relationship between a firm’s fundamental information and stock returns depends on investor behavior. 2. Literature review it is well documented in the literature that changes in securities prices are influenced by market information, firm information, and investor sentiment. in the past, investors’ rationalism was considered the only explanation for the change in share price. investors’ decisions are based on the available information in the market. this belief is strongly supported by traditional finance theory, which assumes market efficiency and investors’ rationality. however, recent behavioral finance theory argues that investors are not always rational. their subjective beliefs and psychological states of mind also influence the movement of share prices. the psychological state of mind, optimism, or pessimism, of investors is measured by investor sentiment. De long et al. (1990) demonstrate how irrational traders influence the financial markets. several studies have investigated whether investors’ psychological state of mind is related to stock returns (Baker & Wurgler, 2006; Brown & cliff, 2005; chen, 2008; gao & Yang, 2017; haritha & rishad, 2020). Baker and Wurgler (2006) find that investor sentiment is inversely associated with stock return. the authors report that investor sentiment is low for firms with low profitability, high earnings volatility, non-paying dividends, and young and mature firms. For these firms, the subsequent returns will be high. in addition, Baker and Wurgler (2006) argue that if it is difficult to determine a firm’s value, investors will be pessimistic, and hence, their sentiment will be low. the share price of such firms is high because of mispricing, which subsequently leads to low returns. in an attempt to find what can reduce security mispricing due to investor sentiment, cornell et al. (2017) report that security mispricing is reduced for firms with high accounting information. in addition, cornell et al. (2017) argue that investor sentiment has little impact on the share prices of firms that display higher accounting information. this is because, the share prices are incorrectly determined if the accounting information is of low quality. this mispricing leads to temporarily high returns. therefore, the quality of a firm’s financial reports is an important factor in the capital market. Furthermore, 4 n. c. Fonou-DoMBeu etAl. the earnings figure is an item in the financial reports that is used as a primary measure of accounting information (Dechow et al., 2010). Before the emergence of behavioral finance, it was assumed that the market was efficient and that accounting information was the main yardstick used by investors to make decisions. rational investors assumes that accounting information is fully reflected in securities prices (Mian & sankaraguruswamy, 2012). As many variables are used as proxies for accounting information, several studies (chan et al., 2007; chen & Zhang, 2007; perotti & Wagenhofer, 2014; shao et al., 2021) have examined how these variables influence stock prices. For instance, chen and Zhang (2007) reported that earnings, profitability, and capital investment are associated with stock returns while chan et al. (2007) found that earnings quality has great predictive power for stock returns. Another study by rajgopal and venkatachalam (2011) report that deterioration of earnings quality is related to an increase in the volatility of stock returns. similarly, Fonou-Dombeu et al. (2022) find that measures of earnings quality are associated with a company’s performance and stock returns volatility. in examining the effect of accruals on stock returns at the aggregate level, hirsleifer etal. (2009) reached different findings from those of previous studies. in fact, in contrast to the study by chan etal. (2007), which reported that accruals are negatively related to stock returns, hirsleifer et al. (2009) found that accruals are positively related to stock returns at the aggregate and sector levels. the results differed depending of the sector. these mixed results may imply that when it comes to examining the effect of accruals on stock returns, the results cannot be generalized because capital markets are different in terms of efficiency. Furthermore, authors have linked investor sentiment to accounting information. in fact, chen (2008) reported that sentiment influence “investor judgement of future cash flow and their risk preference.” the author argues that some earnings components, such as capital expenditures, produce future cash flows with high or low levels of uncertainty. the study revealed that the effect of sentiment on investors’ judgement depends on the type of cash flow (cash flow with high uncertainty vs. cash flow with low uncertainty). in addition, the study finds that the effect of sentiment on expected cash flow is opposite to its effect on risk preference. Miranda et al. (2018) report that investor sentiment is negatively related to earnings management. the authors argue that this negative association could be attribute to financial analyst monitoring. Firms that are monitored by financial analysts have a lower propensity to manipulate financial reports than those that do not. Mian and sankaraguruswamy (2012) examine whether investor sentiment influences stock prices reactions to accounting information measured by the earnings response coefficient. the study revealed that good news about a firm’s reported earnings is quickly incorporated into stock prices when investors are optimistic (high-sentiment period) than when they are pessimistic (low-sentiment period). the study concluded that investor optimism or pessimism states of mind contribute to security mispricing. Another study by seok etal. (2019) linked investor sentiment to price sensitivity to earnings announcements and found that in a high-sentiment period, good news about a firm is fully reflected in stock prices. however, when investors are pessimistic (low-sentiment) about a specific firm, positive news announcements about that firm do not automatically change their perception or sentiment about that firm. however, negative news announcements lead to a sudden decrease in the share prices of such firms. this finding could suggest that only positive earnings news may change investors’ perceptions or judgement about a stock. in light of the above, the literature is not conclusive about the effect of sentiment on a firm’s specific information and stock price/return relationship. Furthermore, none of the above studies have considered whether sentiment affects the relationship between a full set of accounting information (measured from the cash flow perspective) and stock returns. 3. Methodology 3.1. Sample and data 3.1.1. Sample the initial sample comprised non-financial companies listed on the Jse. the sample period spans from 1990 to 2022. therefore, non-financial companies not listed on the Jse over the sample period were cogent Business & MAnAgeMent 5 excluded. in order to avoid deleting too many companies, we did not require all data for each company over the 32-year period. As long as a company was listed on Jse for the 32-year period, it was included in the sample. this resulted in a final sample consisting of 1 386 firm-year observations collected from 42 Jse-listed companies. survivorship bias is unlikely to play a major role in the analysis since the data requirements constrain the sample to long live and stable companies. 3.1.2. Data As discussed above, the data for this study were collected for 32-year period, from 1990 to 2022. the data are secondary in nature and were obtained from different sources. Data for computing accounting variables and earnings quality were extracted from the financial statements of the companies included in the sample. the financial statements of these companies were obtained from the irss research Domain and analyzed to extract relevant data. Accounting data retrieved from the financial statements of sampled firms include revenues, property, plant and equipment, cash and cash equivalent, total assets, total equity, and total liabilities. share price data employed to calculate stock returns were also obtained from the irss research Domain. the data for investor sentiment were collected from the Bureau of economic research website, whereas the data for other variables (macroeconomic variables) were sourced from the south Africa reserve Bank (sArs) website. Details regarding the variables and data sources, and variables description are provided in Appendix. A thorough explanation on how the main variables of the study are measured and computed is discussed in the section to follow. 3.2. Variables and measurements the main variables in this study are firms’ fundamental factors, including accounting variables, measures of earnings quality, and investor sentiments. the measurements of these variables are presented below. 3.2.1. Accounting variables the selection of accounting variables was guided by the literature. Based on chen and Zhang (2007), a number of accounting variables including earnings yield, change in profitability, and capital investment were adopted and used in this study. chen and Zhang (2007) reported that these variables are related to current and future cash flows. therefore, they contribute to the creation of value for the firm and consequently influence stock returns. chen and Zhang (2007) further demonstrate that growth opportunities and discount rates are related to stock returns. however, these two variables (growth opportunity and discount rate) are not included in this study because they are associated with the risk and external environment of the firm. the focus of this study is not on risk preference but on internal factors linked to the accounting process that may affect the movement of the share price. like in chen and Zhang (2007), earnings yield is computed as earnings divided by book value of equity, change in profitability is proxied by the change in return on equity, return on equity is computed as earnings divided by book value of equity, and capital investment is the change in the book value of equity. 3.2.2. Measures of earnings quality Accrual quality, specifically abnormal accrual, is used as a measure of earnings quality in this study. According to larson et al. (2018) “accrual is the primary mechanism through which accountants seek to make the financial statements useful.” Accrual quality is documented as a good measure of earnings quality which is useful for determining a firm’s equity value (chan et al., 2007; perotti & Wagenhofer, 2014). in addition, chan et al. (2007) demonstrate that accruals predict earnings better than other measures of earnings quality. Accrual quality, specifically abnormal accrual, can also be used to gauge the quality of a firm’s reported earnings, which could reflect the true operational activity of the firm or an illustration of earnings manipulation. Abnormal accruals represent the proportion of accruals that are susceptible to earnings manipulation (chan etal., 2007; Kang etal., 2010). A low level of abnormal accruals indicates that earnings are of higher quality (Dechow et al., 2010). 6 n. c. Fonou-DoMBeu etAl. As in Fonou-Dombeu et al. (2023) accrual quality for each firm is defined as the difference between a firm’s total and normal accruals, using eq. (1). ACCRQ TACCR ASSE NACCR it it it it , , , , =       − −1 (1) where ACCRQit , is accrual quality, TACCR ASSE it it , ,−1 total accrual scaled by ASSE it,− 1 , ASSEit , total assets, and NACCRit , normal accrual. it and are the firm and year, respectively. TACCR ASSE it it , ,−1 and NACCRit , were computed using eqs. (2) and (3), respectively. TACCR ASSE ASSE CREV ASSE it it it it it , ,, , ,−− = +        + 1 01 1 2 1 ββ β −− −        +        ++ 1 3 1 4 β βµ PPEQ ASSE ROA it it t it , , ,, i (2) NACCR ASSE CREV ASSE it it it it , , , , =       +        −− ββ  1 1 2 1 1++         − β  3 1 PPEQ ASSE it it , , (3) where CREVit , is the change in revenue, PPEQit , is property, plant, and equipment and the remaining symbols are the same as in eq. (1). As an alternative measure of earnings quality, this study also used a comprehensive measure of accrual (coMpAQ) developed by larson et al. (2018). larson et al. (2018) argued that the coMpAQ is an effective measure of accrual as compared to existing accrual models. Furthermore, the coMpAQ addresses some of the challenges identified in existing models (larson et al., 2018). the coMpAQ is computed as the change in shareholders’ equity minus the change in cash and cash equivalents. 3.2.3. Measurement of investor sentiment investor sentiment is generally measured using either a survey-based or the market-based measures. surveys-based measures include proxies such as the consumer confidence index, whereas market-based measures include a set of variables such as turnover, equity share ratio, dividend premium, and closed-end funds discount rate. each approach (survey or market-based) has advantages and disadvantages. For instance, survey-based-measures have been criticized for not representing the exact and overall population because surveys are generally based on a limited sample size; surveys also suffer from interview and acquiescence biases (Mugoto et al., 2019; Baker & Wurgler, 2007). however, it has been argued that surveys are not dependent on complex financial theories and reflect the psychologic state of investors (Mugoto et al., 2019). similarly, market-based measures have limitations. they incorporated idiosyncratic noise. they are based on the estimation of a set of possible variables to measure sentiment, and there are disagreements and no clarity on which variables best measure sentiment. since investor sentiment is an abstract concept and there is no commonly agreed measure of sentiment in the literature (Dalika & seetharam, 2015; Baker & Wurgler, 2006), we selected survey-based measures to proxy for investor sentiment in this study. this choice was guided by prior studies (Duong et al., 2017; simpson, 2013; Wang, 2018) and was constrained by the availability of data. specifically, the south African consumer confidence index, also called the First national Bank/Bureau for economic research consumer confidence index (FnB/Ber cci), was used to measure investor sentiment in this study. the FnB/Ber cci data were collected from the Bureau for economic research (Ber) website and are available on a quarterly basis. Because the other data were collected annually, to ensure that all the data had the same frequency, cogent Business & MAnAgeMent 7 we computed the annual FnB/Ber cci. For each year, the FnB/Ber cci was computed by averaging the quarterly values. this procedure was also used by simpson (2013) and Duong et al. (2017), who used monthly data to generate quarterly data by averaging monthly frequencies. 3.3. Regression models to examine whether investor sentiment affects the relationship between fundamental information and stock returns, we first test the association between fundamental information (accounting variables and measure of earnings quality) and stock returns to provide up-to-date evidence of the effect of both accounting variables and the measure of earnings quality on stock returns. As explained earlier, the use of both accounting variables and earnings quality measures provides a compressive effect of fundamental information on stock returns, which can be concealed when using individual variables. We then examine the role of investor sentiment in the relationship between fundamental information and stock returns. 3.3.1. Relation between firm’s fundamental information and stock return the fundamental factors used in this study include a set of accounting variables and earnings quality measures. 3.3.1.1. Relation between accounting variables and stock return. to examine the relationship between accounting variables and stock returns, we use equation (4). our approach is based on the work of chen and Zhang (2007). chen and Zhang (2007) identify the following accounting variables that may be related to stock returns: earnings yields, profitability measured by return on equity, capital investment, growth opportunity and discount rate. Following chen and Zhang (2007), we estimate stock returns as a function of accounting variables (earnings yield, change in return on equity, and capital investment), as in eq. (4). however, we did not include growth opportunity and discount rate in the model because these two variables are related to the firm’s external environment (chen & Zhang, 2007). RETU EARY CPROFI CAPI CONV it it t it it it , , ,, , + + =++ ++ 1 01 2 3 4 ββ β β β µ i11 (4) where RETUit , is the annual stock returns; EARYit , earnings yield; CPROFIit , is the change in profitability, computed as the change in return on equity multiplied by the book value of equity; CAPIit , is capital investment computed as the change in the book value of equity; β is the regression coefficient. All independent variables are scaled by the market value of equity. We first estimate eq. (4) without control variables as in chen and Zhang (2007). thereafter, we estimate eq. (4) with control variables reported in previous studies, such as Dang etal. (2017), to be predictors of stock returns. the control variables are firm size, leverage, and the market-to-book ratio. Firm size is computed as the logarithm of the market value of equity, leverage as debt divided by total equity and the market-to-book value as the book value of equity divided by the market value of equity. 3.3.1.2. Relation between measures of earnings quality and stock return. Furthermore, we consider earnings quality measures as another fundamental factor that may explain stock returns in south Africa. specifically, accrual quality is used to measure earnings quality. equation (5) is used to test the relationship between earnings quality measure and stock returns. RETU MEQ CONV it it it it , , ,, + + =++ + 101 2 1 ββ β µ (5) where MeQ is a measure of earnings quality and CONVit , are control variables, including firm size, leverage, and the market-to-book ratio. the remaining symbols are defined by eq. (4). 14 n. c. Fonou-DoMBeu etAl. panel A of table 6 reports the results of estimating eq. (7) using AccrQ as a measure of earnings quality. As shown in panel A of table 6, the coefficient for AccrQ is positive and non-significant, the coefficient for ins is negative and significant, and the coefficient of the interaction between accrual quality and investor sentiment, AccrQ*ins, is also negative and significant. it is interesting to note that, although the coefficient for AccrQ is insignificant, the coefficient of the interaction term, AccrQ*ins, is significant. this suggests that investor sentiment has a strong effect on stock returns and plays a role in the association between AccrQ and stock returns. Additionally, since the sign of the coefficient of the interaction term, AccrQ*ins, is negative, similar to the coefficient of ins, the results further confirm the strong and dominating effect of sentiment on stock returns. this could mean that investors’ psychological state of mines has become a better predictor of stock returns than fundamental information (earnings quality) in south African Jse-listed firms. As noted in section 4.1, on average earnings of the sampled firms are of higher quality. the significant and negative coefficient of AccQ*ins could further indicate that when sentiment increase, subsequent stock returns decrease for firms with high earnings quality. therefore, the results in panel A of table 6 suggest that the quality of a firm’s reported earnings matters for investors and is important in the capital market. this is consistent with perotti and Wagenhofer (2014), who reported that earnings quality provides useful information to investors for investment decisions and that security mispricing is reduced for firms with higher earnings quality. it is a highly possible that investors pay less attention to accounting information when earnings is of lower quality. therefore, further research could investigate whether the results of this study would have been different if earnings of the sampled firms were of lower quality, as well as whether the results would have been different in low-versus high-sentiment periods. As shown in panel B of table 6, when the coMpAQ is used as a measure of earnings quality, the results are similar to those in panel A. that is, the coMpAQ is not related to stock returns, ins is negatively associated with stock returns, and the interaction term coMAQ*ins is negatively related to stock returns. overall, these results suggest that although a firm’s fundamental factors drive stock returns movement, investors behavior appears to be one of the main catalysts of change in stock returns because sentiment influences the way investors process fundamental information. Table 6. Regression results: investor sentiment, measures of earnings quality (aCCRQ & CoMPaQ) and stock return. Panel a Panel B Column 1 Column 2 Column 1 Column 2 Coefficients Coefficients Coefficients Coefficients intercept 1.448*** 1.493*** interpret 1.369*** 1.451*** (0.1096) (0.1113) (0.144) (0.1021) aCCRQ 0.068 0.091 CoMPaQ 0.020 0.010 (0.0610) (0.0640) (0.1008) (0.0278) ins −0.008** −0.002** inVs −0.002** −0.002** (0.0008) (0.008) (0.009) (0.008) aCCRQ*inVs −0.022** −0.005** CoMPaQ*inVs −0.001** −0.089** (0.0094) (0.0018) (0.0006) (0.0075) CPi −1.683*** −1.751*** CPi −1.630*** −1.744*** (0.3275) (0.3063) (0.313) (0.311) gDPg 0.136*** 0.129*** gDPg 0.137*** 0.128*** (0.0370) (0.0383) (0.037) (0.038) iPg −0.006*** −0.004*** iPg −0.006*** −0.004*** (0.0009) (0.0010) (0.0009) (0.0011) size −0.012** size −0.13** (0.0048) (0.005) Leverage 0.060 Leverage 0.057 (0.0379) (0.0368) MBR 0.195** MBR 0.189** (0.0762) (0.0759) n 1386 1386 n 1386 1386 this table reports the results of estimating eq. (7). ***, ** and * denote significance at 1, 5 and 10%, respectively. Below each estimated coefficient is the standard error in parentheses. appendix 2 provides a description of the variables. Source: authors’ computation. cogent Business & MAnAgeMent 15 As explained in section 3, macroeconomic variables, including the consumer price index (cpi), gDp growth (gDpg), and industrial production growth (ipg), which are possibly correlated with investor sentiment and stock returns were included in regression eqs. (6) and (7). columns 1, 2 and 3 of table 5, and panels A and B in table 6 shows that, these variables are related to stock returns. specifically, in all models, cpi and ipg are negatively related to stock returns, whereas gDpg is positively related to stock returns. this is in agreement with prior studies by reddy (2012), omotor (2010), and Benakovic and posedel (2010), who find that macroeconomic variables are associated with stock returns. For both eqs. (6) and (7), the regressions were estimated without control variables, and the findings were almost similar to the estimation with the control variables. this indicates that the inclusion of control variables into the regression eqs. (6) and (7), does not affect the role of investor sentiment on the relationship between fundamental factors and stock returns. 5. Conclusion this study examines the association between a firm’s fundamental factors and stock returns in the south African capital market. the fundamental factors analyzed include accounting variables (earnings yields, change in profitability, and capital investment) and earnings quality measures (accrual quality). Because a firm’s fundamental factors and investor sentiment may affect stock returns, this study further examines whether sentiment affects the association between a firm’s fundamental factors and stock returns. Following prior studies, investor sentiment is proxied by the FnB/Ber consumer confidence index, which is a survey-based measure of sentiment. using a sample of firms listed on the Jse from 1990 to 2022, we find that fundamental factors influence stock returns. specifically, among the fundamental factors studied, the change in profitability predicts best stock returns compared to other variables. We also find that earnings yields and capital investment cause changes in stock returns, however, their effect on stock returns are weak and influenced by other variables. in addition, the findings reveal that the earnings quality measures are unrelated to stock returns. one of the measures of earnings quality analyzed is a proxy for abnormal accruals. the results indicate that abnormal accruals are unrelated to variations in stock returns. could other earnings components, such as non-discretionary accruals or cash flows be related to stock returns in sA? We leave this to future investigations. examining the role of investor sentiment in the relationship between fundamental factors and stock returns, we find that investor sentiment influences the relationship between accounting variables and stock returns. this specifically indicates that, although accounting variables are related to stock returns, the relationship is conditioned by investor behavior. Moreover, the findings reveal that investor sentiment also affects the link between measures of earnings quality and stock returns since the coefficient of the interaction term of measures of earnings quality and investor sentiment is statistically significant. in addition, the earnings quality of the firms included in the study is of higher quality, and the association between the measures of earnings quality and stock return is non-significant. the significance of the coefficient of the interaction term between sentiment and measures of earnings quality, suggests that investors pay attention to the quality of a firm’s reported earnings, and that sentiment has a strong effect on stock returns. Future studies may provide more insights by examining whether sentiment level (high sentiment level vs. low sentiment level) affects stock prices reactions to the quality of accounting information. the overall findings of the study are consistent with the traditional finance literature and the behavioural literature that argue that accounting information and investor behavioural biases affect security prices. in fact, prior studies reported that fundamental information is associated with stock returns. prior studies also found that investor sentiment affect stock returns. our study extends the literature by exploring whether investor sentiment influence the fundamental information and stock returns relation. the results suggest that the incorporation of firm’s fundamental information into stock price/returns may be influenced by investors behavioural bias. As such, the users of accounting information must pay attention to the market sentiment as the later influences the effect of accounting information on the outcomes of capital market. therefore, this study highlights the important roles of both fundamental and behavioral factors in the financial market. 16 n. c. Fonou-DoMBeu etAl. the findings of the study also have implications for accounting standards setters, as the quality of accounting information does matters to capital market participants such as investors, because sentiment may influence the way they process accounting information. Authors’ contributions the corresponding author n.c. Fonou-Dombeu did the data collection, conducted the experiments and written the article. the co-authors B. c. nomlala and c.J. nyide provided guidance in the design, structure of the manuscripts; they also provided insightful comments that help improve the quality of the manuscripts. All authors read and approved the final manuscripts. Disclosure statement the authors report there are no competing interests to declare. About the authors Nyanine Chuele Fonou-Dombeu is currently a lecturer at Durban university of technology. she holds a phD in Accounting from the university of KwaZulu natal, south Africa, a Master and honours degree (Accounting) from north-West university, south Africa and a Bcom from the university of south Africa. her research interest is in the areas of earnings quality, behavioral finance, fair value accounting and lean accounting. Bomi Cyril Nomlala is an accomplished accounting scholar, researcher, and dedicated educator who brings a wealth of knowledge and experience to the field of accounting/auditing. With a passion for fostering the next generation of financial professionals, prof. Bomi nomlala has made significant contributions to academia, the research arena and the accounting industry. Bomi nomlala is a professor in the school of Accounting, economics, and Finance at the university of KwaZulu-natal (uKZn). he received his ph.D. in Accounting in 2019. he has over fifteen years of auditing/forensic education and public sector experience. he is a member of the Accounting and Auditing professional bodies. he is known for his engaging teaching style and commitment to imparting practical knowledge to his students. he has published over 39 research papers on a wide variety of topics ranging from accounting, auditing, finance, risk and insurance. he has also supervised over 8 phD students, more than eight masters students to completion and a lot of honours students. he published his research work both locally and internationally to the audience and also examined a number of theses and dissertations on a wide variety of topics. Celani John Nyide currently heads the Department for Finance and information Management at Durban university of technology. he holds a DBA (Finance) from the university of KwaZulu-natal. Dr. nyide is a well-published multidisciplinary scholar in the fields of managerial accounting and finance, business administration, and information management. he leads a team of researchers in the Accounting and information Management (AiM) project. Additionally, he has successfully supervised numerous postgraduate students and has participated in several high-profile conferences internationally. Data availability Data are available on request Funding not applicable, no funding was received. ORCID nyanine chuele Fonou-Dombeu http://orcid.org/0000-0001-5608-3827 cogent Business & MAnAgeMent 17 Bomi cyril nomlala http://orcid.org/0000-0001-5471-1172 celani John nyide http://orcid.org/0000-0003-2883-0092 References Alduais, F. (2020). 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Appendix 1:Variables and data sources Variables Data source stock returns • share price iRess Research domain Accounting variablesearnings yields • Change in profitability • Capital investment iRess Research domain Earnings qualityaccrual quality • CoMPaQ iRess Research domain • Investor sentimentFnB/BeR Consumer confidence index Bureau of economic Research website Control variablesFirm’s size • Leverage • Market to book ratio iRess Research domain Macroeconomics variablesinflation • gDP growth • industrial production growth saRs Website cogent Business & MAnAgeMent 19 Appendix 2:Variables symbols and descriptions symbols Description Retu annual stock return eaRY earnings yields, computed as earnings divided by book value of equity CPRoFi Change in profitability computed as change in return on equity multiplied by book value of equity CaPi Capital investment computed as the change in book value of equity aCCRQ accrual quality computed using eq. (3) naCCR normal accrual asse total assets CReV Change in revenue PPe Property, Plant and equipment CoMPaQ accrual, computed as the change in common stockholder’s equity minus change in cash and cash equivalent aCCV accounting variables, either, earnings, change in profitability or capital investment MeQ Measures of quality, either aCCRQ or CoMPaQ ins investor sentiment, proxied by CCi CCi annual south african Consumer confidence index (also called FnB/BeR CCi), computed by averaging its quarterly values. ConV Control variables size Firm size computed as the natural logarithm of market value of equity. Leverage Firm leverage computed as debts divided by total equity MaeV Macroeconomic variables MBR Market to book ratio computed as book value of equity divided by market value of equity CPi inflation measured by the Consumer price index gDPg gross domestic product growth iPg industrial production growth