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Investment and Portfolio Management
Eugene Fama from the University of Chicago and Kenneth R. French from the Yale School
of Management examined the validity of the Capital Asset Pricing Model (CAPM) in a study
that was published in 1992. The CAPM is the most recognized model to explain stock price
returns and forms the foundation of Modern Portfolio Theory. Their extensive study showed
that, at minimum, the CAPM was not a complete explanation of the factors explaining asset
pricing. Their findings also have some implications for investment performance of growth
versus value stocks. A summary of their key findings can be found in Rethinking Stock
Returns. After reading this summary, answer the following questions:
1) How did the researchers in the article “Rethinking Stock Returns” define value versus
growth stocks? What relevance did their findings have on investing?
2) What factors did Fama and French examine that may explain stock returns?
3) The CAPM is built on a single measure of risk that explains asset returns. What
measures of risk did Fama and French conclude were necessary to explain stock
returns?
4) Describe the CAPM model and the Fama and French model and the implications of
these models for investors.
5) Finally download an academic paper of your choice from the last five years posted on
the Financial Economics network of the SSRN website
(http://www.ssrn.com/en/index.cfm/fen/). The academic paper must use the Fama-
French model in its analysis. Provide a 1000 word summary of the objective of this
academic paper of your choice and the reasons why the Fama-French model was
used in the paper.
Rethinking Stock Returns
New Evidence on Value Versus Growth
Research by Eugene F. Fama
Investors generally subscribe to the conventional wisdom that growth stocks outperform
value stocks. But a study of international portfolios by professors at the University of Chicago
Graduate School of Business and the Yale School of Management has shown that in reality
the reverse is true: Value stocks reap higher returns than growth stocks in markets around
the world.
“Value Versus Growth: The International Evidence,” a 1997 working paper co-written by
finance professor Eugene Fama of the University of Chicago Graduate School of Business
and Kenneth R. French, a former Chicago faculty member now at the Yale School of
Management, argues that the conventional wisdom is wrong. Speaking about growth stocks,
Fama says “people think because these are good companies, their stock returns will be
high. But in fact, their prices are pegged so high by the market that their returns actually tend
to be low.”
Fama and French define value stocks as those stocks that have high ratios of book value to
market value and growth stocks as those that have low ratios of book value to market value.
“The intuition is that value stocks have low prices relative to their book value, so the market
feels they’re relatively distressed,” says Fama. “The intuition is the opposite for growth
stocks.”
Fama and French reached their findings in the process of examining the validity of the
Capital Asset Pricing Model (CAPM) and other asset pricing models. For 20 to 30 years,
CAPM has been touted in business schools as a means of describing the relationship
between expected return and risk in stocks.
Seeking to test the validity of CAPM, Fama and French in 1992 examined the variables —
price-earnings ratios, firm size, book-to-market equity and leverage — that research had
determined to be related to average returns.
“What we found was that size and book-to-market equity picked up all the variation in returns
that could be explained by the other variables, including the beta (sensitivity to the market
return) of the CAPM,” recalls Fama. “One implication of that finding was that CAPM couldn’t
possibly explain all the variation in expected returns. It says that you only need one measure
of risk, and that’s the sensitivity to the market return.”
Having shown CAPM doesn’t work, Fama and French went on to examine multi-factor
models that allow many different sources of risk to impact expected returns.
“If you want to explain average stock returns, we found you need three measures of risk,” he
says. “Those measures are sensitivity to the market return and two other measures: a
measure to distinguish the risks in small stocks versus big stocks, and a measure to
distinguish the risks in value stocks versus growth stocks.”
In papers published since then, Fama and French have tested that theory to determine
whether it holds up. “We tested it first on U.S. stocks and found that the theory holds up
pretty well in domestic portfolios,” he explained. “In this report, we looked at international
stocks as well. We looked at 13 countries, the U.S. among them, and found that again the
theory worked well. The data base allowed us to look only at big stocks, so we couldn’t test
the size measure. But the measure of value versus growth holds up.”
Fama and French discovered that what was needed to explain average returns in this set of
large international stocks was a market risk factor and a value-growth risk factor. The market
risk factor is the return on an international market portfolio of stocks, and the value-growth
factor is the difference between the return on an international portfolio of high book-to-
market stocks and the return on an international portfolio of low book-to-market stocks.
The implications for investors are that, first, the CAPM gives “too simplistic a view of the
world,” says Fama. “There are at least two additional dimensions of risk that get rewarded in
average returns. And that’s true in both domestic and international portfolios of stocks.”
A second implication for investors is that value stocks have higher returns than growth
stocks in markets around the world. Looking at book-to-market equity, Fama and French
found that value stocks outperformed growth stocks in 12 of 13 developed countries from
1975 to 1995, and that the difference between average returns on global portfolios of high
and low book-to-market stocks was 7.6 percent per year. Furthermore, when earnings-to-
price, cash flow-to-price and dividend-to-price were examined, the value premium continued
to be evident.
Eugene F. Fama is the Robert R. McCormick Distinguished Service Professor of Finance at
the University of Chicago Graduate School of Business.
