By: Frank Armstrong
By: Frank Armstrong, CFP, AIF
Many of you who read the previous installment in this series probably weren’t surprised at the Fama-French finding that small-company stocks delivered higher returns accompanied by higher risk. That’s not exactly earth-shattering news. But some of their other findings are astounding.
Fama and French set out to find a better way to explain stock pricing and market returns than the then state-of-the-art Capital Asset Pricing Model (CAPM). The simplified explanation of CAPM is that the past volatility of an individual stock relative to the market as a whole–its beta–is the only thing an investor needs to know to predict the future performance of a security. If CAPM were true, then it followed that the one “super-efficient” portfolio would be all of the world’s investible assets. This latter idea helped propel the growth of index funds.
However, while CAPM is an elegant and compelling theory, it doesn’t work particularly well in practice. Too many anomalies–that’s economist talk for strange unexpected results–were left unexplained. As it turns out, knowing a stock’s beta doesn’t tell you very much at all about its future returns and prices.
Fama and French wondered if a multi-factor model might do a better job of explaining these anomalies than did the single-factor CAPM model. They tested a number of common measurements in combination (e.g., size, P/E, cash flow, price/book ratio, and so on) to see which one would provide the best fit for their real-world observations. In our last installment we saw how nicely company size–as measured by market capitalization–related to stock returns. But by adding one more factor, Fama and French were able to improve their model to the point where it explained most of the observed performance of stock prices and returns over a long period of time. The additional factor that resulted in the best “fit” was the ratio of a stock’s book value to market price, which we will refer to as BTM.
BTM is a very good proxy for the “value” that is so commonly discussed in the investment world. Stocks with a high BTM are distressed companies that typically have low return on capital, low return on equity, stagnant or falling market share, and various other dismal performance measurements. These companies are just plain ugly, folks. They are out of favor–often for very good reason–and their stock prices have been beaten down relative to their company’s book value.
By comparison, stocks with a low BTM are the glamorous cousins–growth stocks. They have all the signs of healthy, well-run, desirable companies. Investors want to own them, and they push the prices of these stocks to lofty levels.
In our previous article, we sliced the stock market into 10 size-based segments. Now let’s slice the market on the other axis into 10 segments based on BTM. We end up with 100 little market segments on a 10-by-10 grid, and can consider these segments to represent different investment styles. Fama and French tracked the performance of each of these style segments on a year-by-year basis.
Here is where the story gets interesting. It turns out that at every different size level, the doggy value stocks turned in far better performances than did their more glamorous growth cousins! And they did so without any additional risk. Moving from the three lowest deciles of BTM (growth) to the three highest (value) produces nearly 5% in additional compounded return over the period studied. A value investing style beats a growth approach by an astounding degree over long periods of time. Cheap stocks are better than expensive ones!
Let’s compare the entire large-company market with the three deciles that represent growth and value, and look at the same comparison in small-cap stocks:
|Rate of Return||Rate of Return|
|Small-Cap Value||20.94||Large-Cap Value||16.00|
|Small-Cap Growth||14.09||Large-Cap Growth||11.70|
Just as we saw with the small-company effect, other researchers–for different time periods and in different countries–have documented the value phenomenon. Hence, we can have confidence that there is a basic economic principle at work, not just a random anomaly in a single set of data.
The Fama-French research is a breakthrough accomplishment in financial economics, and it has real-world payoffs for investors. It settles the age-old argument between value and growth investors in a very convincing fashion. It has replaced CAPM as the preferred pricing model and has allowed investors to create better portfolios than the “world market.” Finally, it provides us with a far better tool with which to measure the performance of managers against appropriate benchmarks.
Back To Our Portfolio
In addition to better rates of return with about the same level of risk, value stocks have a reasonably low correlation to the rest of the market. Therefore, it’s appropriate to consider them as a separate asset class. Let’s give our portfolio a strong value “tilt” by splitting each of the equity segments into a total-market portion and a value portion. (We don’t have a foreign small-value index with as many years of data, so we doubled up on foreign small caps.)
Voila! Another great day’s work. Adding a value tilt to our holdings produced a gratifying increase in rate of return without adding risk to the portfolio.
We have fashioned a pretty good little portfolio. In our next installment we’ll look at how it might perform over time.