Capital asset Pricing Model is the most recognized model to explain stock price returns and forms the foundation of Modern Portfolio Theory. However, Eugene Fama from the University of Chicago and Kenneth R. French from the Yale school of management found the CAPM was not a complete explanation of the factors explaining assets pricing. Their findings also have some implications for investment performance of growth versus value stocks. After examining the validity of the Capital Asset Pricing Model, they published Rethinking Stock Returns in 1992. In this assignment I have to solve 4 questions. 1) Define value versus growth stocks; 2) determinant of stock return; 3) The measures of risk did Fama and French explain stock returns; 4) CAPM versus Fama and French model.
The comparison of value stocks and growth stocks.
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. Growth stocks have some common characteristics, although individual investors may tweak the numbers for their own purposes. Here are some of the indicators: 1, Strong growth rate. 2, Strong Return on Equity. (Cited http://stocks.about.com/od/investingphilisophies/a/Groval061405.htm. 13 March 2013) Value stock is a stock that is considered to be a good stock at a great price, based on its fundamentals, as opposed to a great stock at a good price. Generally, these stocks are contrasted with growth stocks that trade at high multiples to earnings and cash. The characteristic of Value stocks are stable earnings, undervalued, stocks with higher security, the price-earnings ratio and price/book value ratio are usually lower.
(Cited http://www.investorwords.com/5215/value_stock.html. 13 March 2013) The differences in Growth and Value Stocks are although we cannot argue that growth and value don't have their differences, many overlap. There is growth managers who own companies traditionally defined as value stocks and vice versa. Growth stocks tend to do well when the economy is very strong and investor sentiment is positive. Value stocks tend to do well when the economy is in or recovering from recession. (Cited http://www.investorwords.com/tips/396/differences-in-growth-and-value-stocks.html. 13 March 2013)
Growth and value aren't the only two methods of investing, but they are a way investors make a cut at stocks for investing purposes. In Fama's opinion, people usually think these good companies' 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 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.
Capital Asset Pricing Model VS Fama and French Model
The capital asset pricing model is a centerpiece of finance. This model generates an exact prediction of the risk-return relationship. CAPM is about the equilibrium expected returns of risky assets. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. CAPM important because it serves as a benchmark, for any asset we should need to have a view of the "fair" return given the asset's risk. Capital asset pricing model (CAPM) says that the expected return on an asset above the risk-free rate is proportional to systematic risk, which is calculated by the covariance of portfolio containing all existing securities (market portfolio) with the asset return (Sharp and Lintner). (Cited http://www.academicjournals.org/ajbm/pdf/pdf2012/29Feb/Hamid%20et%20al.pdf. 13 March 2013)
CAPM uses a single factor, beta, to compare a portfolio with the market as a whole. But more generally, you can add factors to a regression model to give a better r-squared fit. The best known approach like this is the three factor model developed by Gene Fama and Ken French. (Cited http://www.moneychimp.com/articles/risk/multifactor.htm. 13 March 2013)
Fama and French model is in 1992, Fama and French noted that stocks of smaller firms and stocks of firms with a high book to market have had higher stock returns than predicted by the CAPM. A factor model that expands on the capital asset pricing model (CAPM) by adding size and value factors in addition to the market risk factor in CAPM. This model considers the fact that value and small cap stocks outperform markets on a regular basis. By including these two additional factors, the model adjusts for the outperformance tendency, which is thought to make it a better tool for evaluating manager performance. (Cited http://www.investopedia.com/terms/f/famaandfrenchthreefactormodel.asp#axzz2NUFOoXBW. 13 March 2013) Fama proposed a 3 factor model of stock returns as follows: 1. Rm- Rf= Market index excess return. 2. Ratio of book value of equity to market value of equity as measured with a variable called HML. HML is high minus low or difference in returns between firms with a high versus a low book to market ratio. 3. Firm size variable measured by the SMB variable. SMB is small minus big or the difference in returns between small and large firms. (Cited http://www.academicjournals.org/ajbm/pdf/pdf2012/29Feb/Hamid%20et%20al.pdf. 13 March 2013) In Fama's opinion, CAPM couldn't 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. "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."
(Cited http://www.chicagobooth.edu/capideas/fall97/fama.htm. 13 March 2013) In the case, Fama and French gave an example about U.S. stocks and found that again the theory worked well.
The CAPM implications are investors will remove firm-specific risks by diversifying across different industrial sectors. But, even the most diversified portfolio will be risky. Investors will be rewarded for investing in such a risky portfolio by earning excessive returns. The returns from a specific investment or asset depend exclusively on the extent to which that investment (or asset) affects the Market Risk and that is captured by Beta. 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.
(Cited http://www.chicagobooth.edu/capideas/fall97/fama.htm. 13 March 2013)
Conclusion
Fama and French attempted to better measure market returns and, through research, found that value stocks outperform growth stocks; similarly, small cap stocks tend to outperform large cap stocks. As an evaluation tool, the performance of portfolios with a large number of small cap or value stocks would be lower than the CAPM result, as the three factor model adjusts downward for small cap and value outperformance. There is a lot of debate about whether the outperformance tendency is due to market efficiency or market inefficiency. On the efficiency side of the debate, the outperformance is generally explained by the excess risk that value and small cap stocks face as a result of their higher cost of capital and greater business risk. On the inefficiency side, the outperformance is explained by market participants mispricing the value of these companies, which provides the excess return in the long run as the value adjusts. (Cited http://www.investopedia.com/terms/f/famaandfrenchthreefactormodel.asp#axzz2NUFOoXBW. 13 March 2013)
