Investment and Portfolio Management

Investment and Portfolio ManagementEugene 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


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

( 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


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.

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