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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.

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