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The Fama and French Study
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One set of anomalies, however, has been identified as very promising. We have designed our investment program and valuation approach around this research. Dr. Eugene F. Fama, the leading proponent of ECMs, and Dr. Kenneth R. French designed and conducted the breakthrough study.4 The study was published in the June 1992 issue of the Journal of Finance, the world s most prestigious academic finance publication. The study compares the performance of portfolios of stocks with certain similar characteristics. For example, Fama and French grouped stocks by book-value-to-market value ratios (BV/MV) and studied their return performance over time. They also grouped stocks by earningsto-price (E/P) ratios, and by the size of stock market capitalization. The study showed, among other things, that portfolios of stocks with a high ratio of book value of equity (BE) to market value of equity (ME), consistently outperformed portfolios with low BE/ME ratios. The study also found that stocks with high earnings-to-price ratios (low price to earnings ratios) consistently outperformed portfolios of stocks with low earnings-to-price ratios (high price-to-earnings ratios) and that stocks with small market capitalization outperformed stocks with large market capitalization. This study called to question the validity of efficient capital markets and was a very troubling result for Professors Fama and French. The F&F study examines monthly stock returns during the period from July of 1963 until December of 1990 and includes nearly all of the nonfinancial stocks traded on the New York Stock Exchange, American Stock Exchange, and NASDAQ. The portion of the study that examines BE/ME ratios was designed so that, at the beginning of July
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of each year, stocks are divided into 10 portfolios based on their BE/ME ratios. Portfolio 1 consists of the stocks with the lowest BE/ME ratios, portfolio 2, 3, 4 . . . consist of groups of stocks with increasing BE/ME ratios, with portfolio 10 consisting of the stocks with the highest BE/ME ratios. The monthly returns for each of the 10 portfolios are measured over 12 months. The following July, each stock s BE/ME ratio is recomputed and stocks are reassigned to the ten portfolios based on their new BE/ME ratios ranging from lowest to highest. Stocks may move from one portfolio to another. The returns for the portfolios are again measured over the ensuing twelve months. The return calculation and sorting process occurs again and again over the 26-year period, and an average return of each of the 10 portfolios is computed. Fama and French further subdivide portfolios 1 and 10 into two portfolios each, resulting in a total of twelve portfolios. Table 2-3 and Exhibit 2-4 present summaries of their findings:
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TABLE 2-3 1992 Fama and French Stock Return Study Portfolios Based on Ascending Book Equity/Market Equity Ratios
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Monthly Return 0.30% 0.67% 0.87% 0.97% 1.04% 1.17% 1.30% 1.44% 1.50% 1.59% 1.92% 1.83% Annualized Return 3.60% 8.04% 10.44% 11.64% 12.48% 14.04% 15.60% 17.28% 18.00% 19.08% 23.04% 21.96% Avg. Number of Stocks 89 98 209 222 226 230 235 237 239 239 120 117 2261 Weighted Avg. Return 14.99% 14.99% 14.99% 14.99% 14.99% 14.99% 14.99% 14.99% 14.99% 14.99% 14.99% 14.99% Difference in Return 11.39% 6.95% 4.55% 3.35% 2.51% 0.95% 0.61% 2.29% 3.01% 4.09% 8.05% 6.97%
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Portfolio 1A 1B 2 3 4 5 6 7 8 9 10A 10B
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EXHIBIT 2-4
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Fama and French Study
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The study s results are eye popping. The efficient capital market hypothesis predicts that the returns of each of the portfolios should be about equal to the average stock return in the sample, approximately 15 percent. This certainly is not the case when the size of BE/ME ratios acts as the basis for the formulation of portfolios. As we move from portfolios with stocks that have lower BE/ME ratios to higher BE/ME ratios, we observe an almost uniform increase in monthly and annualized returns. The investment strategy, which purchases stocks with the highest BE/ME ratios, would have a return that exceeded the average annualized return (14.99 percent) of the 2261 stocks in the study by approximately 7 percent per year. The strategy would have a return that exceeded the average return of stocks in the lowest (BE/ME) portfolio by almost 20 percent per year. These results rock! The F&F study also examines the relationship between earnings/price ratios and finds a similar result. Portfolios of stocks that have high E/P ratios (low P/E ratios) have consistently higher actual returns than portfolios of stocks with low E/P ratios (high P/E ratios). Other researchers have conducted studies based upon the F&F study with roughly the same results. In 1997, Fama & French studied stocks that were traded in 13 international stock markets and found similar results. Stocks with high BE/ME ratios significantly outperformed stocks with lower ratios in 12 of the international markets. The Italian stock market was the lone exception.
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