In an article published in 1992, Fama and French sought to establish the validity of the Capital Asset Pricing Model (CAPM). Their study was titled ‘Rethinking Stock Returns’. In essence, capital asset pricing is the first model used in the valuation of assets held by business entities. The framework laid the foundation for the formulation of the modern portfolio theory. The authors (Fama and French) came up with a number of suggestions to enhance the efficiency of CAPM. To this end, they outlined some of the shortcomings of the model with regards to asset pricing and how to address such limitations. Their suggestions had significant impacts on investment performance, especially in relation to value versus growth stocks.
In the current paper, a critical review of Fama and French’s model is outlined. To this end, the two scholar’s definition of value versus growth stocks will be analysed. The relevance of their findings on investing will also be reviewed. In addition, the factors that Fama and French examined, and which may explain stock returns, are addressed. The various measures of risk that the two academicians concluded were needed to explain stock returns are identified. The rationale here is that CAPM is anchored on a single measure of risk pertaining to asset returns. Finally, a description of CAPM strategy and Fama and French’s model will be provided. The implications of the two strategies on investors will be reviewed.
Examining the Validity of Fama and French’s CAPM Model
Value versus Growth Stocks According to Fama and French
According to Fama and French (1992), value stocks are those exhibiting high book value in relation to their worth in the market. What this implies is that the book value of stocks is higher than their price in the market. The case is different for growth stocks. In this case, the book value is lower than the real worth of the stock in the market. In essence, growth stocks exhibit low ratios of book value in relation to the market price (Fama & French 1992). Consequently, value and growth stocks differ with regards to the way their book values relate to the market.
Fama and French argue that since value stocks indicate lower prices in relation to their book value, they appear to be relatively distressed in the market. Growth stocks, on the other hand, are less distressed. The authors arrived at these conclusions after extensive examinations of the CAPM model. The model was analysed and tested in 13 developed countries, including the United States of America. The findings were also evident in another analysis of these markets between 1975 and 1995. In the latter assessment, the performance of value stocks exceeded that of their growth counterparts.
Factors Explaining Stock Returns
Fama and French examined a wide range of variables in efforts to explain stock returns. The variables they assessed included, among others, price-earnings ratio, book-to-market equity, firm size, and leverage. Additional factors examined included beta coefficients. In earlier studies, the variables were found to have significant impacts on stock returns (Fama & French 1996).
The findings made by Fama and French indicated that book-to-market and size ratios explained all the variations in market returns. In addition, the factors highlighted the variations in returns covered by beta. However, it was revealed that the remaining elements did not have significant impacts on prediction of stock returns.
Measures of Risk Needed to Explain Stock Returns
Beta is the only measure of risk utilised in CAPM approach (Connor 1995). Beta stands for the measure of sensitivity to the market returns. Given the fact that CAPM uses this measurement tool only, Fama and French found that was insufficient. According to Fama and French (1992), CAPM cannot explain the various variations related to expected returns.
Fama and French arrived at the conclusion that three measures of risk are necessary in the explanation of returns. The first measurement tool is beta (Davis, Fama & French 2000). It is the measure of market sensitivity used in CAPM. The other measures proposed by Fama and French include those that are capable of creating a distinction between risks in small and big stocks. Basically, small businesses have higher risks compared to large entities. As such, small establishments earn higher returns than big firms. The realisation creates the need for a measure that takes into consideration the size of the business organisation.
The other quantifier is one that is able to distinguish between the risks associated with growth and value stocks. According to Fama and French, CAPM adopts a simplistic viewpoint towards the world. Fama and French argue that at the least, average returns should reward two additional risks on top of (or including) beta (Fama & French 1992).
CAPM Approach versus Fama and French’s Model: Implications to Managers and Investors
According to Cochrane (2001), CAPM is regarded as one of the earliest models used in the pricing of assets. In addition, the approach is the most widely used strategy, especially due to its simplicity. CAPM is based on the assumption that investors have high regard for the Markowitz mean-variance criterion. They pay attention to this criterion in their choice of portfolios (Davis et al. 2000). The framework is also based on beta.
There are other models used to explain the cross-section of average assets returns. Some of these approaches include the inter-temporal capital asset pricing model. The model is based on consumption (Campbell 2000). Another common approach is the arbitrage theory pricing model (Li, Vassalou & Xing 2006).
As already indicated in this paper, CAPM is based on a number of assumptions. In light of this, the model attempts to quantify the relationship between an asset’s beta and its corresponding returns. The major presupposition touches on the fact that there is only one common risk factor. The strategy also takes into consideration the behaviour of the investor (Campbell 2000).
With regards to investors, CAPM assumes that they only care about volatility and expected returns (Davis et al. 2000). The parties are regarded as rational consumers. In addition, it is assumed that they only seek to maximise expected returns in relation to a given degree of volatility (Campbell 2000). Furthermore, investors are considered to have homogenous beliefs with regards to risk-reward tradeoffs in the market.
CAPM also assumes that only a single risk factor is inherently common in broad-based market portfolios (Davis et al. 2000). The factor involves systematic market risk. It facilitates non-diversifiable volatility as far as investments are concerned. Consequently, CAPM presupposes that investors hold diversified portfolios. The assumption is based on the fact that the market does not necessarily reward investors for holding a diversifiable risk. Consequently, CAPM theorises that expected returns are calculable if beta of the particular security is known (Barber & Lyon 1997).
Campbell (2000) explains how CAPM is used to compute expected excess returns associated with an asset. The returns are achieved when beta (β) is multiplied by the expected excess return on the particular market portfolio. In this case, beta reflects covariance of the asset’s return with regards to the market portfolio. The value is then divided by the market return variance (Davis et al. 2000).
CAPM equation is expressed as follows:
- E (γA) = γf + βA (E(γm)-γf).
γf is the risk-free rate.
(E(γm)-γf) refers to the expected excess return of the market portfolio beyond the risk-free rate (Campbell 2000).
The model by Fama and French emphasises on the size and book-to-market ratios in the determination of expected returns (Barber & Lyon 1997). In addition, size and value are regarded as more significant than market risk. In their representation of these risks, Fama and French (1996) developed two factors. The two include small minus big (SMB) element. The element is used to address the size risk. The other is the high minus low factor (HMS). The concept is utilised in addressing the value risk.
The equation for Fama and French’s three factor model is as shown below:
- E(Ri) € Rf = ßi(E(RM) € Rf ) + siE(SMB) + hiE(HML).
E(Ri): expected stock return.
Rf : risk free rate.
E(RM): expected return of market portfolio.
E(SMB): Small Minus Big.
E(HML): High book to market Minus Low book to market (Fama & French 1996).
In conclusion, it is noted that both CAPM and Fama and French’s models have significant impacts on investors. The issues and factors raised and addressed by the two approaches affect investments. Consequently, investors cannot solely rely on a single model when making decisions. As such, combination of the two strategies is recommended.
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