The researchers in the article “Rethinking Stock Returns” defines as the growth and value stocks in terms of book value to market value ratio. The researchers state that the stocks having high ratio of book value to market value fall under the category of value stocks and the stocks which have low ratio of book value to market value fall under the category of growth stocks. Fama and French, the researchers, found that it is the general notion among the investors that the prices of growth stocks tend to be high and the prices of value stocks tend to be low (Fama and French, 1992).
Fama and French tested the validity of use of CAPM model in evaluating the expected return and risk of a security. The research outcome of Fama and French was that the CAPM model takes only one factor to measure the risk which is not sufficient. Therefore, one implication of the findings of Fama and French on the investors is that believing CAPM for risk assessment could result in too narrow view of risk. The CAPM model usages only beta as the measure of risk but in the views of Fama and French, there are two more factors that affect the risk. Thus, before deciding about the investment, the investors are required to analyze such factors also (Fama and French, 1992).
Further, the general notion is that the growth stocks provide higher returns. However, Fama and French proved that the value stock earn returns higher than the growth stocks. The empirical evidences from the research study of Fama and French showed that the value stocks outperformed the market (Fama and French, 1992).
It has been a debatable matter since the beginning that what factors affect the stock returns. The CAPM model provided that it is beta that signifies the risk in relation to the stock returns. William Sharpe developed the CAPM model and the same was used for more than two decades in security analysis but later Fama and French conducted a new study. Fama and French differentiated between the value stocks and growth stocks. Further, Fama and French found out that the risk of securities is not completely explained by the beta. They asserted that there are two more factors that have great bearing on the risk assessment such as market risk factor and value growth risk factor. The market risk factor refers to the return on the International Market Portfolio of the stocks. Further, the value growth risk factor relates to the difference between the returns of the international portfolio of growth stocks and value stocks. Thus, Fama and French provided two more risk factors such as size and value along with beta for use in the risk assessment (Fama and French, 1992).
Fama and French developed a three factor model rather than using only factor like CAPM model to describe the stock returns. The three factors used by Fama and French were market risk, size of the company, and ratio of book value to market value. The market risk is measured through the use of beta same as like the CAPM model but two other factors such as size and value adds more flavor to the Fama and French model. Fama and French considered that the use of single factor to explain the returns is not enough, thus, there must be a combination of factors to be used in such analysis. Fama and French concluded that the size of the company and the fact that the stock is a growth stock or value stock affects the returns on the stock (Fama and French, 1992).
Findings of Fama and French
The model developed by Fama and French is of immense use in the analysis of the portfolio performance. According to Fama and French, while analyzing the stocks, the investors are concerned more about the market risk, ratio of book value to market value, and size of the company. The expectations of the investors for required rate of return are largely based on these three factors. Therefore, while computing the expected return, the consideration of three factors described by Fama and French is crucial (Fama and French, 1992).
The CAPM model was developed to provide description on the relationship between the risk and the return of an asset. In particular, the CAPM model has been used for the purpose of evaluating the risk and returns of a security. However, the CAPM model only covers the systematic risk through the use of beta and it ignores the unsystematic risk. Further, it takes only beta to explain the systematic risk which also limits the scope of risk assessment. It was debated at various platforms that the use of CAPM model in determining the expected returns of the investors is not appropriate. According to Fama and French, the CAPM model does not incorporate the risk adequately and thus, it will result in inappropriate analysis in regards to stock’s evaluation (Fama and French, 1992).
Beta measures the sensitivity of the stock’s returns relative to the return on the market portfolio. In other words, it explains as to how the stock’s return would change in response to a change in the return on the overall market. Fama and French conducted a study to examine that whether the CAPM model correctly explains the risk and return relationship or not. In their study Fama and French observed that the investors are not only concerned with knowing the market risk but they also want to know the size of the company and the ratio of book value to the market value. Thus, apart from the beta, it is crucial to take into consideration two other measures that provide evaluation of the risk and return relationship (Fama and French, 1992).
The investment decisions of the investors would get better with the adoption of Fama and French model. This is because the evaluation of the risk would get better with the inclusion of size and value factors as envisaged in the Fama and French model. Generally, the investors look to invest in the growth stocks considering that the growth stocks provide higher returns. However, the Fama and French provided a new finding to the investors that the value stocks provide more return than the growth stocks. They concluded that the value stocks outperform the market (Fama and French, 1992).
The article titled as, “The cross section of the stock returns: An application of Fama-French approach to Nepal” has been taken for the purpose of analysis. The objective of the research article is find out the suitability of the CAPM and Fama-French model in explaining the returns on the stocks of companies listed on the Nepal stock exchange. The research in the article has been conducted on a sample return of 134 companies between the periods from December 2004 to July 2011. Further, a review of literatures has been conducted to find out the reasons for change on the stock returns. The review of literatures depicts that the CAPM model which was first used to analyze the relationship between the risk and return has not been much effective in doing. However, the CAPM model is simple and easy to apply but it is argued that this model does not provide correct and complete analysis of the risk and return (Panta, et al., 2016).
Implications on Investment Analysis
The authors argue that the CAPM model only usages beta in correlating the risk with the return on the stocks. The use of beta is legitimate but it is not enough to explain the relationship between the risk and the expected return. This implies that there are other factors also that contribute to the risk and hence affect the expected rate of return for the investors. It is essential to identify these factors and take in consideration by developing a new model for computation of expected return. The primary objective of the article is to explore the other factors having bearing on the expected return through research (Panta, et al., 2016).
The CAPM entails that the expected return of investors is the summation of risk free rate and the premium for the market risk. The market is measured in the form of beta. However, it has been observed that the investors not only look to get the premium for the market risk but they also takes into consideration other factors such as size of the company and growth aspects. The aim of the article is to research and find out that whether this statement is valid or not. Whether there exists an empirical evidence to the effect that investors give weight age to the size, growth, and value aspects while taking investment decisions or not. The objective inherent in the research conducted in this article is also to compare the CAPM and Fama-French model and assert on their suitability for analytical purposes (Panta, et al., 2016).
The primary reason for use of Fama-French model in this article is to overcome the limitations posed by the CAPM model. The article aims at finding out the factors that affect the return of the stocks and establishing a concrete relationship between the risk and return (Panta, et al., 2016). Historically, the CAPM model has been used for this purpose which is given as below:
CAPM return= Rf+beta*(Rm-Rf)
As depicted from the equation shown above, the CAPM model computes expected return by utilizing three factors such as risk free rate, market return, and the beta. In computing the expected return by CAPM model, the risk free rate of return is increased by the market risk premium adjusted for beta factor. The beta factor is considered to incorporate risk in the expected return. Further, the market risk premium is computed as the excess of market return over the risk free rate of return (Panta, et al., 2016).
However, the use of beta in CAPM could not explain the risk and return relationship adequately. Then the Fama-French model was used to determine the factors that are responsible for change in the returns of the stocks. The major advantage of use of Fama-French model is that this model usages three explanatory measures such as beta (market risk), size of company, and book value to market value ratio. The Fama-French model formed a hypothesis that the bigger size companies earn lower return than the smaller size companies. However, the results of data analysis in this regards does not show any concrete evidence. Further, it has been found out that the companies with high book value to market value ratio provide high returns to the investors. The companies having high book value to market value ratio carries high risk and therefore to compensate the high risk, these companies earn higher returns (Panta, et al., 2016).
Further, the results of data analysis in the Article depicts that the stocks larger in size are providing more excessive return as compared to the stocks smaller in size. These results of the research are also not consistent with the finding of Fama-French. Fama-French explored that the bigger size stocks provide lower excessive returns. The test of Fama-French model in this article does not prove to be fruitful. The Fama-French model was used in this article to establish the fact that the stock returns are affected not only by beta but also by the size of the company and ratio of book value to market value. However, research outcome of the article shows that the research has failed in doing so (Panta, et al., 2016).
The results of data analysis in the article show that hypothesizes developed by the Fama-French model are not valid. The Fama-French model states that the value stocks (stocks having higher ratio of book value to market value) earn high returns and outperforms the market, but the same is not true in the context of Nepal’s stock market. Further, the model asserts that the small and medium sized companies are more likely to beat the market and earn high returns, but the same is also proved to be wrong. However, it is concluded in the article that the results of the research could not be said to be as reliable as to should have been. This is because the sample selected for research is not perfect and it consists of composition of banking and financial sector companies in large number. However, when the research will be conducted in future taking more appropriate and diversified sample, the results are likely to be positive (Panta, et al., 2016).
Fama, E.F. and French, K.R. 1992. The cross section of expected returns. The journal of finance, XI(2), pp. 427-465.
Panta, S.B., Phuyal, N., Sharma, R., and Vora, G. 2016. The Cross-Section of Stock Returns: An Application of Fama-French Approach to Nepal. Modern Economy, 7, pp. 223-231.
SSRN. 2017. Online Library. [Online]. Available at: https://www.ssrn.com/en/indexcfm/fen/ [Accessed on: 02 August 2017.
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