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Investment Analysis And Portfolio Management: Growth Stocks

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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 returns?

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 (https://www.ssrn.com/en/index.cfm/fen/). 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.

 

Answers:

1. Fama and French provided an adequate model for analysis of returns considering multiple factors being used in the analysis of risk. According to the Fama French model, the value stocks are the high ratios of the book value in comparison to the market value whereas the growth stocks are the low ratios of the book value in comparison to the market value. The relevance that the Fama and French have given in their findings is their different viewpoint of the growth stocks. This implies that the dividend is not the only consideration which measures the returns to investors but they have also evolved that the growth returns also plays a significant role in the investment decisions of the investors (Chen, Novy-Marx & Zhang, 2011).

2. The factors which are used by the Fama and French model for explaining the stock returns are beta, size and value. Beta is the factor which is used to measure the changes in stock in relation to the market. When one beta will change then the stock will also change. Further it is depicted that the when the beta of any stock is higher than the changes expected are also higher whereas when the beta of any stock is lower than the expected changes will also be lower. The second factor is the size of the company also matters here as when the small company stocks and large company stocks act indifferent to each other because of their capital. In the long-run the companies with small capital stocks will earn larger returns in comparison to the companies with the large capital stocks. The third factor is the value which relates to the growth in earnings and dividend (Forbes, 2013).

 

3. CAPM is the model which measures the risk based on the single factor i.e. beta. Beta represents the changes in the stock’s returns due to changes in the overall market index (Levy, 2011). Therefore; the CAPM model measures the risk on the basis of only one factor which not appropriate to analyse the overall risk of the security. The factors which the Fama and French have explained that are necessary other than beta in analysing risk of stock returns. They included two more factors that are size and value which contributed to the implication of the risk analysis (Chen, 2016). 

4. The Fama and French model have been evolved to overcome the limitations of the Capital Asset Pricing Model (CAPM). The CAPM discussed about only one risk factor i.e. beta whereas the Fama and French model used two more factors i.e. size and value other than beta (Meyers, 2010). The investors need to analyse the risk thoroughly before taking final decision to invest in a particular stock. In this regards, the CAPM model can be considered to be less effective as it takes into account only the systematic risk (beta). However, the investors need to analyse the unsystematic risk also to make the final choice. The analysis of unsystematic risk provides full coverage to the risk analysis of security (Ang, 2014). In this connection, Fama and French moved forward by including two more factors such as size and value in analysing the risk

5. The following answer will address the summary of the chosen article namely, “The Fama French Model or The Capital Asset Pricing Model: International Evidence”. Further the answer will also cover the reasons why the Fama and French model has been used in the chosen paper. The chosen article discusses the comparison between the Fama and French model and the Capital Asset Pricing Model (CAPM). The paper states the usage of the Fama and French model in place of the CAPM model for both the high and small book value to the market stocks of the firms. As the international factors increases the trustworthiness of the stock returns (Alves, 2013).

 


The paper’s objective is to enlarge the base of the CAPM model by adding on the size and value factor which will analyse the market risk. As they found that relying upon only one factor i.e. beta will not rightly analyse the risk of the stocks. In addition to this, it is also dependent on some more factors to measure the changes occurring in the market related to the securities. This paper also expands the Fama and French model by taking into account the international and local factors. The central idea of the paper is to compare the CAPM and Fama and French (FFM) models (Alves, 2013). The size factor introduced by the FFM is related to the profitability. The small stocks results in less earnings as compared to the large stocks but in the long run the small stocks earns a higher return because the market undervalues these stocks in the initial phase of listing. The paper has carried out the research by taking a sample of different firms from ten countries in order to evaluate the two models (Alves, 2013).

This article states that model provided by Fama and French is superior to the CAPM model because the CAPM model does not consider the premium for additional market risk. Avles criticised the use of CAPM model in analysing the risks of securities because assessment of risk based on only one factor is not considered appropriate. The author identified the Fama and the French model overcoming the limitation of CAPM model in realtion to the risk analysis. There was three factor model used by Fama and French which covered the risk analysis comprehensively. Three factors used in the Fama model were beta, size and value. In this model, beta covered the risk pertaining to market; size and value covered the risks specific to the company. Therefore; in this way the Fama and French model has expanded the scope of CAPM model (Alves, 2013).

The empirical work carried out by the author in this article is based on the experimental data methodology (Alves, 2013). In order to carry out the experiment the author selected a number of firms from various countries. Further, the firms selected for analysis are different from each other based on their respective market capital. The sample selected for analysis comprised of firms from large to medium to small market capital. The methodology adopted by the author appears to be appropriate for the purpose. However; there are certain limitations of the research work carried out by the author. The author has not taken into account a common basis while choosing the sample of countries which may lead to inaccurate results of the analysis (Alves, 2013).

 


The reasons why the Fama and French model has been used in this paper is as it covers the factors affecting the market risk of securities better than that of the CAPM model. The FFM model has taken into consideration more than one factor which the investors care about. The motive of the model is to explain the performance of the beta i.e. the market, size and value which. For the investors the performance of the security is judged by its price. The reason behind the usage of the FFM model is that the stocks which are from book to market value stocks are the most powerful ones that tells about whether the stock is high book to market or low book to market. The Fama and French give a reason to the investors to choose between the small stocks or the large stocks. They are able to reason because the FFM model defines the size premium (Alves, 2013).  

The FFM model takes into account the market premium i.e. beta, the size premium, the value premium, zero risk return, impact of the management i.e. considered alpha here and the random error as all these are taken into one picture before investing into any particular security. All the factors of the market are not in the favour of the investors all the time therefore; the model has provided that the consideration of the three factors is very important to draw the attention of the investor in order to get good returns from the stocks (Alves, 2013).

 


The paper also mentions that the FFM model is preferred over the CAPM model because it is more reliable when it comes to the functional aspects are to be taken into account. The paper also includes the involvement of the international factors as the sample taken in the paper is from different countries. Therefore; the researcher knows that it is needed to include the international factors other than the three factors because they might also increase the dependability of the expected stock returns. Hence, it is found more advantageous to apply the Fama and French model to the researcher (Alves, 2013).  

The conclusion drawn from the whole paper is paper is that the main motive of the researcher is to throw some light on the functional aspects of the CAPM and FFM models as it will explain the global functional form and the reliability of the models. The sample of the big firms has led to the  undertaking of the two models and the comparisons between them.

 

References 

Alves, P, 2013, The Fama French Model Or The Capital Asset Pricing Model: International Evidence, The International Journal of Business and Finance Research, 7(2).

Ang, A, 2014, Asset Management: A Systematic Approach to Factor Investing, Oxford University Press.

Chen, L., Novy-Marx, R. and Zhang, L., 2011. An alternative three-factor model.

Chen, M, J, 2016, Postmodern Portfolio Theory: Navigating Abnormal Markets and Investor Behaviour, Springer.

Forbes, 2013, Fama-French Three Factor Model, viewed 25 February 2017 from https://www.forbes.com/sites/frankarmstrong/2013/05/23/fama-french-three-factor-model/#3fd25fd326b3.

Levy, H, 2011, The Capital Asset Pricing Model in the 21st Century: Analytical, Empirical, and Behavioural Perspectives, Cambridge University Press.

Meyers, R, A, 2010, Complex Systems in Finance and Econometrics, Springer Science & Business Media.

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