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Quick Lecture 3: The Value Premium Puzzle

The Long Sample

Recall the value premium puzzle: There is variation in average excess returns associated with book-to-market that is unrelated to variation in the CAPM betas. Fama and French’s classic 1992 Journal of Finance paper used a sample of monthly returns from 1963 to 1990 and the results were striking. Portfolios sorted according to book-to-market display a strong variation in excess of the one month Treasury bill rate, with portfolios of stocks with high book-to-market commanding large excess returns and portfolios of stocks with low book-to-market yielding instead low returns; this variation though is completely unrelated to the variation observed in the CAPM betas of these portfolios. This the well known value premium puzzle.

The sample in that classic paper started in 1963 and went through 1990. As we saw in QL2 the results hold essentially unchanged when we extended the sample to 2011. But what if the sample is extended back to include the prewar years? A recent flurry of papers investigates the performance of the CAPM on the set of value sorted portfolios for the long sample that is now available (the one stretching all the way back to 1926). They are Andrew Ang and Joseph Chen “The CAPM over the Long Run: 1926-2001,'' (Journal of Empirical Finance, 14, 1-40, 2007) and  Eugene F. Fama and Kenneth R. French “The Value Premium and the CAPM” (Journal of Finance 61, 2163-2185). The results are reported both in the table and the plot that accompany this QL.

As the table show, now high average returns are indeed associated with high betas. This is at some level the basic observation that we want to make in this QL: It looks like the low betas of value stocks is an artifact of the sample period that was available to Fama and French when they wrote their classic 1992 paper.   Indeed, as we explore in another QL, the most striking piece of evidence is that value stocks used to have very high betas in the 1920’s, 30’s and 40’s but that after that value stocks have noticeably low betas when compared to growth stocks. This is the heart of the value premium puzzle as presented by Fama and French (1992).  Now the evidence, as the plot so clearly shows, is not so striking. The question is then: Does the CAPM work? First, not in the short sample, even when we extend the sample to include the most recent years. Second, and this is the point of Fama and French (2006), not in the earlier sample, the one covering the years 1926 to 1963, once one does the right test. Indeed, in this paper these authors show that one can still find variation in betas that is unrelated to book-to-market and size that is not rewarded with variation in average returns, which is the key implication of the CAPM. In summary, the evidence against the CAPM in the long sample (1926-2011) is less striking and clear than in the short sample (1963-2011) but once the proper test is performed the CAPM is still found to be wanting.    

Returns Growth DEC2 DEC3 DEC4 DEC5 DEC6 DEC7 DEC8 DEC9 Value
Returns 6.76 7.64 7.89 7.65 8.43 8.92 9.02 10.88 11.65 12.75
ß 1 0.97 0.94 1.06 0.98 1.07 1.12 1.16 1.24 1.45
CAPM Returns 7.49 7.29 7.02 7.93 7.3 7.98 8.37 8.66 9.3 10.87

Sample: 1926-07 to 2011-07. Average excess returns (in %), CAPM betas and CAPM fitted excess returns for ten book-to-market sorted portfolios of all stocks in Compustat; annualized; value weighted.; the portfolios are resorted at the end of June and BE/ME is book equity at the last fiscal year end of the prior calendar year divided by ME at the end of December of the prior year. Data: Ken French database.

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