Cross-Section of Stock Returns: Size & Value Premium

Question 1

Knez and Ready 1997

Answer 1

• use a robust regression estimator to analyze the risk premia on size and book- to-market.
• We find that the risk premium on size that was estimated by Fama and French (1992) completely disappears when the 1 percent most extreme observations are trimmed each month.
• We also show that the negative average of the monthly size coefficients reported by Fama and French can be entirely explained by the 16 months with the most extreme coefficients.
• We argue that further investigation of these results could lead to an understanding of the economic forces underlying the size effect, and may also yield important insights into how firms grow.

Question 2

Fama and French 2007

Answer 2

• Average returns on value and growth portfolios are broken into dividends and three sources of capital gain: (1) growth in book equity, primarily from earnings retention, (2) convergence in price-to-book ratios (P/Bs)from mean reversion in profitability and expected returns, and (3) upward drift in P/B during 1927-2006.
• The capital gains of value stocks trace mostly to convergence: P/B rises as some value companies become more profitable and their stocks move to lower-expected-return groups.
• Growth in book equity is trivial to negative for value portfolios but is a large positive factor in the capital gains of growth stocks.
• For growth stocks, convergence is negative: P/B falls because growth companies do not always remain highly profitable with low expected stock returns.
• Relative to convergence, drift is a minor factor in average returns.