With all the talk about “smart beta” and factor investing, it’s easy to forget that virtually all of the newfangled ETFs being launched every week owe a debt of gratitude to the most famous factors of all—the Fama-French factors.
The seminal 1992 work by Eugene Fama and Kenneth French divided up stock market returns into factors so common we don’t even think of them as factors anymore—size and style.
From those basic insights, a fundamental framework for how many investors view the market was formed—the so-called style box popularized by Morningstar, and widely used throughout popular finance.
Size is perhaps the easiest thing for most investors to grasp. Over time, it’s been shown that companies of a given size tend to perform similarly to each other—so that in a regime where large-caps are in favor, the average large-cap is doing better than the average small-cap. Over the last five years, for instance, it’s been a midcap-favoring market:
Midcaps, represented here by the MSCI US MidCap index, are a solid 11 percent higher than large-caps, with small-caps in last place.
Of course, as with any factor, we’re looking across thousands of stocks here. There are large-cap stocks that have beaten the pants off the average small-cap, and vice versa. But size is one of the things at work.
But once we step away from the super-easy-to-understand world of “market cap” as a factor, things immediately get hairy. In their original work, Fama and French settled on a single variable to measure “style”—a word they didn’t even use: price-to-book value (P/B).
Growth Tricky To Identify
Most of us think of “P/B” as a basic measure of value, especially in a classic Ben Graham-style value hunter’s parlance. When I see that Richfield’s P/B is “0.5” I know that means the market is saying, “This company is trading at half its accounting value.” Sometimes there’s a very good reason for that, but sometimes it means a stock is actually genuinely undervalued—that’s the premise of value investing.
The problem is defining what the other end of the spectrum looks like. A high P/B isn’t necessarily a clean definition of a “growth” company. In fact, very few otherwise-rational investors can even agree on what it means to be a “growth” company.
Clearly, “growing” must be part of it, but how do you measure that? Price growth? Well, we generally call that factor “momentum.” Dividend growth? Well, we tend to pull that off to the side and make buckets of “dividend companies.” Earnings growth? Sure, but at what price? Hence the whole “growth at a reasonable price” approach made famous by Fidelity’s Peter Lynch in the 1980s.