Yet finance theory has shown that if capital markets are “efficient”
in the sense that known valuation criteria are already factored into
prices, investing on the basis of these fundamentals factors will not im-
prove returns. In an efficient market, only higher risk will enable in-
vestors to receive higher returns. The capital asset pricing model(CAPM)
has shown that the correct measure of a stock’s risk is the correlation of
its return with the overall market, known as beta.2,3
Beta can be estimated from historical data, and it represents the
fundamental risk of an asset’s return that cannot be eliminated in a well-
diversified portfolio and for which investors must be compensated. If
beta is greater than 1, the stock requires a return greater than the market,
and if it is less than 1, a lesser return is required. Risk that can be elimi-
nated through diversification (called diversifiableorresidual risk) does not
warrant a higher return. The “efficient market hypothesis” and the
CAPM became the basis for stock return analysis in the 1970s and 1980s.
Unfortunately, as more data were analyzed, beta did not prove suc-
cessful at explaining the differences in returns among individual stocks
or portfolios of stocks. In 1992, Eugene Fama and Ken French wrote an
article, published in the Journal of Finance, which determined that there
are two factors, one relating to the size of the stocks and the other to the
valuation of stocks, that are far more important in determining a stock’s
return than the beta of a stock.^4
After further analyzing returns, they claimed that the evidence
against the CAPM was “compelling” and that “the average return
anomalies... are serious enough to infer that the [CAPM] model is not
a useful approximation” of a stock’s return, and they suggested re-
searchers investigate “alternative” asset pricing models or “irrational
asset pricing stories.”^5
140 PART 2 Valuation, Style Investing, and Global Markets
(^2) The capital asset pricing model was developed by William Sharpe and John Lintner in the 1960s.
See William Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of
Risk,”Journal of Finance, vol. 19, no. 3 (September 1964), p. 442, and John Lintner, “The Valuation of
Risk Assets and the Selection of Risky Investment in Stock Portfolios and Capital Budgets,” Review
of Economics and Statistics, vol. 47, no. 1 (1965), pp. 221–245.
(^3) Greek letters are used to designate the coefficients of regression equations. Beta, the second coeffi-
cient, is calculated from the correlation of an individual stock’s (or portfolio’s) return with a capi-
talization-weighted market portfolio. The first coefficient, alpha, is the average historical return on
the stock or portfolio above the return on the market.
(^4) Eugene Fama and Ken French, “The Cross Section of Expected Stock Returns,” Journal of Finance,
vol. 47 (1992), pp. 427–466.
(^5) Eugene Fama and Ken French, “The CAPM Is Wanted, Dead or Alive,” Journal of Finance, vol. 51,
no. 5 (December 1996), pp. 1947–1958.