Fama and French’s findings have prompted financial economists to
classify the stock universe along two dimensions: size, measured by the
market value of the stock, and valuation, or the price relative to “funda-
mentals” such as earnings and dividends. The emphasis on valuation to
gain an investment edge did not originate with Fama and French. Valu-
ation formed the cornerstone of the principles that Benjamin Graham
and David Dodd put forth more than 70 years ago in their investment
classicSecurity Analysis.^6SMALL- AND LARGE-CAP STOCKS
Cracks in the capital asset pricing model’s predictions of stock returns
appeared well before Fama and French’s research. In 1981, Rolf Banz, a
graduate student at the University of Chicago, investigated the returns
on stocks using the database that had been recently compiled by the
Center for Research in Security Prices (CRSP) located at the university.
He found that small stocks systematically outperformed large stocks,
even after adjusting for risk as defined within the framework of the cap-
ital asset pricing model.^7
To illustrate this point, the returns from 1926 through 2006 on 10
groups of 4,252 stocks sorted by market capitalization are shown in
Table 9-1. The largest 168 stocks comprising 61.64 percent of total market
value had a compound annual return of 9.60 percent, and even though
the beta of these stocks was less than 1, the return trailed the CAPM pre-
diction. On the other hand, smaller stocks had a higher beta, but their re-
turn increased more than predicted by the CAPM. The smallest 1,744
companies—each of which had a market value less than $314 million
and comprised less than 1^1 ⁄ 2 percent of the market capitalization of all
stocks—had a compound return of 14.03 percent, which was 627 basis
points above what would have been predicted by the CAPM.^8
Some maintain that the superior historical returns on small stocks
are compensation for the higher transaction costs of acquiring or dispos-
ing of these securities, especially in the earlier years of the sample. But
for long-term investors, transactions costs should not be of great impor-
tance. The outperformances of these small stocks, although variable,CHAPTER 9 Outperforming the Market 141
(^6) Benjamin Graham and David Dodd, Security Analysis, 1st ed., New York: McGraw Hill, 1934.
(^7) Rolf Banz, “The Relationship between Return and Market Value of Common Stock,” Journal of Fi-
nancial Economics, vol. 9 (1981), pp. 3–18.
(^8) These data are adapted from Stocks, Bonds, Bills, and Inflation (SBBI) 2007 Yearbook, Chicago: Morn-
ingstar Publications, Chap. 7.