Chapter 9
EVIDENCE ON THE CHARACTERISTICS OF CROSS-
SECTIONAL VARIATION IN STOCK RETURNS
Kent Daniel and Sheridan Titman
THERE IS NOW CONSIDERABLEevidence that the cross-sectional pattern of
stock returns can be explained by characteristics such as size, leverage, past
returns, dividend-yield, earnings-to-price ratios, and book-to-market ra-
tios.^1 Fama and French (1992, 1996) examine all of these variables simulta-
neously and conclude that, with the exception of the momentum strategy
described by Jegadeesh and Titman (1993), the cross-sectional variation in
expected returns can be explained by only two of these characteristics, size
and book-to-market (B/M), Beta, the traditional Capital Asset Pricing
Model (CAPM) measure of risk, explains almost none of the cross-sectional
dispersion in expected returns once size is taken into account.^2
There is considerable disagreement about the reason for the high dis-
count rate assigned to small and high B/M firms. The traditional explana-
tion for these observations, exposited by Fama and French (1993, 1996),
is that the higher returns are compensation for higher systematic risk.
Fama and French (1993) suggest that B/M and size are proxies for distress
and that distressed firms may be more sensitive to certain business cycle
We thank participants of seminars at Dartmouth, Harvard Business School, MIT, Northwest-
ern, UCLA, University of Chicago, University of Illinois Urbana-Champaign, University of
Michigan, University of Southern California, University of Tokyo, Wharton, the February
1995 NBER Behavioral Finance Workshop, the Pacific Capital Markets, Asia Pacific Finance
Association and American Finance Association conferences, and Jonathan Berk, Mark Carhart,
Randy Cohen, Douglas Diamond, Vijay Fafat, Wayne Ferson, Kenneth French, Narasimhan
Jegadeesh, Steven Kaplan, Mark Kritzman, Josef Lakonishok, Craig MacKinlay, Alan Marcus,
Chris Polk, Richard Roll, Robert Vishny, and especially Eugene Fama for helpful discussions,
comments, and suggestions. We also wish to thank the editor, René Stulz, of The Journal of Fi-
nance, and an anonymous referee for their thoughtful suggestions. Daniel thanks the Center
for Research in Security Prices (CRSP) at the University of Chicago for research support. Titman
gratefully acknowledges research support from the John L. Collins, S. J. Chair in International
Finance. We are, of course, responsible for any errors.
(^1) The size anomaly was documented by Banz (1981) and Keim (1983), leverage by Bhan-
dari (1988), the past returns effect by DeBondt and Thaler (1985) and Jegadeesh and Titman
(1993), the earnings-to-price ratio by Basu (1983), the book-to-market effect by Stattman
(1980) and Rosenberg, Reid, and Lanstein (1985).
(^2) See also Jegadeesh (1992).