Practica! Applications of

Book-to-Market and theCross-Section of ExpectedReturns in InternationalStock MarketsOverview

This empirical analysis extends the well-known work by Fama and French [2008]*on book-to-market ratios (B/Ms) for the US equity market to the international stockmarkets. Changes in the book value of equity are more informative about future stockreturns than recent changes in price for all six non-US G7 countries, the study finds.For five of the non-US G7 markets (except Japan), recent changes (past 12 months)in book equity and price are more relevant than distant or older changes.

Practical Applications

• Look to recent changes. Investors should look at recent changes in book equity

when estimating future stock returns. This analysis shows that a 1% change in book

equity better predicts expected stock returns than a 1% change in price.

• Benefit for hedge funds. Hedge funds investing in G7 markets can sort individualstocks based on changes in book equity and achieve a superior risk-rewardprofile.

• Consider B/M components. Equity analysts should look at the components ofB/M to understand the changes in book equity and price and what they can revealabout expected future returns.

Practical Applications Report

A number of studies of the US equity market have attempted to explain the "valuepremium." The value premium refers to the higher average returns, over the long run,of value stocks purchased at low prices relative to their book value.

But what part of the value premium—taking B/M as a proxy—has higher predictivepower for estimating future returns, particularly in the international markets? That'swhat he and his co-authors sought to understand in this article, says Turan G. Bali,Robert S. Parker Chair Professor of Business Administration at the McDonoughSchool of Business at Georgetown University in Washington, DC.

Book-to-Market and the Cross-Section of Expected Returns in InternationalStock Markets appeared in the Winter 2013 issue of The Journal of PortfolioManagement (JPM). Bali, Nusret Cakici and Frank J. Fabozzi extend theanalytical method and findings of the 2008 Fama and French study for the US equitymarket to the six non-US G7 countries: the United Kingdom, Germany, France, Italy,Canada and Japan.

Authors: Turan G. Bali, Nusret Cakici

and Frank J. Fabozzi

Source: The Journal of Portfolio

Management, Vol. 39, No. 2.

Report Written by: Gauri Goyal

Keywords: Book-to-Market, Fama

and French, Hedge Funds, Value Premium

Key Definitions

Book-to-Market Ratio (B/M)

A ratio of a public company's book valueto its market value (i.e., a comparison ofa company's net asset value per shareto its current share price). A ratio ofgreater than 1 indicates the companymay be undervalued. A ratio of less than1 indicates it may be overvaiued.

Value premium

The value premium refers to the higheraverage returns, over the long run, ofvalue stocks purchased at low pricesrelative to their book value.

2O // Practical Applications, volume l, no. 3

^^ The researchshows this is a globaloccurrence.. .changein the book value ofequity has the mostpredictive powerfor expected stockreturns. '*'

—Turan G. Bali

Cakici is Professor of Finance in the School of Business at Fordham Universityin New York. Fabozzi is Professor of Finance at EDHEC Business Schooland is a member of the EDHEC-Risk Institute in Nice, France. He is also theEditor of JPM.

WHICH B/M COMPONENTS BEST PREDICT?

When looking at B/M and its three components—the lagged book-to-market ratio,the change in book value or equity, and the change in price—it would be useful forinvestors to know which component can best predict future cash fiows and hencefuture returns in these international markets, Bali points out.

The 2008 Fama and French study showed that for US microcap and all-but-microcap(ABM) stocks, using the breakdown of the three components of B/M better predictedfuture returns than just using B/M alone.

But does this predictive power of B/M and its components also hold true for non-UScompanies?

Non-US companies may operate in very different environments—with varyinggrowth opportunities, liquidity structures and target levels for debt/equity ratios thatdetermine shares issued—and face different regulatory and earnings constraints.

THE METHODOLOGY

Using international stock data from Thomson Reuters Datastream, the authorsconsidered all stocks for each country, as well as the four subcategories of microcap(below 20"' percentile sorted by market cap), small cap (between 20"' and 50*percentile), large cap (over 50"' percentile) and ABM (above 20"' percentile).

They examined cross-sectional regressions of individual stock returns on marketcap and B/M and tested B/M in terms of share issues and changes in book equityand price per share.

THE RESULTS

Taking the July 1981 to June 2007 period for the six markets, the authors analyzeand show average returns, size, B/M, change in price, book equity and market sharefor the four subcategories. They find the following:

• For all six countries, average returns for microcap stocks are greater than those forsmall-cap stocks.

• Average returns for small-cap and microcap stocks are greater than those for large-cap and ABM-cap stocks trading in Italy, Canada and Japan.

• Average returns for small-cap and large-cap stocks are similar for the UnitedKingdom, Germany and France.

PREDICTIVE POWER

Applying cross-sectional regressions, the authors then present their findings on thepredictive power of B/M on future stock returns in the six countries. They find there

Practical Applications, volume l, no. 3 // 21

Hedge fund managers

in Europe can take

this analysis and sort

individual stocks

based on change in

book value.

For a long/shortequity portfolio,using change in bookvalue can generatehigher returns withless risk.

In all countries

except Japan,the past one-yearchanges in bookequity positivelypredict the cross-section of futureStock returns.

is a significant relationship between B/M and expected returns for all countries andfor most of the four market cap subcategories. This B/M effect is a bit weaker amongmicrocap stocks, particularly in Canada and Italy, and among small-cap stocks inFrance.

DRILLING DOWN

• For the United Kingdom, Germany, Italy and Canada, in all market-cap groups,

changes in B/M are mainly due to changes in book equity, not changes in price.

• In France, changes in B/M are also mainly due to book equity, but price changesalso significantly impact the market, ABM cap and small cap.

• In Japan, however, lagged B/M ratios offer more information about expectedreturns than do recent changes in book equity and price.

• In all countries except Japan, more recent news is more relevant than older news

about changes in book equity and price when estimating future returns.

KEY FINDING

"The research shows this is a global occurrence ... looking at the B/M components,change in the book value of equity has the most predictive power for expected stockreturns," Bali says. This was a key finding, given that prior research on the B/Mcomponents had not been done before, he adds.

Hedge fund managers in Europe can take this analysis and sort individual stocksbased on change in book value, Bali suggests. For a long/short equity portfolio, usingchange in book value can generate higher returns with less risk, he notes. Bali addsthat this approach allows a manager to have a broader exposure to the G7 markets,rather than just being limited to his or her domestic market.

In addition, the authors sorted the data by country and subcategory into a series offive portfolios by level of changes in book equity for the past 12 months. Portfolio 1had stocks with the lowest log of book equity per share; Portfolio 5 had the highestlog of book equity per share.

The results of this analysis supported the results from the cross-sectional regressions:In all countries except Japan, the past one-year changes in book equity positivelypredict the cross-seetion of future stock returns.

The statistically significant results show that the average return spread differencebetween the highest and lowest portfolios was 1.11% per month for the UnitedKingdom, 1.82% per month for Germany, 1.59% per month for France, 1.2%per month for Italy and 1.5% per month for Canada. For Japan, however, the averagereturn difference between Portfolios 1 and 5 was only 10 basis points per month.

TESTING ROBUSTNESS

Two robustness checks are part of the study.

First, the authors considered long-term predictability by looking at the cross-sectional relation between B/M and expected returns one year into the future. Theirresults clearly indicate that old news is less relevant than new news. More distant

22 // Practical Applications, volume l, no. 3

changes in book equity and price are much less important to determining future cashflows than are recent changes.

Second, controlling for stock price momentum, the authors find the results have noeffect on their main findings.

*Fama, E.F., and K.R. French. "Average Returns, B/M, and Share Issues." Journal ofFinance, 63 (2008), pp. 2971-2995.

To order reprints of this report, please contact Dewey Palmieri at dpalmieri(iiijournals.com or 212-224-3675.

Practical Applications, volume l, no. 3 // 23

Turan G. Balitgb27@georgetown.edu

Turan is Robert S. Parker Chair Professorof Finance at the McDonough Schoolof Business at Georgetown University.He specializes in asset pricing, riskmanagement, fixed-income securities andfinancial derivatives. A founding memberof the Society for Financial Econometrics,he has wori<ed on consuiting projectssponsored by major financial Institutionsand government organizations in theUnited States and other countries.In addition, iie currently serves asan Associate Editor for the Journalof Banking and Finance, Journalof Futures Markets, The Journal ofPortfolio Management, Review ofFinancial Economics, and Journalof Risk.

With more than 50 published articies ineconomics and finance journals, Turan'swork has appeared in The Journalof Finance, Journal of FinancialEconomics, Review of FinancialStudies, Journal of MonetaryEconomics, Management Science,Review of Economics and Statistics,The Journal of Business, Journal ofFinancial and Quantitative Analysis,and many others.

Nusret Cakicicakici@fordham.edu

Nusret is a Professor of Finance atthe School of Business at FordhamUniversity. He previously taught atArizona State University, the City Collegeand the Graduate Center of CUNY.He was a Visiting Professor of Finance atColumbia for the academic year 2005-2006. He also taught at Rutgers Universityand Odense University (Denmark).He received his Ph.D. from BaruchCollege in 1989.

Nusret has published more than 40articles in finance journals, includingThe Journal of Finance, Journal ofFinancial Economics, Journal ofFinancial and Quantitative Analysis,Management Science, Journalof Empirical Finance, FinancialManagement, Journal of Banking andFinance, Financial Analysts Journal,Journal of Futures Markets, Journalof Financial Engineering, Journal ofComputational Finance, The Journalof Fixed Income and Risk. His researchaddresses issues in derivatives, corporatefinance, international finance, riskmanagement and investments. Currently,he is conducting research on investmentstrategies, the cross-section of expectedreturns and high-frequency trading andmarket efficiency.

Frank J. Fabozzifranfc fabozzi@edhec. com

Frank is the Editor of The Journal ofPortfolio Management.

He is Professor of Finance at EDHECBusiness School and a member of theEDHEC Risk Institute. Prior to joiningEDHEC, he held various professorialpositions in finance at Yale and MIT.A trustee for the BlackRock family ofclosed-end funds. Frank has authoredand edited many books in assetmanagement. Frank is the CFA Institute's2007 recipient of the C. Stewart SheppardAward given "in recognition of outstandingcontribution to continuing education in theCFA profession."

Frank earned an MA and a BA ineconomics in 1970 from the City Collegeof New York and was elected to PhiBeta Kappa in 1969. He earned a Ph.D.in economics in 1972 from the CityUniversity of New York. Frank holds twoprofessional designations: CharteredFinancial Analyst (1977) and CertifiedPublic Accountant (1982). For the2013-2014 academic year, he wiil joinPrinceton as James Wei Visiting Professorof Entrepreneurship.

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