Picking Stocks by Thinking Small
WHY YOU SHOULD CARE
Because with a ton of academic theory, you can actually explain the ways of Wall Street.
By Steven Butler
Academic theory could never explain the randomness that landed Eugene Fama and Kenneth French in adjacent offices at the University of Chicago some 30 years ago. Fama was already an accomplished business-school professor destined to win the Nobel Prize for his work on so-called efficient market theory; French, now a professor at Dartmouth’s Tuck School of Business, was a mere postdoctoral researcher. But as random as it was, it would become one of the greater academic hookups that would go on to revolutionize the real world of investing.
And now it may again.
Once dominant, Fama-French is increasingly on the lips of investment managers everywhere, as they try to find a way to provide long-term value in today’s increasingly choppy — actually downright scary — investment markets. Based on an obscure 1992 paper in The Journal of Finance with the inviting title of “The Cross-Section of Expected Stock Returns,” the two identified three major criteria that a savvy stock picker can follow to beat the odds, criteria that have made both these men and countless managers fairly rich. Now, it’s quietly gaining favor inside some of Wall Street’s bigger circles — which could well trickle down to a financial adviser near you.
Most famously, at least among money-management folks, the theories have underpinned the most successful investment houses in the business, including Dimensional Fund Advisors, with $390 billion of assets, and AQR, with $131 billion in assets. (Fama and French serve on the board of Dimensional.) Both of these funds have routinely beaten the market. But the impact has been much broader than that. The pair found statistical evidence that it’s the smaller companies and cheaper or so-called value stocks that do well, better than larger companies or fast-moving growth stocks the world used to cherish. Established investment adviser Cardiff Park Advisors, with more than $1 billion in assets under management, is one of many firms sticking with the Fama-French way despite what its CEO, John Gorlow, says is a slew of copycat approaches and relabeling. “Others try to emulate Dimensional’s success, but what I like about Dimensional is their singular focus on this approach,” Gorlow says.
There’s a really good idea in finance about once every five years, but “a new marketing idea? That’s every day.”
Polite and modest, French, 61, attributes the odd pair’s success to a formula far simpler than their financial models: “The easiest way to describe it,” French tells OZY, “is that we both work crazy amounts of hours.” Did he anticipate that a series of papers the two co-authored would have real-world applications on which people could actually make money? “No,” he says, without hesitation.
Since that first paper, the two continue to issue major reports only every few years, and each is generally considered a landmark among managers. In particular, many managers are now adopting “smart beta,” a catchall label for one of the latest hot investment products, which, essentially, try to capture the performance of a narrow slice of the market. Fama, 76, tells OZY he figures there’s a really good idea in finance about once every five years, but “a new marketing idea? That’s every day.”
Trying to explain the whole Fama-French approach to a layman, without going crazy over some mind-twisting notions, is about as easy as discussing quantitative theory with a 12-year-old. In general, it starts with the idea that all markets are efficient, dictated by publicly available information about companies that make it virtually impossible for investors to consistently beat the market. Of course, that hasn’t stopped people from trying, and alternative theorists, including Robert Shiller at Yale University, have looked at the foibles of human behavior as an explanation, under an umbrella labeled behavioral finance. Fama-French argues that there is some reward in taking risks with, say, smaller companies or those with cheap stock prices.
Still, as much as Fama-French has captured the mainstream, and made investors a ton of money, one question looms: No one’s really sure why the strategies have worked. That includes French, who perhaps surprisingly isn’t a true believer in efficient markets or that stock prices are always right. “Every interesting model is false,” he says, meaning that it only captures a slice of reality, maybe a bigger slice than other models, but not everything.
Fama agrees, in spite of the Nobel Prize for efficient market theory, and he listens to his critics, some of whom say the validity of the three-factor model is just an artifact of a particular historical period, and not a predictor of the future. He laughs when I mention that criticism, pointing out that the model was first tested back to 1963, and then back to 1926, then all over the world, and then through the past 20 years. But, he concedes, “That criticism is valid.” Should investors everywhere start following the model, they could well bid up prices to a point where the advantages of investing in small cap or value stocks is wiped out. It’s a theory, anyway. As for the theory of the Fama-French duo? “I’m babbling,” says French after trying to explain why they fit together. “We’re just compatible.”