The size and book-to-market effects are two of the most frequently studied phenomena of stock returns. They were first documented in the early 1980s and were later made famous by Fama and French (1992). These two firm-specific variables have been found to be the strongest among all variables that have explanatory power for cross-sectional stock returns, subduing the market beta, earnings-price ratio, and other variables previously found useful in explaining average returns.
While some researchers resort to behavioral biases to explain the size and book-to market effects, a standard interpretation of the two effects is that these two firm-specific variables are proxies for the betas of stock returns with respect to unidentified systematic risk factors. Fama and French (1993) demonstrate this by constructing two factor-mimicking portfolios. Together with the return on the market portfolio in excess of the risk free rate, the Fama-French factors explain the excess returns on twenty-five size and book-to-market-sorted portfolios, by and large.
An annoyance to the risk-based theory, however, is the behavior of the returns on small growth stocks. The low average return on small growth stocks can be found in Fama and French (1993, 1996), in which the pricing error on the portfolio of small growth stocks with respect to the Fama-French three factors is significantly negative. The problem is obvious during the 1980s and more so in the 1990s. In this paper, we ask why the returns on small growth stocks were so low and whether these low returns were expected. We argue that there is a fundamentals-based reason for the low returns on small growth stocks.
The realized average returns on small growth stocks were low because their earnings were low, a phenomenon that was not seen before 1980. The composition of the small growth firms changed dramatically starting in 1980. Many information technology firms were listed in the 1980s and 1990s. Some of them were very successful and created tremendous value.A large number of them, however, did not succeed and some of them did not survive the competition. The low average stock returns on small growth firms are the result of these companies’ low average earnings.
