:a,

Hersh SheErin and Meir Statman

S ize and book-to-market ratios have emergedas

the two prominent variablesthat aresignificant-
ly related to stock returns. Fama and French
[1992] find that stock returns are negatively
relatedto sizeand positively relatedto book-to-market
ratios. They also find that the relationship between
stock returns and betais not statisticallysignificant.
The Famaand French researchcapsearlierstud-
ies that revealstrongrelationshipsamong stock returns,
size, and book-to-market ratios (Banz [1981], Rein-
ganum [1981], Stattman[1980], and Rosenberg,Reid,
and Lanstein[1985]). It also follows earlier studiesthat
reveala weakrelationshipbetweenstockreturnsand beta
(Levy [1978] and Lakonishokand Shapiro[1986]).
Famaand Frenchdivide the set of theories into
two contextswithin which the empirical resultscan be
viewed, one relatedto rational valuation and the other
relatedto overreaction.The essenceof the rational val-
uation theory is that size and book-to-market areindi-
catorsof risk through their relationship with the eco-
nomic prospectsof com~es. The essenceof overreac-
tion, asdescribedby De Bondt and Thaler [1985], is that
investorsoverreactto recent stock returns,thereby caus-
ing the stocksof "losers" to become undervaluedand
the stocksof "winners" to become overvalued.Fama
HERSH SHEFRIN and MEIR and Frenchlean toward the rational valuationtheory;
ST A TMAN are professors of Famaand French'sanalysishasbeen challenged
finance at the Leavey School of on several grounds. Chan and Lakonishok [1993]
Business of Santa Clara University emphasizethat the relationship between returns and
in SantaClara (CA 95053). beta must be interpreted with caution becauserealized

26 MAKING SENSEOF BETh. SIZE.AND BOOK-TO-MARKET WINTER 1995

 returns are noisy. Black [1993] and Roll and Ross there is a strong relationship between stock returns and
[1994] say that the relationship between returns and beta when beta is measured relative to a mean-variance
beta might be \1.'eakif the benchmark portfolio is not efficient portfolio.
mean-"\"arianceefficient. Black goes further, and cau- But what are the characteristics that distinguish
tions that the strong relationships among stock returns, good companies from bad? We show that companies that
size, and book-to-market ratios might be due to no are perceived asgood companies are large, and have low
more than clan mining. book-to-market ratios. We also show that even experi-
We propose a behavior-based approach to secu- enced investors rank stocks as if they believe that good
rity valuation, which differs from both the overreaction stocks are stocks of good companies. Moreover, we show
and the rational valuation approaches discussedby Fama that these investorsrank stocks asif they are indifferent to
and French. we offer empirical evidence about the way beta, when betais estimated relative to a proxy of the mar-
that investors form expectations about stock returns, ket portfolio. Later, we discussthe link between expecta-
and we relate this evidence to the findings on realized tions about stock returns and expected stock returns. But
returns. we begin with expectations about stock returns.
We bwld on the behavioral capitalassetpricing
theory that we have presentedin SheErinand Statman EXPECTATIONS ABOUT STOCK RETURNS
[1994]. Assetprices in the behavioralcapitalassetpricing
theory are the outcome of an interaCtionbetweentwo Fortune magazine has been publishing the results
kinds of traders,information tradersand noise traders. of an annual survey of company reputations since 1983.
Information tradersknow the relationshipbetweenchar- The survey published in February 1993 was conducted
acteristicsof companiesand the return distributions of in the autumn of 1992, with most questionnaires com-
the stocksof thesecompanies.Noise traders,however, pleted by the end of September. It includes 311 com-
make systeImtic errors as they assessthe relationship panies in 32 industries.
betweencharacteristics of companiesand the return dis- More than 8,000 senior executives, outside
tributions of their stocks.(In a world of quadraticutility directors, and financial analysts were asked to rate the
funcrions, information tradershold mean-varianceeffi- ten largest companies in their own industry on eight
cient portfolios, while noise tradershold portfolios that attributes of reputation, using a scale of zero (poor) to
deviatefrom mean-varianceefficiency:) ten (excellent). The attributes are: quality of manage-
A central element in the behavioral capitalasset ment; quality of products or services; innovativeness;
pricing theory is a cognitive error that leads noise long-term investment value; financial soundness; abili-
tradersto the belief that good stocksare stocksof good ty to attract, develop, and keep talented people; respon-
companies.We discussthis error in detai1later,but for sibility to the community and the environment; and
now we note that the observationthat investorstend to wise use of corporate assets.
identify good stocks as stocks of good companiesis The best company, according to the 1993 survey,
longstanding.Bernstein [1956] observedthat tendency was Merck, with an average score of 8.74 on the eight
nearly forty years ago. More recent work includes attributes. The worst was Wang Laboratories, with an
Arnott [1983], Statman [1983], Sherrin and Statman average score of 1.99. Merck ranked first on financial
[1986], Clayman[1987], and Solt and Statman[1989]. soundness, quality of products or services, and ability to
Roll and Ross reiterate that there is an exactlin- attract, develop, and keep talented people. It ranked
ear relationship between expected returns and betas second on quality of management and innovativeness. t
measuredrelativeto a mean-varianceefficientportfolio. While Fortune ranks the quality of a company by its
They raisethe possibility that the proxiesused for the averagescore on the eight attributes, 82% of the survey
market portfolio are not mean-varianceefficient, but respondents consider quality of management the most
they do not identify mean-varianceefficient portfolios. important attribute of the quality of a company.
In Shefrin and Statman [1994], we characterizethe The ratings of the quality of companies by the
conditions under which mean-varianceefficient port- Fortune respondents are subjective. So what are the
folios are tilted away from stocks of good companies objective characteristics that correspond to the Fortune
and toward stocks of bad companies. Consistentwith ratings?We find that good companies are companies that
Roll and Ross's general statement,we postulate that are large and have low book-to-market ratios. In regres-

WINTER 1995 lliEjOURNAL OF PORTFOUO MANAGEMENT27

sionsof qualityof managementagainstsizeand book-to- of the quality of their stocks?
marketratios,we find the following relationships? .Consider the relationship between the Fortune
survey scores on quality of management and value as a
Quality of Management= long-term investment. The relationship is reflected in
the equation:
3.71
(11.32) Value asa Long-Term Investment =

+ 0.36 (Log of Size) -0.79

(9.02) (-5.13)

N = 270 + 1.03 (Quality of Management)

Adjusted R 2 = 0.23
(43.95)

Quality of Management= N = 311

Adjusted R 2 = 0.86
6.16
(79.02) The slope coefficient is positive and highly statistically
significant.The R 2 is 0.86. Typical Fortunerespondents
0.75 (Log of Book- to-Market) chooseas if they believe strongly that good stocksare
(-9.46) stocksof good companies.We obtain similar resultsfor
eachof the ten earlier Fortunesurveys.
N = 257 The conclusion becomes even more evident
AdjustedR 2 = 0.26 when we explore the direct relationship between the
Fortuneratingsof stocksby value asa long-term invest-
Quality of Management= ment and sizeand book-to-market ratios. Consider the
three equations.
4.64
Value asa Long-Term Investment=
(13.72)

+ 0.21 (Log of Size) 2.07

(4.60) (6.51)

0.57 (Log of Book-to-Market) + 0.49 (Log of Size)

(-6.60) (12.65)

N = 257 N = 270
Adjusted R2 = 0.31 Adjusted R 2 = 0.37

Value asa Long-Term Investment =

The Fortunesurvey respondentsimply through
their ratingsthat good companies,companieswith high
scoreson the quality of managementscale,arelargeand 5.50
have low book-to-market ratios. We obtain similar (69.47)
resultsfor eachof the ten earlier Fortunesurveys.
Sevenof the eight attributes in the Fortunesur- -0.88 (Log of Book- to-Market)
vey relate to companies. One, value as a long-term (-10.89)
investment,relatesto expectationsabout returns on the
N = 257
companies' stocks.3What is the relationshipbetWeen
Adjusted R 2 = 0.31
perceptionsof the quality of companiesand perceptions
WINTER 1995
28 MAKING SENSE
OF BETA. SIZE.AND BOOK-TO-MARKET
 Value asa Long-Term Investment= THE ROLES OF BETA AND
THE STANDARD DEVIATION
3.10
(9.60) The standard deviation of the returns of a securi-
ty is one element of beta. Beta is proportional to the
+ 0.32 (Log of Size) product of the standard deviation of the returns of a secu-
(7.63) rity and the correlation between the returns of the secu-
rity and a mean-variance efficient portfolio. A poor proxy
0.59 (Log of Book-to-Market) for a mean-variance efficient portfolio can add consider-
(-7.18) able noise to the estimate of beta. In this case,the stan-
dard deviation of a stock's returns might feature a better
N = 257Adjusted
correlation with beta than an estimate of beta derived
R 2 = 0.44 from a poor proxy: Indeed, Levy [1978] finds that the cor-
relation between standard deviation and returns is higher
The results imply that typical Fortune respondents than the correlation between beta and returns.
rank stocks as if they believe that stocks of compa- The standard deviation has more than one role.
nies that are large and have low book-to-market One role, of course, is as a proxy for beta. Another role
ratios are likely to outperform, over the long term, is as an objective characteristic that distinguishes good
stocks of companies that are small and have high companies from bad. In particular, we find that stocks
book-to-market ratios. Of course, this is the oppo- of good companies have statistically significant lower
site of what empirical evidence on returns shows.4 standard deviations than stocks of bad companies, even
We obtain similar results for each of the ten earlier when controlling for size and book-to-market ratios.
Fortune surveys. We analyze the relationship between the 1993 Fortune
The belief tha,t high value as a long-term invest- survey data and the corresponding measuresof beta and
ment stocks are stocks of large companies with low standard deviation. Beta is measured relative to the S&P
book-to-market is strikingly evident in a regression 500 Index, a proxy for the market portfolio.5
where quality of management joins size and book-to- Consider the relationships among quality of
market as an independent variable. management, a subjective measure of company quality,
and standard deviation, beta, size, and book-to-market:
Value as a Long-Term Investment=
Quality of Management=
-0.86
6.84
(-4.48)
(78.93)
+ 0.85 (Quality of Management) 0.02 (StandardDeviation)
(31.69) (-3.79)
+ 0.15 (Log of Size) N = 265
(7.53) Adjusted R 2 = 0.05

0.11 (Log of Book- to-Market) Quality of Management=

(-2.63) 6.70
N = 257 (27.98)
Adjusted R 2 = 0.89
0.06 (Beta)
(-0.32)
Note that the coefficient of size remainspositive, the
coefficient of book-to-market remains negative, and N = 265
that both coefficientsare statisticallysignificant. Adjusted R 2 = 0.00

WlI-n"ER. 1995 THE jOURNAL OF PORTFOLIOMANAGEMENT29

 Quality of Management =
0.02 (StandardDeviation)
4.99 (-4.85)
(14.02) N = 265
Adjusted R 2 = 0.07
+ 0.18 (Log of Size)
(3.95) Valueasa Long-Term Investment=

0.58 (Log of Book-to-Market) 6.53

(-6.65) (25.84)

0.01 (StandardDeviation) 0.44 (Beta)

(-2.70) (-2.01)

N = 252 N = 265
Adjusted R 2 = 0.31 Adjusted R 2 = 0.01

Quality of Management = Value asa Long-Term Investment=

4.16 3.52
(9.48) (10.54)

+ 0.21 (Log of Size) + 0.29 (Log of Size)

(4.77) (6.86)

0.58 (Log of Book-to-Market) 0.60 (Log of Book-to-Market)

(-6.58) (-7.31)

+ 0.02 (StandardDeviation)
0.35 (Beta)
(-3.55)
(1.87)
N = 252
N = 252 Adjusted R 2 = 0.45
Adjusted R 2 = 0.31
Value asa Long-Term Investment =
Note that a high standard deviation is an objec-
tive characteristic of a bad company. The correlation 3.00
between quality of management and standard deviation
(7.14)
is negative and statistically significant even when size
and book-to-market are added into the equation. In + 0.32 (Log of Size)
contrast, the relationship between quality of manage-
(7.43)
ment and beta is not statistically significant.
Consider further the relationships among the 0.59 (Log of Book-to-Market)
Fortuneratings of stocksby value asa long-term investment
(-7.05)
and standard deviation, beta, size,and book-to-market.
+ 0.10 (Beta)
Value asa Long-Term Investment=
(0.56)

6.33 N = 252
(69.84) Adjusted R 2 = 0.43

30 MAKING SENSEOFBETA.SIZE. AND BOOK-TO-MARKET

WINTER 1995
 There is a negative and statistically significant from the indicated probability that Jack is an engineer
relationship between standard deviation and value as a given that thereare seventyengineersin the population.
long-term investment. While there is also a negative This, of course,is inconsistentwith Bayes'rules.
and S'".atisticallysignificant relationship between beta Kahnemanand Tverskyargue that people reachedtheir
and value asa long-term investment, this relationship is conclusionsby consideringthe degreeto which Jack is
weaker than the relationship between standard devia- similar to or representativeof an engineer,ignoring the
tion and value as a long term investment.6 proportion of engineersin the population. We argue
The relationship between standard deviation and similarly that representativeness
leadsinvestorsto iden-
value as a long-term investment remains negative and tify good stocksas stocksof good companies,ignoring
statistically significant when size and book-to-market are the evidence that the proportion of stocks of good
added into the equation. However, the relationship companiesthat do well is smallerthan the proportion
between beta and value as a long-term investment is no of stocksof bad companiesthat do well.
longer statistically significant when size and book-to-
market are added into the equation. Thus, the Fortune FROM EXPECTATIONS ABOUT
respondents rank stocks as if they care about size, book- STOCK RETURNS TO EXPECTED
to-market, and standard deviation as they assess a stock's STOCK RETURNS
value as a long-term investment. But they are indifferent
to beta. Suppose that most investors are indeed noise
traders who believe, erroneously, that good stocks are
A BEHAVIORAL FRAMEWORK FOR stocks of good companies. But surely not all investors
EXPECTATIONS ABOUT STOCK RETURNS are noise traders. Imagine that information traders
know that good stocks are generally stocks of bad com-
Why do typical investors believe that good panies. Would information traders not nullify any effect
stocksare stocksof good companies?We argue that the of noise traders on security prices through arbitrage?
belief is rooted in representativeness,a common cogni- If the effects of noise traders on stock prices are
tive error described by Kahneman and Tversky. To nullified, risk-adjusted expected returns to stocks of
understandthe nature of representativeness,
consideran good companies will be no different from risk-adjusted
experiment by Kahnemanand Tversky [1973]. expected returns to stocks of bad companies! If arbi-
Subjectsgiven a description of "Jack," drawn at trage is incomplete, however, risk-adjusted expected
random from a population of lawyers and engineers, returns to stocks of bad companies will exceed risk-
were asked to indicate the probability that Jack is an adjusted expected returns to stocks of good companies.
engIneer: As we consider arbitrage and the likelihood that
it would nullify the effects of the preferences of noise
Jack is a 45-year-old man. He is married and has traders on security prices, we should note that no per-
four children. He is generallyconservative,care- fect (risk-free) arbitrage is possible here. To see the
ful, and ambitious. He showsno interestin polit- implications of imperfect arbitrage, imagine informa-
ical and social issuesand spendsmost of his free tion traders who receive reliable, but not perfect, infor-
time on his many hobbies, which include home mation about the expected return of a particular stock.
carpentry, sailing,and mad1ematicalpuzzles. Imagine also that the nature of the information is such
that the expected return of the stock as assessedby
One group of subjectsis told that dIe population information traders is higher than the expected return
includes thirty engineersand seventylawyers.The other as reflected in the current price of the stock.
group is told that dIe population includesseventyengi- It is optimal for information traders to increase
neersand thirty lawyers. Kahnemanand Tversky found their holdings of the particular stock, but as the amount
that the indicated probability that Jack is an engineeris devoted to the stock increases, their portfolios become
not affectedby the "baserate;' dIe proportion of engi- less diversified as they take on more unsystematic risk.
neersin dIe population; that is, the indicated probability The increase in risk leads information traders to limit
that Jackis an engineer,given that dIere are only thirty the amount allocated to the stock, and with it, limit
engineersin dIe population, did not differ significantly their effect on its price.

WINTER 1995 THEJOURNALOF PORTFOUO MANAGEMENT31

 Arbitrage can nullify the effect of the preferences financial strength. The quality rating has no
of noise traders on stock returns in two ways. First, bearing whatsoeveron the direction the price
there might be many information traders with much may take in the furore
wealth, and the combined effect of their trades might
be sufficient to nullify the effect of the preferences o~ You will be ableto sleepbetter at night asa mer-
noise traders on security prices. Yet information traders chandiserof quality stock shares When high
seem to be in a minority. quality investmentslose value, their holders are
Second, information traders might have a greater less likely to litigate, by the way, than they
effect on stock prices by becoming brokers or money would be with similarlossesin low-rated issues.
managers for noise traders. As money managers, they Investorswho lose money on high-quality issues
can leverage their effect on stock prices by investing frequently direct their anger more toward the
funds provided by noise traders. We contend, however, market than toward the broker who recom-
that aversion to regret limits the effectiveness of money mended the stock. Investorswho lose on low-
management as a mechanism for arbitrage. Kahneman quality issuestend to direct their anger toward
and Tversky [1982] describe "regret" as the pain that the broker, and they may seekredressthrough
comes with the realization, ex post, that a choice has court action (pp. 174-176).
turned out badly. The regret potential of a choice of a
stock is a function of two elements, the quality of the Peter Bernstein has pointed out to us that the
company and the share of responsibility for the choice. effectiveness of the choice of stocks of good companies
Consider first noise traders who choose stocks as a defense against poor performance might diminish,
on their own, without the help of money managers. now that clients specifically instruct money managers to
Loss by a noise trader who chooses the stock of a good buy stocks of bad or "value" companies. Time will tell
company over the stock of a bad company is an "Act of if he is right. The evidence is not encouraging.
God." The noise trader feels little responsibility, and the Consider the application of prudent man regula-
choice has little regret potential. The choice of a stock tions. Stocks of good companies have traditionally been
of a bad company, however, involves "going out on a a good defense against accusations of imprudence,
limb," so the regret potential is high. Thus, aversion to without regard to the overall portfolio. That changed in
regret reinforces the cognitive error that leads noise 1979. Since 1979, prudent man regulations specify that
traders to prefer stocks of good companies over stocks risk be assessedwithin the context of the portfolio. Yet
of bad companies. Del Guercio [1994] reports that judges and juries con-
Now consider money managers. While choos- tinue to assessrisk stock-by-stock.
ing the stocks of good companies is a way to reduce It seems that cognitive errors are persistent.
regret potential, an alternative is to transfer the respon- Investors who tell money managers that they can take
sibility for choice to a money manager. Money man- risk often change their mind when losses occur. We
agers might use their control over client funds to tilt the believe that the same holds for investors who tell
portfolios of noise traders toward stocks of bad compa- money managers that they can take regret.
nies, thereby facilitating arbitrage. Their willingness to Noise traders prefer stocks of good companies
do this, however, is limited by the likely response of over stocks of bad companies; and arbitrage by infor-
their noise trader clients. Clients are more forgiving of mation traders is unlikely to nullify the effects of noise
losses on stocks of good companies than of losses on traders on stock prices. This argument has three impli-
stocks of bad companies. cations. First, we hypothesize that variables associated
Consider the advice of Gross [1982] in his man- with known cross-sectional return anomalies are also
ual for stockbrokers: characteristics that distinguish good companies from
bad. Second, we hypothesize that variables that distin-
When selectinga stock to attempt to merchan- guish good companies from bad are also associatedwith
dise in a big way to many people, one of my return anomalies. Third, we hypothesize that betas esti-
essentialrequirementsis that the stock be rated mated relative to a portfolio tilted optimally toward
A-, A, or A+ by Standard& Poor's. Theserat- stocks of bad companies have a strong relationship with
ings are basedon an assessment of a company's stock returns.

WINTER 1995
32 MAKING SENSE
OF BETA.SIZE,AND BOOK-TO-MARKET
 Consider, for example, "neglected" companies.
Arbel and Strebel [1983] and Arbel, Carvell, and
Strebel [1983J report that stocks -of neglected compa-
nies provide higher risk-adjusted returns than stocks of
followed companies. We hypothesize that neglected
companies are bad companies, companies with low rat-
ings on the scale of quality of management.
De Bondt and Thaler [1985] report higher risk-
adjusted returns to "losers" then to "winners." We
hypothesize that "losers" are stocks of bad companies.
Solt and Statman [1989] report that stocks of
companies with low Tobin's q provide higher risk-
adjusted returns than stocks of companies with high
Tobin's q. We hypothesize that companies with low
Tobin's q are bad companies.
Now, consider objective characteristics that dis-
tinguish good companies from bad companies. Reese
[1993] reports in Fortune that reputation scores are
closely related to ten-year annual return to sharehold-
ers, profits asa percent of assets,total profits, and stock
market value. Size is measured by stock market value,
and we already know that it is associated with a return
anomaly. We hypothesize that the other three variables
are also associated with return anomalies.
CONCLUSION
We analyze the Fortune magazine surveys of
company reputations and find that survey respondents
rank stocks as if they believe that good companies are
large companies with low book-to-market ratios.
Moreover, survey respondents rank stocks as if they
believe that good stocks are stocks of good companies.
The preference of the Fortune respondents for stocks of
large companies with low book-to-market ratios con-
trasts sharply with the empirical evidence that indicates
that good stocks are stocks of smaIl companies with
high book-to-market ratios.
We also find that the Fortune respondents rank
stocks as if they are indifferent to beta. We argue that
the belief that good stocks are stocks of good compa-
nies, and the indifference to beta, underlie both the
superior performance of stocks of small companies with
high book-to-market ratios and the weak relationship
between realized returns and beta.
ENDNOTES
The authors thank Lena Lim for researchassistance;Robert
WINTER 1995
Amott, Peter Bernstein, Ed Chow, David Ikenberry, Rosemary
Macedo, Jay Ritter, and Atulya Sarin for comments, and the Dean
Witter Foundation for financial support.
IThe Fortune scores for each of the eight attributes were
obtained from Fartut/(. (The publishec articles provide only [he average
of the eight scores for each company.) Data on size and book-to-mar-
ket ratios are from Compustat. Size of a company for the 1993 Fortune
survey is me2Suredasthe log of market value of equity as of the end of
September 1992. The book-to-market ratio of a company is measured
as the log of the ratio of book value of equity as of the end of 1991 to
the market value of equity asof the end of September 1992. Log trans-
fonnations of size and book-to-market are used to facilitate comparison
with Farnaand French's analysis.
2T-statistics are in parentheses.The sample size for most of
the regressionsis smaller than the full sample because of missing data.
3An indication of what value asa long-term investment means
can be gleanedfrom the 1990 survey. This survey ranked Philip Morris
first by this measure,with a scoreof9.42. SarahSmith [1990J, the author
of the survey, notes that "Philip Morris succeededlargely by giving share-
holders exactly what they want: an outstanding rerum, year afteryear after
year Wall Street expressedits approval...by bidding up the price of its
stock 63% during the year,to a recent $41.50 per share. With that kicker,
the company's ten-year total return to investorsaveragedjust over 300/0a
year -tops among the 305 companies in our survey" (p. 42).
4Noise traders believe that good stocks are stocks of good
companies. While the evidence indicates that typical Fortune respon-
dents are probabIy noise traders, we do not have sufficient evidence for
a definite conclusion. We know that stocks of good companies under-
perfonn stocks of bad companies over long periods. But there are short
periods when stocks of good companies outperfonn stocks of bad com-
panies. Indeed, the 1980s,when most of the Fortunesurveys were con-
ducted, include a number of years when stocks of large, low book-to-
market companies outperformed stocks of small, high book-to-market
companies. We cannot dismiss the possibility that typical Fortune
respondents are information traders who know when to switch from
stocks of good companies to stocks of bad companies.
Moreover, rypical Fortune respondents might be information
traderswho know how to selectwinning stocks from the population of
good companies. If so, rypical Fortune respondents are like Peter Lynch
(formerly of Magellan) who achieved outstanding returns even though
Magellan's portfolio was composed largely of stocks of low book-to-
market companies (see Sharpe [1992]). We will know more when we
conclude an investigation of the perfonnance of portfolios constructed
by the rankin~ of the Fortunerespondents.
5Dataon betaand standard deviation are from MeTTi1ILynch
Pierce F~nner & Smith, Inc.'s "Security Risk Evaluation Market
Sensitivity Report" of September 1992.
~e relationship betWeen beta and value as a long-term
investment aswell asthe relationship between beta and quality of man-
agement is not robust. We find a relationship that is not statistically sig-
nificant for Fortunesurveys of other years.
'We use the term "risk-adjusted" to denote risk adjustment
that employs a proxy of the market portfolio for a mean-variance effi-
cient portfolio.
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