Eugene F. Fama

Common risk factors in the returns on stocks and bonds

This paper identities five common risk factors in the returns on stocks and bonds. There are three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity. There are two bond-market factors. related to maturity and default risks. Stock returns have shared variation due to the stock-market factors, and they are linked to bond returns through shared variation in the bond-market factors. Except for low-grade corporates. the bond-market factors capture the common variation in bond returns. Most important. the five factors seem to explain average returns on stocks and bonds.

Separation of Ownership and Control

This paper analyzes the survival of organizations in which decision agents do not bear a major share of the wealth effects of their decisions. This is what the literature on large corporations calls separation of ownership and control. Such separation of decision and risk bearing functions is also common to organizations like large professional partnerships, financial mutuals and nonprofits. We contend that separation of decision and risk bearing functions survives in these organizations in part because of the benefits of specialization of management and risk bearing but also because of an effective common approach to controlling the implied agency problems. In particular, the contract structures of all these organizations separate the ratification and monitoring of decisions from the initiation and implementation of the decisions.

Agency Problems and the Theory of the Firm

This paper attempts to explain how the separation of security ownership and control, typical of large corporations, can be an efficient form of economic organization. We first set aside the presumption that a corporation has owners in any meaningful sense. The entrepreneur is also laid to rest, at least for the purposes of the large modern corporation. The two functions usually attributed to the entrepreneur--management and risk bearing--are treated as naturally separate factors within the set of contracts called a firm. The firm is disciplined by competition from other firms, which forces the evolution of devides for efficiently monitoring the performance of the entire team and of its individual members. Individual participants in the firm, and in particular its managers, face both the discipline and opportunities provided by the markets for their services, both within and outside the firm.

Industry costs of equity

Abstract Estimates of the cost of equity for industries are imprecise. Standard errors of more than 3.0% per year are typical for both the CAPM and the three-factor model of Fama and French (1993). These large standard errors are the result of(i) uncertainty about true factor risk premiums and (ii) imp ecise estimates of the loadings of industries on the risk factors. Estimates of the cost of equity for firms and projects are surely even less precise.

Agency Problems and Residual Claims

Social and economic activities, like religion, entertainment, education, research, and the production of other goods and services, are carried on by different types of organizations, for example, corporations, proprietorships, partnerships, mutuals and nonprofits. There is competition among organizational forms for survival. The form of organization that survives in an activity is the one that delivers the product demanded by customers at the lowest price while covering costs. The characteristics of residual claims are important both in distinguishing organizations from one another and in explaining the survival of organizational forms in specific activities. This paper develops a set of propositions that explain the special features of the residual claims of different organizational forms as efficient approaches to controlling agency problems.

Business conditions and expected returns on stocks and bonds

Abstract Expected returns on common stocks and long-term bonds contain a term or maturity premium that has a clear business-cycle pattern (low near peaks, high near troughs). Expected returns also contain a risk premium that is related to longer-term aspects of business conditions. The variation through time in this premium is stronger for low-grade bonds than for high-grade bonds and stronger for stocks than for bonds. The general message is that expected returns are lower when economic conditions are strong and higher when conditions are weak.

Dividend yields and expected stock returns

The power of dividend yields to forecast stock returns, measured by regression R2, increases with the return horizon. We offer a two-part explanation. (1) High autocorrelation causes the variance of expected returns to grow faster than the return horizon. (2) The growth of the variance of unexpected returns with the return horizon is attenuated by a discount-rate effect - shocks to expected returns generate opposite shocks to current prices. We estimate that, on average, the future price increases implied by higher expected returns are just offset by the decline in the current price. Thus, time-varying expected returns generate ‘temporary’ components of prices.

PERMANENT AND TEMPORARY COMPONENTS OF STOCK PRICES

A slowly mean-reverting component of stock prices tends to induce negative autocorrelation in returns. The autocorrelation is weak for the daily and weekly holding periods common in market efficiency tests but stronger for long-horizon returns. In tests for the 1926-85 period, large negative autocorrelations for return horizons beyond a year suggest that predictable price variation due to mean reversion accounts for large fractions of 3-5-year return variances. Predictable variation is estimated to be about 40 percent of 3-5-year return variances for portfolios of small firms. The percentage falls to around 25 percent for portfolios of large firms.

Testing Trade-Off and Pecking Order Predictions About Dividends and Debt

Confirming predictions shared by the tradeoff and pecking order models, more profitable firms and firms with fewer investments have higher dividend payouts. Confirming the pecking order model but contradicting the tradeoff model, more profitable firms are less levered. Firms with more investments have less market leverage, which is consistent with the tradeoff model and a complex pecking order model. Firms with more investments have lower long-term dividend payouts, but dividends do not vary to accommodate short-term variation in investment. As the pecking order model predicts, short-term variation in investment and earnings is mostly absorbed by debt. The finance literature offers two competing models of financing decisions. In the tradeoff model, firms identify their optimal leverage by weighing the costs and benefits of an additional dollar of debt. The benefits of debt include, for example, the tax deductibility of interest and the reduction of free cash flow problems. The costs of debt include potential bankruptcy costs and agency conflicts between stockholders and bondholders. At the leverage optimum, the benefit of the last dollar of debt just offsets the cost. The tradeoff model makes a similar prediction about dividends. Firms maximize value by selecting the dividend payout that equates the costs and benefits of the last dollar of dividends. Myers (1984) develops an alternative theory known as the pecking order model of financing decisions. The pecking order arises if the costs of issuing new securities overwhelm other costs and benefits of dividends and debt. The financing costs that produce pecking order behavior include the transaction costs associated with new issues and the costs that arise because of management’s superior information about the firm’s prospects and the value of its risky securities. Because of these costs, firms finance new investments first with retained earnings, then with safe debt, then with risky debt, and finally, under duress, with equity. As a result, variation in a firm’s leverage is driven not by the tradeoff model’s costs and benefits of debt, but rather by the firm’s net cash flows (cash earnings minus investment outlays). We test the dividend and leverage predictions of the tradeoff and pecking order models. Our menu is ambitious. We examine predictions about how long-term leverage and the dividend payout ratio vary across firms with the main driving variables proposed by the two models – profitability and investment opportunities. Moreover, to test predictions about the interdependence of long-term leverage and the dividend payout, we model dividends and leverage jointly. We test the tradeoff model’s prediction that leverage is mean-reverting. And we test pecking order predictions about how financing decisions respond to short-term variation in earnings and investment. To our knowledge, we are the first to test tradeoff and pecking order predictions about the dividend payout ratio, and we are the first to jointly model and test the interaction between the payout ratio and leverage. But one can argue that many of our leverage results just confirm previous evidence.

Asset returns and inflation

Abstract We estimate the extent to which various assets were hedges against the expected and unexpected components of the inflation rate during the 1953–1971 period. We find that U.S. government bonds and bills were a complete hedge against expected inflation, and private residential real estate was a complete hedge against both expected and unexpected inflation. Labor income showed little short-term relationship with either expected or unexpected inflation. The most anomalous result is that common stock returns were negatively related to the expected component of the inflation rate, and probably also to the unexpected component.