Research Library · Study 04
Value Investing Explained: What Fama and French Found
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Overview
Value investing means buying shares that look cheap compared with what the company owns or earns, and avoiding ones that look expensive. Research by Eugene Fama and Kenneth French made it one of the most studied ideas in finance, and its long slump after 2007 made it one of the most argued about.
- Timeframe
- Years to decades
- Markets
- Shares, usually through value index funds or ETFs
- Difficulty
- Beginner
Cheap versus expensive
A company’s book value is roughly what it owns minus what it owes, as shown in its accounts. Comparing that with the share price gives the price-to-book ratio. Divide the share price by the book value per share.
A low price-to-book ratio means investors are paying little for what the company owns: a value share. A high ratio means they’re paying a lot, usually because they expect fast growth: a growth share. Other value measures compare price with earnings or cash flow.
Worked example: book value and price-to-book
- The company owns
- £800 million
- It owes
- £300 million
- Book value: £800m − £300m
- £500 million
- Shares in issue
- 100 million
- Book value per share: £500m ÷ 100m
- £5
- The share price is
- £4
- Price-to-book: £4 ÷ £5
- 0.8
Below 1 means you’re paying less than the accounts say the company is worth. That’s cheap on this measure, not a guaranteed bargain.
What Fama and French found
In 1992 Fama and French studied US shares from 1963 to 1990. Shares with high book value relative to price earned higher average returns than those with low ratios. So did smaller companies compared with larger ones1.
Researchers have argued ever since about why. One view is that value shares are riskier, often companies in trouble, so investors demand more return to hold them. Another is that investors get carried away with exciting growth stories and overpay for them.
Why might value shares have earned more?
The risk view
- Value companies are often in trouble
- Holding them is riskier
- So investors demand a higher return
The behaviour view
- Investors get carried away by exciting growth stories
- They overpay for growth shares
- So cheap, dull shares end up doing better
Researchers still argue about which is right. Both could be partly true.
The long slump
From 2007 to mid-2020, value did badly. A widely used measure of value against growth fell about 55%, its biggest slump since at least 19632.
A 2021 study by Arnott, Harvey, Kalesnik and Linnainmaa looked at why. Most of the slump came from value shares becoming much cheaper relative to growth shares. Book value also misses things like brands, software and research, which matter more to modern companies2. Their conclusion was that the evidence didn’t show value was “dead”, but it showed how long a premium can disappear.
What a 55% fall means
- Start
- 100
- After a 55% fall
- 45
- To get back to 100, it must gain 55 from 45
- 55 ÷ 45 × 100
- +122%
A fall of 55% needs a rise of about 122% to recover. That’s why long slumps are so hard to sit through.
The catch
A value premium, if it exists, only pays those who stick with it, and the slumps can last over a decade. Many investors give up near the bottom.
Cheap shares are often cheap for a reason. Some keep falling and never recover. That’s why researchers test value across hundreds of shares at once, never one or two.
One cheap share, or hundreds?
One or two cheap shares
- May be cheap for a good reason
- Could keep falling and never recover
- Your result depends on luck
Hundreds of cheap shares (a fund)
- Some fail, others recover
- This is what the research measured
- Results closer to the average
Value investing rules
Entry
- Get value exposure through a broad value index fund or ETF rather than picking a few cheap shares.
- Hold it alongside a broad market fund, not instead of one, so a long slump doesn’t sink your whole plan.
- Check the fund’s yearly charge and how it defines “value”.
Exit
- Decide your mix in advance, for example a fixed share of your shares in value, and once a year move money between funds to get back to it (rebalancing).
- Don’t abandon the plan just because value has lagged for a few years. Long lags are part of the record.
Risk
- Expect to trail the market for long periods.
- Avoid concentrating in one cheap industry, such as only banks or only oil companies.
- Remember the research is about averages across many shares, not about any single bargain.
Worked example: comparing two shares
- Company A’s shares cost £4. Its book value is £5 a share. Price-to-book = 4 ÷ 5 = 0.8. That’s a value share.
- Company B’s shares cost £30. Its book value is £3 a share. Price-to-book = 30 ÷ 3 = 10. That’s a growth share.
- The research looks at thousands of shares sorted like this. It says nothing certain about A or B on their own: A might be cheap because it’s in serious trouble.
Pros and cons of value investing
Strengths
- Backed by decades of research across many countries.
- Easy and cheap to do through value index funds.
- Can balance a portfolio heavy in expensive growth companies.
Weaknesses
- Can lag the market for more than a decade, as it did from 2007 to 2020.
- Cheap shares can keep getting cheaper.
- Book value misses things like brands and software, which matter more today.
Key terms
- Value share
- A share that looks cheap compared with what the company owns or earns.
- Growth share
- A share that looks expensive because investors expect fast future growth.
- Book value
- Roughly what a company owns minus what it owes, as shown in its accounts.
- Price-to-book ratio
- Share price divided by book value per share. Lower means cheaper.
- Value premium
- The extra average return value shares have earned over growth shares in past research.
Sources
Numbers in the lesson, like 1, point to these sources.
- Fama, E. F. and French, K. R. (1992), “The Cross-Section of Expected Stock Returns”, Journal of Finance 47(2). Journal article (no link).
- Arnott, Harvey, Kalesnik and Linnainmaa (2021), “Reports of Value’s Death May Be Greatly Exaggerated”, Financial Analysts Journal 77(1). RePEc / IDEAS listing.
Lesson complete
You have reached the end of the lesson. Now test what you learned with the five-level quiz.
Quiz zone
Test yourself: Value investing: cheap versus expensive quiz
Five levels, from the basics to expert judgment. Clear each level to unlock the next.
- Level 1: Foundations. Recognise the strategy and its vocabulary.
- Level 2: Mechanics. Know how the signals and rules work, and why.
- Level 3: Application. Apply the rules to realistic chart situations.
- Level 4: Numbers & risk. Size, measure and manage the trade with real calculations.
- Level 5: Mastery. Judge edge cases, failure modes and market conditions.
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The questions only. Answers and explanations appear when you take the quiz above.
Level 1: Know the basics
A value share is one that…
- has risen the most this year
- looks cheap compared with what the company owns or earns
- pays the biggest dividend
- is the most expensive in its industry
Who published the famous 1992 study on value?
- Wilder
- Sharpe
- Bollinger
- Fama and French
True or false: a low price-to-book ratio means the share looks cheap.
True or false?
A growth share usually looks expensive because…
- the company owns nothing
- its price never changes
- it’s been around longer
- investors expect fast future growth
Level 2: Understand how it works
In the 1992 study of US shares from 1963 to 1990, which shares earned higher average returns?
- Those with the most famous names
- Those that rose most last year
- Those with the highest prices
- Those with high book value relative to their price
Which is one explanation researchers give for the value premium?
- There is no explanation at all
- Value shares are always safer
- Brokers favour value shares
- Value companies are riskier, so investors demand more return
True or false: researchers test value across hundreds of shares at once rather than one or two.
True or false?
What happened to value from 2007 to mid-2020?
- It rose 55%
- It stopped being measured
- It stayed level
- It fell about 55% compared with growth
Apart from book value, what else can value measures compare the price with?
- The weather
- Earnings or cash flow
- The share’s colour on a chart
- The company’s logo
Level 3: Use it
You want some value exposure as a beginner. What fits best?
- The five cheapest shares you can find
- All your money in one value fund
- Only bank shares
- A broad, low-cost value index fund held alongside a market fund
Your value fund has trailed the market for four years. What does the research suggest?
- Value is dead
- Sell it now
- Put everything into growth
- Long lags are part of the record, so stick to your planned mix
True or false: a share with a price-to-book of 0.5 is certain to be a good investment.
True or false?
Why might book value miss what a modern software company is worth?
- Software companies don’t have accounts
- Book value is always too high
- It counts the same thing twice
- It doesn’t capture things like software, brands and research
All the cheapest shares right now are oil companies. Why might buying only those be a mistake?
- Oil companies can’t be value shares
- It concentrates you in one industry’s risks
- It’s too spread out
- There’s no problem
Two value funds have very different holdings. What should you check?
- Nothing: they must be the same
- Which has the nicer website
- How each fund defines “value”, and its yearly charge
- Which one a friend owns
Level 4: Work out the numbers
A share costs £6 and its book value is £8 a share. What is its price-to-book ratio? Give two decimal places.
Type a number (price-to-book).
A share costs £45 and its book value is £5 a share. What is its price-to-book ratio?
Type a number (price-to-book).
A company owns £800 million and owes £300 million. It has 100 million shares. What is its book value per share, in pounds?
Type a number (a share).
Same company: book value £5 a share. The share price is £4. What is the price-to-book ratio?
Type a number (price-to-book).
A share has a price-to-book of 2 and a book value of £6 a share. What is the share price, in pounds?
Type a number.
Something worth 100 falls 55%. What is it worth now?
Type a number ((what’s left)).
It’s now worth 45. By what percentage must it rise to get back to 100? Round to the nearest whole number.
Type a number (%).
Level 5: Judge the evidence
The 1992 study covered US shares from 1963 to 1990. What should you keep in mind?
- It will always be true
- It was proven false in 1993
- A result from one period can fade or disappear later, as value’s 2007 to 2020 slump showed
- It only applied to one company
The 2021 study found most of value’s slump came from value shares getting cheaper compared with growth. Why does that matter?
- It means value shares are now expensive
- Cheaper starting prices have historically meant better odds later, though not a promise
- It proves value is dead
- It doesn’t matter
True or false: if an investing idea has a long slump, that proves it never worked.
True or false?
Which investor is most likely to capture a value premium, if it exists?
- One who picks a single cheap share
- One who buys after a great year and sells after a bad one
- One who checks prices every hour
- One who holds a broad value fund through long slumps and rebalances
Why do many investors miss out on a value premium even when it exists?
- The premium is paid only to professionals
- It’s taxed away completely
- They give up near the bottom of a long slump
- Funds don’t pass it on
Company A has a price-to-book of 0.8. What does the research say about A on its own?
- A is a safe investment
- Nothing certain: the research is about averages across many shares
- A will be taken over
- A will beat the market
Why hold a value fund alongside a market fund instead of on its own?
- So a long value slump doesn’t sink your whole plan
- To pay more fees
- Because value funds can’t be bought alone
- Because the market fund is the same thing
What does rebalancing mean in this lesson?
- Once a year, moving money between funds to get back to the mix you chose
- Selling everything each year
- Changing your mix whenever the news changes
- Buying whatever did best