NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Fundamentals and Systematic Risk in Stock Returns

"The data indicate that the bad beta of value stocks and the good beta of growth stocks are both primarily determined by the cash-flow news of those stocks."

Economists have long evaluated the risk of a given stock by its beta, or the sensitivity of the stock's return to the return on the market as a whole. More recently, a two-beta model has been developed in which the required return on a stock is determined not by its overall beta but rather by its "bad beta," with market cash-flow shocks that earn a high premium, and by its "good beta," with market discount rates that earn a low premium. It has further been found that value stocks have relatively high bad betas, while growth stocks have relatively high good betas.

In Growth or Glamour? Fundamentals and Systematic Risk in Stock Returns (NBER Working Paper No. 11389), co-authors John Campbell, Christopher Polk, and Tuomo Vuolteenaho examine whether stocks' bad and good betas are determined by the characteristics of their cash flows - the fundamentals view -- or whether they arise from the discount rates, possibly driven by sentiment, that investors apply to those cash flows. The researchers subject both the fundamentals view and the sentiment view to a number of tests. Their results, they say, have important implications for understanding the underlying cash-flow risks of value and growth companies, strongly suggesting there is more to growth than mere "glamour."

In a first test, the researchers break firm-level returns of value and growth stocks into components driven by cash-flow shocks and discount-rate shocks. They then look at these components for value and growth portfolios, regressing portfolio-level cash-flow and discount-rate news on the market's cash-flow and discount-rate news to determine whether sentiment or cash-flow fundamentals drive the systematic risks of value and growth stocks. The data indicate that the bad beta of value stocks and the good beta of growth stocks are both primarily determined by the cash-flow news of those stocks.

In another test, Campbell, Polk, and Vuolteenaho regress the accounting profitability of value and growth portfolios on the market's cash-flow and discount-rate news, measured by the market's profitability and price-earnings ratio. They examine longer-term trends rather than short-term fluctuations in profitability. Here they find that the profitability of value stocks is more sensitive to the market's profitability but less sensitive to the market's price-earnings ratio than is the profitability of growth stocks.

In a third test, the researchers run cross-sectional firm-level regressions of the ex-post beta components onto the book-market ratio. They find that a firm's book-market ratio predicts its bad beta positively and its good beta negatively, consistent with the findings of earlier studies. But when Campbell, Polk, and Vuolteenaho deconstruct each firm's bad and good beta into components driven by the firm's cash-flow news and discount rate news, they find that the book-market ratio primarily predicts the cash-flow component of the bad beta, not the discount-rate component.

All these test results point in the same direction: The high betas of growth stocks with the market's discount-rate shocks, as well as the high betas of value stocks with the market's cash-flow shocks, turn out to be determined by the cash-flow fundamentals of both growth and value companies. Growth stocks therefore are not merely "glamour stocks" whose systematic risks are driven solely by investors' sentiment. And while formal models are still lacking in this area, the researchers say, any structural model of the value-growth effect must relate to the underlying cash-flow risks of value and growth companies.

The study also begins a broader exploration of firm-level characteristics that predict firms' sensitivities to market cash flow and discount rate shocks. Campbell, Polk, and Vuolteenaho use cross-sectional stock-level regressions to identify characteristics of common stocks that predict their bad and good betas. They consider market-based historical risk measures, the lagged beta and volatility of stock returns; accounting-based historical risk measures, the lagged beta and volatility of a firm's return on asset (ROA); and accounting-based measures of a firm's financial status, including its ROA, debt-asset-ratio, and capital-investment-asset ratio.

The researchers find that market-based risk measures, such as historical return betas and return volatilities, predict with considerable accuracy firms' sensitivities to market discount rates, but are much less reliable forecasters of sensitivities to market cash flows. Accounting data, by contrast, are relatively important indicators of firms' sensitivities to market cash flows. This implies that accounting data should play a more important role in determining a firm's cost of capital in a two-beta model, which stresses the importance of cash-flow sensitivity, than in the traditional Capital Asset Pricing Model.

Finally, Campbell, Polk, and Vuolteenaho stress that these effects -- of firm characteristics on firm sensitivities to market cash flows and discount rates -- primarily operate through firm-level cash flows rather than through firm-level discount rates. This result extends their findings for growth and value stocks and suggests that fundamentals have a dominant influence on the cross-sectional pattern of systematic risks in the stock market.

-- Matt Nesvisky


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