Given the persistence of the positive abnormal returns accruing to common stocks that have low price-earnings ratios, small corporate capitalizations and less institutional ownership, a pricing model that incorporates these factors in addition to systematic risk may provide estimates of return superior to those derived from a conventional Capital Asset Pricing Model.
Tests of a model using only systematic risk indicate that historical betas were not very useful in predicting one-year holding period returns for individual stocks over the years April 1969 through March 1983. The addition of the three additional factors—P/E ratio, market capitalization and institutional ownership—improved results somewhat, but still resulted in a volatile and statistically weak association with annual, individual stock returns.
Results are more promising on a portfolio basis. A portfolio of 18 to 25 stocks, selected from the companies with the smallest market capitalizations, lowest P/E ratios and least institutional ownership, outperformed both the total sample portfolio and the CRSP value- weighted index in 10 of the 14 years studied. In three of these years, during “up” markets, returns on this “special effect” portfolio exceeded the two benchmark returns by over 30 percentage points. The price-earnings factor and the small capitalization factor, especially, can have a positive effect on portfolio returns over the long term; their effects on individual stocks and in individual years are less certain.