The research of Drs. Fama and French show US small companies outperformed the S&P 500 Index by 4.11% annualized, from 1928 through 2015. Their research also showed US companies with low price-to-book value (Value stocks) outperformed US companies with high price-to-book value (Growth stocks) by 4.81% annualized since 1928 through 2015.
In the 1960s and 70s, Drs. Eugene Fama and Kenneth French designed a three factor model to describe stock returns. The three factors are 1) company Size, 2) company Price-to-Book Ratio (Value), and 3) Market Risk. Dr. Fama eventually won the Nobel Prize in Economic Sciences for this work in 2013.
The traditional asset pricing model, known formally as the capital asset pricing model (CAPM) uses only one variable to describe the returns of a portfolio or stock with the returns of the market as a whole. In contrast, the Fama–French model uses three variables. Fama and French started with the observation that two classes of stocks have tended to do better than the market as a whole: 1) small companies (aka small cap) and 2) stocks with a low Price-to-Book ratio (value stocks). They then added these two factors to the CAPM to reflect a portfolio’s exposure to these two classes.
The Fama–French three-factor model explains over 90% of the diversified portfolios returns, compared with the average 70% given by the CAPM alone. They found positive returns from small size as well as value factors, high book-to-market ratio and related ratios.
In 2015, Fama and French added two additional factors; profitability and investment.