Book-to-Market Value Trading System & Strategy is commonly referred to as the book-to-market effect and dates back to famed value investor Benjamin Graham and showed a difference of 7.6% average returns between high and low book-to-market stocks and that value stocks outperformed growth stocks in 12 out of 13 major indices.
What is book-to-market?
The book-to-market anomaly compares the book value of a company to its market price. Therefore, the larger the book-to-market ratio, the cheaper the company is on a pure fundamental basis.
For example, if a stock has $100 million in real assets but is valued with a market cap of only $80 million, the B/M ratio is 1.25 (100 / 80).
You can therefore say that the stock is trading below its book value and is fundamentally cheap.
If you were to strip the company and liquidate all the assets you would end up with more cash than the current market value (that is assuming the assets are valued correctly).
The book-to-market effect is one of those anomalies that makes logical sense and has a good history of out-performance which contradicts the efficient market hypothesis.
Book To Market Value Trading System & Strategy Explanation
Explanations of this anomaly are mostly behavioral based.
For example, one explanation is that investors overpay for growth stocks with compelling narratives and so value stocks get overlooked and undervalued. Investors overweight past performance into their investing decisions.
Another explanation is that high book-to-market stocks are often distressed companies and therefore entail higher investment risk.
An obvious drawback of the book-to-market anomaly is that it only takes into account one variable.
Famed value investors such as Warren Buffett would say that it’s best to look at the book-to-market ratio as simply one piece of a much larger puzzle.
The following chart from Slide-hare (apparently with data from Ken French) shows an illustration of the book-to-market effect with data from 1927 – 2007:
Book-to-Market Value Trading System & Strategy:
You can calculate the book-to-market ratio using the total book value of the stock divided by the market capitalization of the shares. You can then scan for stocks with high book-to-market values and use these as a basis for further investigation.