Making Sense of Beta, Size, and Book-to-Market

Abstract

We know from empirical studies that stocks of small companies with high book-to-market ratios have provided higher returns than stocks of large companies with low book-to-market ratios. But do senior executives, outside directors and financial analysts believe that? We show that senior executives, outside directors and financial analysts surveyed annually by Fortune magazine rank companies as if they believe that good companies are large companies with low book-to-market ratios. They rank stocks as if they believe the opposite of what empirical research has demonstrated; they rank stocks as if they believe that good stocks are stocks of good companies. We argue that a misperception of the relationship between the quality of a company and the expected rate of return of its stock underlies the superior performance of stocks of small, high book-to-market companies and the weak relationship betweenrealized returns and beta.

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