High Minus Low

Advertisement

Introduction

High minus low [HML] is an investment strategy which is, and has been helping many investors to get steady returns over the last few decades. The strategy is based on the [book value] – to – [market value] ratio of a stock. It says that a high book to market ratio stock tends to outperform the low one. High ‘book value to market value stocks’ are referred to as ‘value stocks’ and the low ones as ‘growth stocks’. So, value stocks give higher returns than growth stocks according to this strategy. High minus low finds its applications in ‘Fama and French’s three factor model’, which is used to analyze portfolios.

Calculation

HML takes into consideration, the ‘book value’ to ‘market value’ of a stock, and analyzes it accordingly. ‘Book value’ of a stock is estimated or calculated by looking at the historical costs and accounting values of the company. Book value of a stock also reflects the share price of it. Generally, stocks trade at ‘2’ to ‘3’ times the book value. On the other hand, ‘Market value’ is the market capitalization of the stock and it represents the capital sizing of the company. Mathematically, Market value is calculated by:

Market Value = N * CMP

Here,
N = Number of outstanding shares,
CMP = Current market price of the stock.

Now, using the book value and the market value, the ratio is measured. According to this ratio, stocks are grouped into ‘Value stocks’ and ‘Growth stocks’. Now, according to ‘HML’, value stocks will outperform the growth stocks.

HML is an important concept from an investor’s point of view. ‘Fama and French’s three factor model’ uses ‘HML’ to analyze portfolios. There are three factors in this model, in which one of these is ‘HML’. The other one is ‘SMB’ which stands for ‘Small capital’ minus ‘Big capital’. Fama and French’s model is another important strategy used by investors to manage their portfolios. This is an addition to the CAPM [Capital asset pricing model]. Using ‘SMB’ and ‘HML’, Fama and French’s model is interpreted as:

r - Rf = [ B3 * (Km - Rf) ] + [ Bs * SMB ] + [ Bv * HML ] + [A]

Here,
r = Portfolio’s return rate,
Rf = Risk-free return rate,
B3 = Three factor beta,
Km = Returns of the market,
Bs = ‘0’ to ’1’, based on the portfolio. ‘1’ for pure small cap portfolio and vice-versa,
Bv = ‘0’ to ’1’, based on the portfolio. ‘1’ for value stocks, ‘0’ for growth stocks.

Here, in Fama and French’s model, it could be seen that it considers the market capital of the stock, its beta, and the book value of the stock. That is the reason, beta, ‘HML’ and ‘SMB’ are used in the formula. This model redefines the statement of ‘HML’, saying that ‘small-cap stocks’ with high ‘book to market ratio’ outperform the index and other large cap stocks.

Advertisement

Theory

‘HML’ considers the ‘book to market ratio’ of a stock and uses it to evaluate and analyze a portfolio and its returns. Stocks with high book-market ratios are termed as ‘Value stocks’. These value stocks are fundamentally rich. They are, in most cases, undervalued and have superior fundamentals. Another great thing about a value stock is the dividend payout. These companies pay rich and consistent dividends.

On the other hand, a growth stock is the one whose ‘book-market ratio’ is low. Investors, generally consider a growth stock to be overvalued. These companies don’t care about paying dividends. They just concentrate on their growth and hence, are termed as ‘growth stocks’.

According to ‘HML’, value stocks outperform the growth stocks. Value stocks also pay rich dividends which makes the investors lean towards these stocks. Another concept which is similar to ‘HML’ is ‘SMB’. ‘SMB’ stands for “Small cap minus Big cap”. This too, in a similar fashion, interprets that ‘Small cap stocks’ generate higher returns than the ‘large cap ones’. Combining all these is the “Fama and French’s three factor model”, in which all these concepts act as factors. So, the combination turns up saying that “small capital stocks” with “high book-market ratios” outperform the index and the blue-chips.

Advantages

  1. This strategy takes into account, ‘book value’ to ‘market value’ ratio and has been successful in the past.
  2. ‘HML’ is one of the three factors in Fama and French’s three factor model.
  3. It is used by investors to manage and analyze their portfolios and risks.

Disadvantages

  1. It has been criticized recently due to a feature called ‘Overcrowding’.
  2. This strategy doesn’t work in some cases. ‘Growth stocks’ outperform ‘value stocks’ in those cases.
  3. In the past few years, the returns using ‘HML’ as a strategy, has been deteriorating.

Conclusion

‘HML’ is an important strategy from an investor’s point of view. It does find many applications in well- known models. It is one of the three factors in the Fama and French’s three factor model. Capital asset pricing model uses it to evaluate portfolios. The interpretation that value stocks generate higher returns than growth stocks has made this strategy a popular and an important one. But, in the recent past, this formula has been criticized because of a well-known feature in the stock markets called “Overcrowding”. Overcrowding simply means that a strategy when used by most of the stock market players tends to give lesser results over time. So, as time goes on, successful strategies become popular and are used by many players. Hence, overcrowding takes place and these methods don’t work, or in other words, generate low returns.