Growth Opportunities, Assets in Place, Stocks Migration and CAPM : A Rational Foundation for the Fama-French and Momentum Factors
Can the Fama-French (1993) factors and Carhart's (1997) momentum factor be derived from CAPM? Surprisingly, the answer is YES, once a basic form of stock market incompleteness is accounted for. Investors cannot trade growth opportunities (GOs) separately from net assets in place (NAIPs). Because shares are sold as bundled units containing set amounts of GOs and NAIPs, investors do not fulfill their potential demands for GOs and NAIPs “shares” when buying value and growth stocks. The mean reversion of profitability and price-to-book ratios that leads to predictable patterns of stock migration across cap and style categories (Fama and French, 2007) plays a key role in the analysis. The momentum factor is related to the temporary mean-aversion of price-to book ratios for stocks that transit through the neutral category