The Book-to-Market Anomaly in the Chinese Stock Markets

Abstract

I. INTRODUCTIONThe book-to-market effect (otherwise known as the effect) is an empirical regularity that stocks with high book-to-market (BM) ratios (low market prices to the book values of equity) earn higher average (riskadjusted) returns than stocks with low BM ratios. Many previous asset pricing studies suggest that the existence of premium can be explained from either the perspective of risk or the influence of mispricing factors.? Findings from these asset pricing studies extensively rely on datasets from the U.S. stock market which not only has a large pool of global institutional investors but also is considered a relatively efficient market.Previous studies such as Fama and French (1998 and 2012) and Asness, Moskowitz and Pedersen (2013) have also confirmed the existence of premium in international financial markets. However, premium could exist in various markets with different explanations. For example, risk-based explanation has built on the efficient market hypotheses. Those explanation may fit in the U.S. market, but not in other less developed and less efficient markets such as the Chinese market. Drew, Naughton, and Veeraraghavan (2003) and Euna and Huang (2007) have shown that the premium exists in Chinese markets. However, they have not provided its explanation.Unlike previous studies, this study goes further by providing the explanation for the existence of premium in Chinese markets. We notice that the Chinese stock market is a natural candidate for testing whether individual investors drive premium with the following reasons. First, the mainland Chinese stock markets are often perceived as casinos driven by fast money flows in and out of stocks with little regard for their underlying value (Wall Street Journal, August 22 2001). In addition, the segmentation of the markets and the predominance of individual investors in these markets make the Chinese stock market a natural candidate for testing whether individual investors drive premium.Our results confirm that, like Drew et al. (2003) and Eun and Huang (2007), the premium does exist in the Chinese markets for the period from 1994 to 2010. Moreover, there is a significantly negative relationship between institutional ownership of stocks and premium. This is apparently consistent with findings of Phalippou (2007, 2008) that premium is related to trading activities of individual investors, not institutional investors in the U.S. market.Our findings with the Chinese firms contribute to empirical asset pricing literature by providing international supporting evidence that the premium could be driven by individual investors, whereas stocks that are mostly held by institutional investors are value-premium free.The rest of the paper is organized as follows. Section 2 reviews the literature regarding the premium, the characteristics of the Chinese stock markets and develops several testable hypotheses. Section 3 then discusses the datasets and explains the empirical methodology. The empirical results are analyzed in detail in Section 4. Finally, this paper concludes by discussing the implications of our results for policy regulators, the role of institutional investors, and the overall market efficiency in China.II. THE VALUE PREMIUM AND CHINESE STOCK MARKET1. The Value Premium and Its ExplanationThe economic interpretation of the premium is a much debated issue, with current explanations falling into two broad categories. One explanation suggests that the premium is compensation for risk that is not captured by the capital asset pricing model (Fama and French, 1995, 1996, 1998; Lindaas and Simlai, 2014). In particular, Fama and French suggest that the premium is apparently related to the degree of relative in the economy. When the economy weakens, investors demand a higher risk premium on firms with distress characteristics. …