AssetPricingTestsattheMicroPortfolioLevel:

NewEvidenceontheValuePremium


LaurentBarras

(McGillUniversity)

Paperpresentedatthe

10thInternationalParisFinanceMeeting
December20,2012

www.eurofidai.org/december2012.html

Organization:Eurofidai&AFFI

 Asset Pricing Tests at the Micro Portfolio Level:
New Evidence on the Value Premium
Laurent Barras

This version: November 15, 2012

JEL Classification: G12

Keywords: Asset Pricing Tests, Large Cross-Section, Leverage

ABSTRACT

This paper develops a new testing methodology that (i) greatly expands the
cross-section of test assets by forming micro portfolios; (ii) allows for a detailed
evaluation of models in this large cross-section. As a result, it largely eliminates
the strong factor structure in returns that tend to make previous tests either too
accommodating or too stringent. Applying this methodology, I find that both the
human capital CAPM and the conditional CAPM are able to partly but not fully
explain the value premium. This balanced assessment, which highlights the merits
and failures of each model, helps reconcile the conflicting results obtained by past
studies. This paper also reveals that leverage helps explain why value firms are
riskier than growth firms. In the cross-section, portfolios with high operating and
financial leverage exhibit positive human capital betas, as well as higher market
betas during recessions. For micro-cap stocks, however, illiquidity is more closely
related to the value premium than leverage.

Desautels Faculty of Management, McGill University, Montreal. E-mail: laurent.barras@mcgill.ca.
I thank Sebastien Betermier and Aytek Malkhozov, as well as seminar participants at the 3rd Annual
CIRPE Applied Financial Time Series Workshop and the 2012 meeting of the Institute for Mathemat-
ical Finance (IFM2) for their comments.

1
I Introduction

The recent finance literature has extended the Capital Asset Pricing Model (CAPM) on
several directions to explain the value premium, i.e., the positive dierence in average
returns between high and low Book-to-Market (BM) firms. Prominent examples include
the human capital CAPM and the conditional CAPM. In the first model, the rationale
for such premium is that value stocks tend to underperform precisely when aggregate
employment and wages decrease. In the second one, value stocks earn higher returns
because they become riskier in recessions when the market risk premium is higher than
averageb. How these models perform empirically is a source of intense debate. On the
one hand, evidence from cross-sectional tests reveals that they explain a large fraction of
the variation in average returns (e.g., Lettau and Ludvigson (2001), Santos and Veronesi
(2006)). On the other hand, time-series tests conclude that they perform nearly as poorly
as the CAPM (e.g., Avramov and Chordia (2006), Lewellen and Nagel (2006)).
One possible explanation for these opposite results comes from the test assets used in
these studies a limited number of broad BM portfolios (typically, the 25 Fama-French
portfolios).1 Because of diversification eects, these portfolios exhibit little variation
in factor loadings that is independent of BM (Daniel and Titman (2012; DT)). Stated
dierently, they have a strong return factor structure (Lewellen, Nagel, and Shanken
(2010; LNS)). Since loadings line up monotonically with BM, the cross-sectional test
can choose the factor risk premia to help the model fit the data. On the contrary, the
time-series test is deprived of this flexibility, and, therefore, cannot compensate for the
low variation in loadings.
To address these issues, this paper develops a new testing methodology that dif-
fers from previous work in two key aspects. First, it implements a portfolio formation
technique that builds micro portfolios to expand the cross-section to more than 5,000
BM portfolios. This expansion largely eliminates the strong factor structure that makes
previous tests either too accommodating or too stringent. Second, this paper allows
for a detailed performance analysis in this large cross-section. Specifically, it combines
two measures, (i) the proportion of mispriced portfolios, and (ii) the average alpha they
generate, to summarize how imperfect (or misspecified) each model is. These measures
depart from the commonly-used joint tests, which only indicate whether the model per-
fectly fits the data or not. This departure is essential because virtually all models are
1
One may think that the approach used by Avramov and Chordia (2006) diers from the rest of the
litterature, since they examine whether the alpha of individual stocks is linearly related to BM This
approach turns out to be very similar, because forming broad BM portfolios is simply the non-parametric
counterpart of the linear regression they examine (Cochrane (2011))

1
likely to be misspecified when testing a large number of portfolios.
Like past studies, the portfolio formation technique used here first sorts stocks each
year according to their BM. But instead of grouping them into broad portfolios, it
creates, for each stock, a "surrogate" portfolio that contains the stock itself, and nine
additional stocks with the nearest BM. Finally, it chains these surrogates over years
to produce a large number of micro portfolios with constant BM. In addition to ex-
panding the cross-section, this approach maintains the key advantages of portfolio sorts
over individual stocks. For one, their alphas are estimated with far greater accuracy.
To compute the two mispricing measures for a given model, this paper only requires as
input the estimated alpha of each micro portfolio. Importantly, the estimation proce-
dure distinguishes between true and spurious mispricing, because it explicitly accounts
for portfolios that exhibit mispricing by chance alone. While this procedure borrows
from Barras, Scaillet, and Wermers (2010; BSW), it also brings several important inno-
vations. In particular, it provides closed-form expressions for the standard deviation of
the mispricing measures under cross-sectional dependence in portfolio returns.
To begin the empirical analysis, I measure the extent of the value premium in this
large cross-section of BM micro portfolios. To this end, I group them into BM quintiles
(growth, 2, 3, 4, and value), and evaluate the performance of the CAPM in each of these
groups. To control for firm size, this analysis is performed separately on micro-cap,
small-cap, and big-cap stocks, following the classification in Fama and French (2008).
The results obtained between July 1963 and December 2010 highlight the striking con-
sistency of the value premium in the cross-section. For one, the proportion of mispriced
portfolios in the value quintile ranges between 72.5% and 97.8% across the three size
groups. In addition, the average alphas produced by these portfolios are economically
large (between 4.2% and 8.9% per year). Since this level of consistency is very dicult
to obtain by chance, data-snooping the collective search over a large number of random
characteristics is unlikely to drive the value premium. Finally, I examine the evolution
of this premium over time. If it is driven by irrational behaviour, one would expect
it to progressively vanish as investors become aware of their "mistakes". Instead, the
proportion of mispriced portfolios remains very stable over the entire period.
Is the human capital CAPM able to capture the value premium? The answer is
clearly positive for big-cap stocks. Specifically, the proportion of mispriced portfolios in
the value quintile drops from 86.2% under the CAPM to just 36.9%, while the average
alpha falls from 4.2% to 3.3% per year. This is a remarkable success given that these
firms represent more than 90% of the total market capitalization. However, the model
performs as poorly as the CAPM in the other size groups (micro-cap and small-cap).

2
Next, I turn to the analysis of the conditional CAPM, where the dividend yield and the
term spread are used to track business cycle variation (e.g., Fama and French (1989)).
On average, the time-variation in market betas is too small for the conditional CAPM
to capture the value premiuma point forcefully made by Lewellen and Nagel (2006).
But within the cross-section of micro portfolios, this variation is suciently strong to
allow the model to achieve some notable success. Specifically, it completely eliminates
mispricing for more than 15% of the small-cap and big-cap portfolios in the value quintile.
This reduction comes with a drop in the average alpha by 0.7% per year (compared to
the CAPM). While these results are obtained with a parsimonious specification, allowing
for additional predictors and nonlinearity along the lines suggested by Choi (2012) and
Gulen, Xing, and Zhang (2011) may further improve performance. In short, the testing
approach developed here allows for a detailed performance analysis that highlights both
the merits, as well as the shortcomings of each model. Importantly, this balanced
assessment helps reconcile the previous empirical studies on the value premium.
While this performance analysis provides support for a risk-based explanation for
the value premium, it does not shed light on the underlying characteristics that make
value stocks riskier. A large body of literature that links firms corporate decisions to
asset returns shows that leverage plays a critical role. Specifically, Carlson, Fisher, and
Giammarino (2004), Cooper (2006), or Gomes and Schmid (2010) show theoretically
that firms with high BM are precisely those with: (i) higher Operating Leverage (OL)
through fixed production costs, and (ii) higher Financial Leverage (FL) through fixed
interest payments.
Motivated by these results, I first examine whether value firms exhibit higher lever-
age than growth firms. To address this issue, I use book-based measures of leverage,
defined as the ratio of fixed assets to total assets (OL), and total debt to total assets
(FL), respectively. Consistent with the above studies, the empirical evidence documents
a strong and positive relation between BM and leverage among small-cap and big-cap
portfolios. Next, it strongly supports the view that leverage drives the additional risk-
iness of value stocks. Specifically, portfolios with high levels of OL and FL are more
exposed to both human capital and time-varying market risks. For instance, I find that
66.2% of the big-cap portfolios in the highest OL quintile exhibit positive human cap-
ital betas, and more than 80% of them have market betas that increase in recessions.
Overall, the close similarity between these results and the performance analysis suggests
that the success of each model depends on its ability to capture leverage risk. Second,
the large proportion of micro portfolios that exhibit time-varying betas provides strong
evidence that equity risk vary over the business cycle. Finally, leverage conveys critical

3
information on the risk dynamics of BM portfolios and helps explain why the betas of
value stocks increase in bad times, as documented by Lettau and Ludvigson (2001) or
Petkova and Zhang (2005).

Turning to the analysis of micro-cap stocks, I find that leverage is only weakly related
to BM, suggesting that other factors such as liquidity may explain the value premium
in this specific size group. For one, these stocks exhibit considerable cross-sectional
variation in illiquidity based on the Amihud measure (2002). Consistent with this inter-
pretation, I find that micro-cap growth and value stocks exhibit very dierent liquidity
levels. Specifically, while 84.5% of portfolios with negative CAPM-alphas exhibit lower-
than-average illiquidity, the opposite pattern holds for portfolios with positive alphas.
However, this result does not translate into dierent exposures to liquidity risk adding
the Pastor and Stambaugh (2003) liquidity factor to the CAPM does not improve per-
formance in the cross-section. Therefore, while liquidity is related to the value premium,
the latter cannot be interpreted as a compensation for bearing marketwide liquidity risk.

This paper is at the center of several converging lines of research. On the methodol-
ogy front, it is closely related to the papers by DT and LNS that explain why the strong
factor structure in broad portfolios have a negative impact on asset pricing tests. To
address this issue, they both suggest to increase the number of test assets. While simi-
lar in spirit to BSW, this paper brings several important innovations to evaluate asset
pricing models in a large cross-section. On a theoretical front, this paper relates to the
large literature that links firms investment and financing decisions to asset returns (e.g.,
Carlson, Fisher, and Gammarino (2004), Cooper (2006), Gomes and Schmid (2010)).
On the empirical front, a large number of studies evaluate the ability of the human cap-
ital CAPM and the conditional CAPM to explain the value premium (e.g., Lettau and
Ludvigson (2001), Santos and Veronesi (2006), Lewellen and Nagel (2006)). Previous
work also examines the relation between leverage and the value premium (e.g., Grif-
fin and Lemon (2002), Garcia-Feijoo and Jorgensen (2010), Noxy-Marx (2011)). Here,
the key novelty is to allow for a detailed analysis of these issues by considering a large
cross-section of micro portfolios. Finally, this paper adds to the literature by providing
a detailed analysis of the impact of leverage on both human capital and time-varying
market risk.

The remainder of this paper proceeds as follows. Section II presents the methodology,
while Section III describes the data and the dierent asset pricing models. Finally,
Section IV contains the empirical results of the paper, along with some robustness tests.

4
II Methodology

A Expanding the Cross-Section using Micro Portfolios

As discussed by DT and LNS, one potential limitation of previous asset pricing tests
comes from their use of portfolio returns with a strong factor structure. To address this
issue, I follow their prescription and develop a new portfolio formation technique that
greatly expands the number of Book-to-Market (BM) portfolios. To elaborate, consider,
for simplicity, that the sample period is equal to 2 years. At the start of year 1, I sort
the 1 existing stocks according to their BM values. Then, I create, for each stock
( = 1 1 ) an equally-weighted "surrogate" portfolio that contains stock as well as
1 additional stocks having the closest BM, where is set equal to 10 in the baseline
specification. This procedure is described in Figure 1 for a specific stock indexed by 2
It departs from the usual approach in which stocks are grouped into a limited number
of broad portfolios (typically quintiles or deciles). At the start of year 2, I use the same
approach to form surrogates of the 2 existing stocks. The population size, 2 is
typically larger than 1 as the number of stocks in the CRSP database expands over
time.
Next, I chain each year-1 surrogate with the year-2 surrogate having the nearest
(standardized) BM value. To illustrate, Figure 1 shows that a combination of the
surrogates of stocks and produces a micro portfolio with a high BM, denoted by
bm Its vector of monthly returns during year 1 and 2, is simply equal to
1 1 2 2 ]0 where 1 , and 2 is the first-month return of stock
[1 12 1 12 1 1
and stock surrogates, respectively. In this simple 2-year example, the chaining proce-
dure yields a cross-section of 2 micro portfolios: (i) 1 portfolios created in year 1 and
having return observations over the entire period (24 monthly returns); (ii) 2 1
portfolios created in year 2 and having 12 monthly return observations. More gener-
ally, with a sample period of years, the total number of micro portfolio is equal to
= max ( ).
Finally, to distinguish between growth and value, I rank these portfolios according
to their BM and form five dierent groups. While the bottom quintile includes growth
portfolios, the top one contains value portfolios.

Please insert Figure 1 here

2
This procedure borrows from a technique called "local averaging" used in genetics (see Efron (2010,
ch. 9)). In our context, "local averaging" simply means that we "average" the returns of stocks that
are "local" to one another in terms of BM.

5
 Alternatively, one could use individual stocks to increase the number of test assets
(e.g., Gagliardini, Ossola, and Scaillet (2012)). I do not follow this approach here because
the alphas of individual stocks are estimated with a lot of noiseunreported results show
that stocks have, on average, much higher return volatility (45.3% vs 16.6% per year),
and shorter return history (210 vs 340 monthly observations) than the micro portfolios.
To elaborate, suppose that the true CAPM-alpha, is as high as 8% per year. Figure
2 shows that the probability of detecting such large mispricing using stock return data
is only equal to 50%, while it is above 90% with micro portfolios Another important
insight from Figure 2 is that small levels of alphas (i.e., 1%) tend to stay undetected.
Therefore, the new portfolio formation technique allows to focus on mispricing levels
that are economically significant, as advocated by Cochrane (2008). Finally, we see that
increasing to 20 stocks leaves the detection probability nearly unchanged. Since it
tends to raise cross-correlation among portfolio returns (as discussed below), keeping
equal to 10 seems a reasonable choice.

Please insert Figure 2 here

B Evaluating Asset Pricing Models using Micro Portfolios

B.1 Overview of the Mispricing Measures

The next objective is to develop a framework to evaluate the performance of each model
across the five BM groups, from growth to value. To address this issue, I build on a
very simple two-group model discussed, among others, by Efron and Tibshirani (2002).
Specifically, I assume that each micro portfolio in group ( = 1 5) can either be:
(i) correctly priced with probability 0 , or (ii) mispriced with probability 0
= 1 .
If the portfolio is correctly priced, its true alpha, is equal to zero. Otherwise, its
alpha is drawn from a distribution function, () with mean
In this paper, I use the mispricing measures,
and to determine how well the
model prices each portfolio in group while
determines the proportion of mispriced
portfolios, measures the average level of mispricing these portfolios generate.3 As

such, it departs from the commonly-used joint tests (such as the -statistic), which only
indicate whether the model can price all portfolios or not. This departure is essential
3
As discussed in Efron (2010, ch. 2), the two-group model is closely related to the empirical Bayes
approach. Specifically, we can write the prior distribution of the portfolio alpha, () as 0 0 () +
(1 0 ) () where () is the delta function at = 0 Similar to the estimation procedure explained
below, the empirical Bayes approach consists in estimating the parameters of the prior distribution (i.e.,
the mispricing parameters) using data from the cross-section of micro portfolios.

6
because it is unlikely that a given model produces no mispricing at all in a large cross-
section In this context, the important question is not whether the model is misspecified,
but how misspecified it is. Another advantage of this approach is that is does not
impose any functional form between BM and mispricing (e.g., linearity), as portfolios
with similar BM are allowed to have dierent levels of alphas.
To estimate these mispricing measures from the data, we cannot rely on the distribu-
tion of the true alphas, because it is not observable. However, we do observe the alpha
b , where
-statistic of each micro portfolio, defined as = b is the portfolio estimated
alpha, and its standard deviation. Therefore, the next step consists in expressing
the mispricing parameters as a function of the observable -statistic distribution, ()
Under the two-group model, () is a mixture of distribution:

() = 0 0 () +
() (1)

where 0 denotes the null distribution of under no mispricing ( = 0), and is the
alternative distribution of under mispricing ( 6= 0). As the number of return obser-
vations grows large, the null distribution, 0 converges towards the standard normal
distribution, 0 ()
Since mispriced portfolios produce non-zero alpha, the probability that their asso-
ciated -statistics are close to zero is small. To formalize this intuition, I impose that
() = 0 for 0 , where 0 is a small interval centered around zero that I de-
fine precisely below. This assumption is critical because it makes the two-group model
identifiable from the data. First, it allows to express the proportion of correctly priced
portfolios, 0 as a function of Specifically, the expected number of -statistics be-
longing to 0 ( 0 ) is equal to the expected number of -statistics associated
with correctly priced portfolios, 0 0 ( 0 ) implying that
R
( 0 ) ()
0 = = R 0 (2)
0 ( 0 ) 0 0 ()

Second, we can determine the alternative distribution () from by combining Equa-

tions (1) and (2), i.e.,
() 0 0 ()
() = (3)
1 0

where the term 0 0 () is a luck adjustment factor that explicitly controls for "false
discoveries", i.e., for portfolios with zero mispricing ( = 0) that produce large estimated
b by chance alone (see BSW for further discussion). Finally, we can express
alphas,

7
the mispricing parameters as a function of Specifically, the proportions of portfolios
with negative and positive alphas in group are defined as
Z 0

= ( 0) = (1 0 ) ()

Z +
+
= ( 0) = (1 0 ) () (4)
0

where + 0
+ is equal to the total proportion of mispriced portfolios, = 1 (see
the appendix for a proof) Similarly, we can also write the average levels of negative and
positive alphas that the mispriced portfolios generate as
Z
(1 0 ) 0

= ( | 0) = ()


Z +
(1 0 )
+
= ( | 0) = () (5)
+
0

where is the average standard deviation in estimated alpha across portfolios in group
(see the appendix for a proof) In short, Equations (4) and (5) express the mispricing
parameters as function of a single inputthe -statistic distribution (i.e., and 0
are functions of )

B.2 Estimation Procedure

To estimate the distribution I use the following expression obtained after applying
Bayes theorem:
() () ( | ) (6)

where () is the -statistic distribution in the portfolio population, and ( | ) is the

probability that the micro portfolio belongs to group conditional of . Using Equation
(6) increases the precision of the estimator of because it exploits information from
the entire cross-section of BM portfolios. This contrasts with a direct estimation of
that would only rely on data from group 4
In order to estimate I assume that it belongs to the -parameter exponential

(b ())
4
An approximation based on the sample size implies that (b()) where b is the direct
estimator of . Based on a simulation analysis, Efron (2008) shows that the volatility ratio for the
(b ())
indirect estimator obtained from Equation (6), (b()) is much smaller than

8
family, i.e.,

X
log( ()) = (7)
=0

where determines the shape of the distribution. If we set = 2, Equation (7) corre-
sponds to a normal distribution. Increasing allows to approximate all possible distri-
butions at the cost of estimating a very large number of parameters. Following Efron
(2010, ch. 5), I choose equal to 7 to combine the respective advantages of parametric
and non-parametric approaches (i.e., parsimony vs flexibility).5 To estimate the param-
eter vector = [ 0 7 ]0 from the portfolio -statistics, ( = 1 ) I rely on a
simple discretization method that uses standard regression techniques. In a nutshell, I
partition the range of -statistics into bins, of size equal to 01 ( = 1 ),
and denote the number of -statistics falling into each bin by = #( ) Then,
we choose b such that the RHS of Equation (7) is as close as possible to each histogram
height The resulting estimate of the discretized -statistic distribution, b( ) is
P b ), where the centerpoint of bin .
given by exp( 7=0

Next, to estimate the conditional probability ( | ) I follow Efron (2008) and use
a cubic logistic regression:
3
X
(( | )) = (8)
=0

The estimation procedure is similar to the one discussed above. After computing, for
each bin the fraction of -statistics from group = = #( )
I estimate the parameter vector = [0 3 ]0 by fitting the RHS of Equation (8)
to each fraction, The resulting estimate of the discretized conditional probability,
P P
)(1+exp 3=0 b
b ( ) = ( | ) is equal to exp( 3=0 b )) The appendix
contains additional detail on the estimation procedure.

Inserting the estimates b( ) and b ( ) in Equation (6) I obtain the estimated

-statistic distribution for group :

b( ) b ( )
b ( ) = (9)
1

Then, b ( ) can be used to determine the empirical counterparts of Equations (2) and

5
It turns out that the empirical distribution, b is quite smooth, so it can be well approximated with
lower values for In unreported results, I find that reducing to 3 or 5 has little impact on the results.

9
(3):
P b
( ) b ( )
b0 0 ( )
b0
=P 0 and b ( ) = (10)
0 0 ( ) b0
1
where 0 ( ) is the density of the standard normal distribution evaluated at =
and the interval, 0 is set equal to [05 05].6 Finally, I insert b ( ) in Equations
(4) and (5) to obtain estimates of the dierent mispricing parameters:
X X
b
b0 )
= (1 b ( ) and b+
b0 )
= (1 b ( ) (11)
0 0

b0 )
(1 X b0 )
(1 X
b
= b
b ( ) and b+
= b
b ( ) (12)
b
0
b+
0

While the methodology presented here shares some similarities with the one pro-
posed by BSW to measure mutual fund performance, it also brings several important
innovations. First, it develops estimators of the average level of alphas, +
and
in addition to the proportion estimators Second, it shows how to accurately estimate
these parameters for groups that are smaller than the entire population. Third, it uses
-statistics, which are arguably easier to work with than the -values used in BSW. Fi-
nally, as discussed below, the discretization technique used here oers a convenient way
to account for cross-sectional correlation between -statistics.

B.3 Volatility of the Mispricing Measures

As shown in Equations (11) and (12) , the mispricing measures are all functions of the
-statistic distribution, b . Since the latter is a sample average, i.e., b ( )
these measures inherits from the statistical properties of the sample average as grows
largein particular, they are consistent under many forms of cross-sectional dependence
between portfolio return residuals.7 However, dependence does increase the variance
of the dierent estimators. This is a valid concern given that the portfolio formation
technique introduced in Section II.A allows the same stock to be included in several micro
portfolios. To address this issue, I derive, in the appendix, closed-form expressions for
the variance of the mispricing measures that are valid under cross-sectional dependence
in portfolio returns.
6
Alternatively, one can use the bootstrap approach proposed by Storey (2002) to determine the length
of the interval 0 . However, the simulation analysis performed by BSW and Storey (2002) shows that
there is little dierence between these two approaches.
7
BSW, Efron (2010, ch. 4), and Storey, Taylor, and Siegmund (2004) provide a detailed discussion
on this issue.

10
 The empirical evidence shows that the mispricing measures tend to be precisely
estimated. To illustrate, the standard deviation of the estimated proportion of mispriced
portfolios under the CAPM is equal to 4.0% on average; for the average alpha estimators,
it is even smaller at 0.4% per year. This precision can be explained by the fact that:
(i) the cross-section contains more than 5,000 micro portfolios; (ii) overlapping across
portfolios is low because the number of individual stocks 16,161 in the sample is much
larger than the stocks included in each "surrogate" (i.e., = 10); and (iii) asset pricing
models capture some of the common variation in portfolio returns and, thus, reduce
cross-correlation.

III Data Description and Asset Pricing Models

A Stock and Portfolio Data

I obtain monthly return data on 16,161 common stocks (excluding financials) from
the Center for Research in Security Prices (CRSP) between July 1963 and December
2010. Firm characteristics are measured from Compustat in June-end of each year using
accounting data disclosed during the previous fiscal year I follow Fama and French
(2008) to construct variables for size and BM. To proxy for Operating Leverage (OL),
I use the book measure proposed by Garcia-Feijoo and Jorgensen (2010) and defined as
the ratio of fixed assets to total assets. This measure is consistent with the models of
Carlson, Fisher, and Giammarino (2004), and Cooper (2006) in which fixed operating
costs depend on the level of physical capital.8 Similarly, Financial Leverage (FL) is
measured as the ratio of total debt to total assets. As noted by Novy-Marx (2011), one
advantage of book measures over market measures is that the latter are, by construction,
highly correlated with BM, irrespective of whether this link is due to a risk-based or a
behavioral story. Finally, I measure stock illiquidity (ILLIQ) using the Amihud measure
(2002), computed as the absolute daily price change per dollar of daily trading volume
over the previous month.9
To create the cross-section of micro portfolios, I begin by allocating NYSE, Amex,
and NASDAQ stocks into three size groups: micro-cap, small-cap, and big-cap stocks.
Similar to Fama and French (2008), this grouping is performed in June-end of each
8
Alternatively, some studies estimate OL as the ratio of the percentage change in earnings over sales
using time-series regressions. However, as shown by Lord (1995, 1998), time-series estimates are severely
flawed when operating parameters (such as the selling price) vary during the sample period
P | | 6
9
Specifically, it is computed as 1 =1 10 where is the return of stock on day ,
is the daily dollar trading volume, and is the number of days in month

11
year taking as breakpoints the 20th and 50th percentiles of the market capitalization
for NYSE stocks. Then, within each size group, I implement the portfolio formation
technique described in Section II.A. To reduce portfolio return volatility and cross-
correlation, I work with size-adjusted returns, defined for each micro portfolio as
= where is the month portfolio return and is the month
return of the value-weighted size portfolio corresponding to the size group of portfolio
( =micro, small, or large). In addition, I require each portfolio to have at least
60 monthly return observations. Finally the portfolio characteristics (size, BM, OL,
FL, ILLIQ) are measured each year by taking a simple average of characteristics across
stocks included in the portfolio.
Table I contains some descriptive statistics for the cross-section of BM micro port-
folios. Panel A shows that the cross-section contains as many as 5,377 portfolios, while
Panel B highlights the large dierences in market capitalization across the three size
groups. An important question is whether using a large cross-section of test assets helps
weaken the factor structure in portfolio returns. To address this issue, I measure the
adjusted 2 and residual standard deviation obtained with the Fama-French model for:
(i) the cross-section of micro portfolios; (ii) the cross-section of individual stocks, and
(iii) quintile BM portfolios commonly used in previous tests. The results in Panel C
show that the new portfolio formation technique does a very good job at increasing the
dimension of the return space. For instance, in the small-cap group, the median 2 of
11.2% is much lower than the level produced by the quintile portfolios (2 =60.0%), and
is nearly as low as the one obtained with individual stocks (2 =7.5%).

Please insert Table I here

B Asset Pricing Models

The first extension of the CAPM considered in this paper includes a human capital
risk factor. For each micro portfolio ( = 1 ) I estimate its alpha, from the
following time-series regression:

= + + + (13)

where is the month size-adjusted return of portfolio , is the month excess

return on the CRSP value-weighted market portfolio, and is the month excess
return on the human capital mimicking portfolio. From the estimated alpha, b I
b b
compute the -statistic, b as b is the Newey-West (1987) estimator of the
where

12
standard deviation of b (using three lags). To construct , I follow Avramov and
Chordia (2006) and form a portfolio that is maximally correlated with the variation in
human capital. To this end, I first compute the month return on human capital,
as the monthly growth rate in aggregate income, = (1 + 2 ) (2 + 3 )
where 1 is the month 1 per capita labor income obtained from NIPA.10 Since
news about aggregate income data is generally released with a one-month lag, the 1
dating convention assumes that the information contained in 1 is fully incorporated
in equity prices only in month (Jagannathan and Wang (1996), Jagannathan, Kubota,
and Takehara (1998)). Then, I regress on a set of variables that includes a constant
and the month excess return of base portfolios, ( = 1 ) that span the
P
equity payo space as closely as possible. Finally, we set equal to =1 b
,
where b is the estimated slope coecient associated with portfolio .
To allow human capital risk to be a potential driver of the value premium, I include
two value minus growth portfolios of small and large stocks, and large in
our set of base portfolios. In addition, I consider three broad industries (durables, non-
durables & services; manufacturing, energy & utilities; business equipment & telecom)
to capture the potential impact of industry shocks on income growth. Finally, I include
the market portfolio and two zero-cost portfolios that control for the size and momentum
eects. Return data for all these portfolios is taken from Ken Frenchs website.
Panel A of Figure 3 plots the tracking performance of the mimicking portfolio over
time. At the end of each year starting in 1980, I use monthly data up to that point in
time to compute the correlation between the excess return of the mimicking portfolio and
income growth. Overall, the base assets do a decent job at tracking income growth, i.e.,
the correlation ranges from 0.35 to 0.2 and is similar to with the level generally achieved
with economic factors (e.g., Ferson, Siegel, and Xu (2006)). Panel B shows that the
time-variation in the coecient -statistics associated with large and small While
the -statistic is strongly positive for large stocks, the opposite pattern holds for small
stocks. This finding resonates with previous studies that highlight the specific nature of
small stocks.11 It suggests that the ability of the human capital CAPM to explain the
value premium may be quite dierent across size groups.

Please insert Figure 3 here

10
Measuring the return on human capital is inherently dicult because we only observe the cash-flow
component (income). Setting = is correct if future labor growth is unforecastable and labor income
discount rate is constant (e.g., Jagannathan and Wang (1996)).
11
For instance, Campbell and Vuolteenhao (2004) find that the return of small-growth stocks is pos-
itively related to increase in the market discount rate. Since such increase is more likely to occur in
recessions when income growth is low, it may explain why b turns out negative.

13
 The second model is a conditional version of the CAPM. To track business cycle
variation, I use a parsimonious specification that includes two economically motivated
instruments: the dividend yield from the value-weighted CRSP index, and the term
spread, measured as the dierence between 10-year and 1-year Treasury bond yields.
Parsimony avoids the search over a large number of variables which could invoke data-
mining concerns. While the previous literature shows that these two predictors tend
to be high during recessions, Fama and French (1989) suggest that they track dierent
business episodeslong-term ones for the dividend yield versus shorter ones for the term
spread. This yields the following model specification:

= + 1 + = + (0 + 1 + 1 ) + (14)

where 1 is the conditional market beta, defined as a linear combination of the

(demeaned) dividend yield and term spread observed at 1 and denote
the coecients associated with the two predictors. To examine whether the market risk
premium, 1 rises in recessions, I estimate the coecients of the following predictive
regression at the end of each year: = 0 + 1 + 1 +
Panel A of Figure 4 shows that b1 = b0 + b 1 + b 1 is indeed
countercyclicalthe -statistics of the estimated coecients, b and b are positive
and, most of time, highly significant between 1980 and 2010. Panel B also confirms that
the time-variation in b1 is substantial, since its monthly volatility, b(1 ) ranges
between 0.58% and 1.13%.

Please insert Figure 4 here

IV Empirical Results
A The Value Premium in the Cross-Section of Micro Portfolios
A.1 How Large is the Value Premium?

To begin the empirical analysis, I measure the ability of the CAPM to price the cross-
section of Book-to-Market (BM) micro portfolios. Since cross-sectional variation in
BM is mostly driven by dierences in future cash-flows (Cohen, Polk, and Vuolteenaho
(2003)), high BM values may not necessarily signal positive CAPM-alphas. To address
this issue, I compare the level of mispricing produced by portfolios sorted in BM quintiles
(growth, 2, 3, 4, and value). After estimating the alphas of each portfolio between
July 1963 and December 2010 using the CAPM, I apply the methodology outlined in

14
Section II.B to obtain, for each quintile ( = 1 5): (i) the proportion of mispriced
b
portfolios, b+
and b
; (ii) the level of alphas, and b+ these portfolios generate.
Importantly, the estimation procedure explicitly distinguishes between truly mispriced
portfolios ( 6= 0) and "false discoveries"that is, correctly-priced portfolios ( = 0)
which, by chance, exhibit large estimated alphas, b.
The main insight from Table II is the strong consistency of the value premium in
the cross-section. Across the three size groups (micro-cap, small-cap, and big-cap), the
proportion of portfolios with positive CAPM-alphas in the value quintile ranges between
72.5% and 97.8%, and is statistically highly significant. In addition, these alphas are
economically largefor instance, its average, b+value amounts to 4.2% per year among
big-cap stocks, with a cross-sectional volatility 1.6% per year (in brackets).12 In short,
high BM is a strong indicator of positive expected returns. Similar to previous studies, I
also find evidence of negative alphas among micro-cap and small-cap growth portfolios.
Comparing the growth and value eects, we see that the former is driven by a smaller
number of portfolios which produce larger mispricing levels (i.e., b+growth is around -10%
per year)
A common explanation to the value premium is data-snooping, i.e., the collective
search over a large number of random characteristics. For one, Conrad, Cooper, and
Kaul (2003) show that it can explain a large fraction of the return spread between the
two decile portfolios of value and growth stocks. While such a spread is subject to
"luck" because it can be produced by only a small proportion of mispriced stocks, the
strong consistency in Table II suggests that data-snooping is unlikely to drive the value
premium.
Please insert Table II here

Finally, I look at the evolution of the value premium over time. At the end of each
year starting in 1980, I use the entire return history up to that point in time to estimate
the mispricing measures in the growth and value terciles.13 For each size group, the left
panel of Figure 5 plots the variation in the proportion of growth portfolios exhibiting
negative alphas, bgrowth along with their associated CAPM-alphas, bgrowth . Similarly,
the right panel shows the evolution of the mispricing estimates in the value tercile, b+
value
and b+value . As noted by Campbell (2000), if the value premium is driven by investors

12
The cross-sectional
q volatility in portfolio alphas conditional on positive mispricing, ( | 0) is
+ 2 0
(1b )
P
computed as 2+
b b where b 2+
= + )2 b ( ) and
0 (b b+
is given in Equation
b

(12). The same approach is used to estimate ( | 0)
13
We form terciles to obtain more precise estimates during the early part of the sample which contains
fewer individual stocks.

15
irrational behaviour, it should progressively vanish as market participants become aware
of their "mistakes". The results displayed in Figure 5 cast doubt on this anomaly-based
explanation, as the mispricing measures remain stable over time. For micro-cap and
small-cap stocks, the proportions of mispriced portfolios are even higher in the later
than in the earlier part of the sample.
While there are no clear downward trends in the proportions of mispriced portfolios,
Figure 5 still displays some temporary variations. Of particular interest is the "dot com"
bubble in the late 90s, which has a strong impact on the cross-section of both small-
cap and big-cap stocks. As growth stocks are favoured over value stocks, we observe a
b
sharp reduction in mispricing in the two terciles (i.e., b+
growth and value jointly drop).
However, this pattern reverts extremely quickly after the burst of the bubble.

Please insert Figure 5 here

A.2 Performance of the Dierent Asset Pricing Models

As noted by Heaton and Lucas (2000) and Jagannathan and Wang (1996), a significant
fraction of investors wealth is tied to the value of their human capital. If value stocks
perform poorly when both aggregate employment and wages decrease, investors may
require an additional premium to hold them (e.g., Cochrane (1999, 2008)). Adding a
human capital risk factor to the CAPM may therefore address Rolls concern (1977)
that the stock market return is a poor proxy of the return on aggregate wealth. An-
other issue with the CAPM is that it does not account for potential changes in market
risk premium and betas over the business cycle. As discussed by Lettau and Ludvigson
(2001), value stocks may earn higher average returns than growth stocks precisely be-
cause they are riskier in bad times, when the risk premium is high. This suggests that
a conditional version of the CAPM may be better equipped to price equity prices in a
dynamic economy.
To evaluate the performance of these two models, I compute the estimated alphas
of each micro portfolio from the time-series regressions in Equations (13) and (14),
respectively. Then, I use this information to compute the mispricing measures across the
dierent BM quintiles. The results obtained with the human capital CAPM are displayed
in Panel A of Table III. Among big-cap stocks, we see that the model significantly
outperforms the CAPM. First, the proportion of mispriced portfolios, b+
in the highest
BM quintiles decreases dramaticallyfrom 48.9% to 23.5% (quintile 4), and from 86.2%
to 36.9% (value). Second, the average alpha, b+
produced by the portfolios that remain
mispriced also drops by 0.4% (quintile 4) and 0.9% per year (value). However, the model

16
performs as poorly as the CAPM in the micro-cap and small-cap groups.
Turning to the analysis of the conditional CAPM, Panel B reports some notable
success. On the value side, there is a widespread reduction in mispricing among both
small-cap and big-cap stocks. First, the change in the proportion of mispriced port-
folios ranges between -15.0% and -18.4% in the two highest BM quintiles. Second,
b+
the average alpha drops as well, i.e., is around 0.7% per year lower than its
CAPM-counterpart. On the growth side, we also observe a decrease in the proportion
of mispriced portfolios among small-cap firms (bgrowth decreases from 68.2% to 60.6%).
However, the model fails to price micro stocks, just like the human capital CAPM.
When the human capital CAPM is combined with the conditional CAPM, we see
the largest improvement over the CAPM for big-cap stocks. As shown in Panel C, the
proportions of mispriced portfolios in the two highest quintiles, which are respectively
equal to 12.6% and 11.9%, are statistically indistinguishable from zero. In short, while
both models help explain the value premium, they seem to capture dierent dimensions
of risk.
Please insert Table III here

Previous asset pricing tests generally use a limited number of broad portfolios. Since
dierences in risk loadings between these assets tend to average out, cross-sectional tests
may become too accommodating, and time-series tests too stringent. To illustrate, the
cross-sectional tests performed by Lettau and Ludvigson (2001) and Santos and Veronesi
(2006) show that the conditional CAPM does a very good job at capturing the value
premium, explaining up to 54% of the variation in average portfolio returns. On the
contrary, the time-series tests run by Lewellen and Nagel (2006) and Petkova and Zhang
(2005) conclude that the conditional CAPM performs nearly as poorly as the CAPM.
Similar conflicting results are also documented for the human capital CAPM (e.g., Lettau
and Ludvigson (2001), Avramov and Chordia (2006)).
This study takes a dierent perspective by expanding the cross-section of BM port-
folios. Since this approach allows for a precise assessment of the merits and limitations
of each model, it helps reconcile these two strands of the literature. To elaborate, I
find that the human capital CAPM explains a large part of the value premium among
big-cap stocks. Given that this specific size group represents more than 90% of the total
market capitalization (Fama and French (2008)), this is a remarkable success. How-
ever, it does not address the large levels of mispricing among micro-cap and small-cap
stocks. On a similar vein, the results clearly show that the conditional CAPM alone
cannot explain the value premium. But it is still able to completely eliminate mispricing

17
among some of the high BM portfolios. This last result is obtained with a very simple
specificationallowing for additional predictors and nonlinearity, as suggested by Choi
(2012) and Gulen, Xing, and Zhang (2011), may further improve the performance of
the model. Overall, the balanced assessment of these two models documented in Table
III is consistent with the commonly shared view that a model is a useful, but simplified
description of a complex environment.

A.3 More on the Conditional CAPM

As noted by Lewellen and Nagel (2006), the performance of the conditional CAPM
crucially depends on the covariance term between the market risk premium, 1
and the conditional beta, 1 Here, I examine how this covariance varies across
micro portfolios. To begin, I estimate, for each BM quintile ( = 1 5), the
average beta volatility among portfolios that exhibit time-varying betas, defined as
= (( 1 ) | 6= 0 )14 The results reported in Table IV show that
b
equals 0.17 per month in the value quintile for both small-cap and big-cap firms.
Multiplying this quantity by b(1 ) = 06% per month from Figure 4, we obtain:
c 1 1 )
( b( 1 )b (1 ) = 1% per year.15 Comparing it with the average
CAPM-alpha, b+value of 5.5% and 4.2% per year (see Table II) makes it clear that the
conditional CAPM cannot fully explain the value premiuma point forcefully made by
Lewellen and Nagel (2006).
However, the beta volatility does vary in the cross-section, i.e., its standard deviation
is equal to 0.05 (shown in brackets). It implies that the estimated 95%-confidence
b( 1 ) ranges between 0.02 and 0.27 in the value quintile (i.e., 0.172
interval for
c 1 1 ) is between 0.2% and
005) The resulting interval for the covariance, (
2.0% per year. This is well above the lower confidence bound of the CAPM-alpha, equal
to 0.8% (5.2-2 22) and 1% (4.2-2 16) per year for the two size groups. Looking at
the entire-cross section is therefore necessary to unveil the success of the conditional
CAPM.
Please insert Table IV here

14
With the conservative assumption that the true coecients,
and q are sampled independently, we estimate as
P P 2 2 2 2 b b

0
0 b +
b + 2
b ( ) ( )
where = b ( ) = b 2
b ( ) and b 2
b are the elements of the
estimated covariance matrix of the predictors.
15 b
As b
1 and 1 are driven by the same predictors (e.g., the dividend yield and the term spread),
the correlation between them, b should be close to 1 in absolute value.

18
B Leverage as a Driver of the Value Premium

While the previous analysis shows that the human capital CAPM and the conditional
CAPM help explain the value premium, it does not shed light on the underlying charac-
teristics that make value firms riskier. A large body of literature that links firms corpo-
rate decisions to asset returns suggests that leverage plays an essential role. Specifically,
in the models of Carlson, Fisher, and Giammarino (2004) and Cooper (2006), value firms
are riskier because they exhibit higher Operating Leverage (OL) through fixed produc-
tion costs (such as wage contracts or commitments to suppliers). Put it simply, if firm
A yields the same expected cash flows as firm B except that it pays some fixed costs, ,
each period, it has a lower BM (BM BM ). In addition, Firm A is riskier because its
fixed cost structure reduces its flexibility to absorb future economic shocks.16 More re-
cently, Gomes and Schmid (2010), Obreja (2010), and Ozdagli (2012) examine the joint
interaction between firms investment and financing decisions and show that Financial
Leverage (FL) through interest payments plays a similar role as OL in increasing the
equity risk profile of value firms.
Motivated by these theoretical results, I first determine whether value stocks are
more leveraged than growth stocks. Next, I examine whether dierences in leverage
can explain why value stocks are more sensitive to both human capital and time-varying
market risks. Similar to the performance analysis performed above, using the large cross-
section of micro portfolios allows for a precise examination of these relations without
assuming a specific functional form.

B.1 Are Value Firms more Leveraged?

To address this issue, I examine how portfolios in each BM quintile are distributed across
leverage quintiles (based on either OL or FL). Consistent with the above studies, the
results in Panel A of Table V show that leverage is strongly associated with BM for
both small-cap and big-cap stocks. For one, 81.7% and 70.4% of big-cap portfolios in
the value quintile achieve the highest levels of OL and FL, respectively. In addition,
we observe the exact opposite pattern in the growth quintile.17 However, the empirical
16
We can see this more formally using the accounting-based definition of OL,

=

=
where is the unit variable cost margin (e.g., = 50%), and = .
If = 0 a 5%-decrease in sales leads to a 5%-decrease in profits. However, if = 25% the decrease in
profits is two times larger (10%).
17
While Garcia-Feijoo and Jorgensen (2010) document similar evidence using quintile BM portfolios,
Table IV expands their results by showing that the BM-leverage relation holds consistently in the entire
cross-section. In contrast, Noxy-Marx (2011) documents a negative relation between BM and OL.
However, as noted by Garcia-Feijoo and Jorgensen (2010), his proxy for OL includes both fixed and

19
evidence is much weaker for micro-cap firms, consistent with Grin and Lemmon (2002)
and Wang and Yu (2012). For instance, while 31.3% of growth portfolios have low FL,
36.2% of them exhibit high FL. These results suggest that alternative factors besides
leverage, such as illiquidity, may aect the price of these specific stocks.
If financial markets are imperfect, leverage and investment are generally correlated
so that leveraged firms have more assets in place and fewer growth options (e.g., Gomes
and Schmid (2010)). This argument is consistent with the empirical evidence that value
firms exhibit higher levels of both OL and FL. This raises the question of whether one
type of leverage is more important in driving the value premium. The results reported
in Panel B of Table IV suggest that both leverage measures are required to produce the
value eect. Specifically, we find virtually no evidence of positive CAPM-alphas when
OL or FL belongs to the two lowest leverage quintiles. By the same token, the small-cap
growth eect is mostly driven by portfolios exhibiting low levels of both OL and FL.

Please insert Table V here

B.2 Leverage and Human Capital Betas

Since value firms are more leveraged than growth firms, they should be more vulnerable
to economic shocks that occur in recessions. Since aggregate employment and wages
generally drop during these specific periods, leverage risk should translate into a positive
exposure to human capital risk.
To test this prediction, I sort each micro portfolio into quintiles based on OL or FL
b , using Equation (13)
(low, 2, 3, 4, and high). After estimating the portfolio betas,
I determine, for each leverage quintile, the proportion of portfolios that are sensitive to
human capital risk (i.e., portfolios with 0) The estimation procedure is exactly
the same as in Section II.B, except that it is applied to estimated betas (instead of
alphas).
The view that human capital risk can be driven by leverage is strongly supported for
big-cap firms. As shown in Table VI, 66.2% of portfolios in the highest OL quintile do
have positive human capital betas ( 0) Second, more than 30% of portfolios in
the two lowest OL quintiles exhibit negative betas ( 0). Third, the same patterns
hold when OL is replaced with FL. For the remaining size groups (micro-cap and small-
cap), the proportions of portfolios with non-zero betas ( 0) are small and do not
change consistently across quintiles.

variable costs, and diers from the measures commonly used in the literature.

20
 Overall, the empirical evidence documented here mirrors the results of the asset
pricing test shown in Table III (Panel A). Specifically, the ability of the human capital
CAPM to capture leverage risk among big-cap stocks coincides with its success at pricing
them. This suggests that leverage is an important factor explaining the performance of
the model.
Please insert Table VI here

B.3 Leverage and Conditional Market Betas

As shown theoretically by Carlson, Fisher, and Giammarino (2004), Gomes and Schmid
(2010), or Zhang (2005), the risk associated with OL and FL tends to rise during re-
cessions. Intuitively, if investment is largely irreversible, a negative aggregate shock
(recession) leaves the present value of fixed costs unchanged, but reduces the firms eq-
uity value. The resulting change in leverage ratio raises the firms beta, reflecting the
higher stock return sensitivity to future economic shocks.18
To examine how leverage is related to equity risk dynamics, I use Equation (14) to
compute the coecients, b and b that drive the evolution of the conditional
market beta for each micro portfolio: b b b b
1 = 0 + 1 + 1 Then,
for each OL and FL quintile (low, 2, 3, 4, and high), I measure the proportion of
portfolios exhibiting (i) countercyclical betas ( 0 or 0) and (ii) cyclical
betas ( 0 or 0)
The results reported in Table VII for both small-cap and big-cap stocks strongly sug-
gest that leverage produces countercyclical betas. First, the vast majority of portfolios
in the highest OL quintile exhibit positive coecients with respect to both predictors.
Second, I document very similar patterns when portfolios are sorted into FL quintiles.
It implies that the eect of OL and FL reinforces each other to produce larger market
betas during economic downturns.19 By the same token, portfolios with cyclical betas
tend to exhibit low levels of OL and FL.
Overall, we see that leverage conveys critical information on the risk dynamics of
BM portfolios. As such, it helps explain why the betas of value stocks increase in bad
18
Similar to footnote 15, this eect can be illustrated using the simple, accounting-based definition
of OL. For instance, if after an aggregate shock, the firms profitability, falls from 50% to 30%, a
5%-decrease in sales leads to a 30%-decrease in profits (with = 25%) This loss is six times larger than
the one incurred by a firm with no leverage.
19
A recent paper by Choi (2012) addresses a similar issue by directly estimating asset returns from
stock and bond market data. Since his approach requires additional data, his sample is significantly
smaller than the one used here. More importantly, his analysis focuses on decile BM portfolios, while
we study a large cross-section of BM micro portfolios. Despite these dierences, both papers provide
empirical evidence that the risk associated with OL and FL increases in bad times.

21
times, as documented by Lettau and Ludvigson (2001) or Petkova and Zhang (2005). In
addition, this cross-sectional analysis reveals widespread evidence of time-varying betas.
For one, more than 50% of the big-cap portfolios exhibit time-varying betas (see final
column Avg.). While this variation is not suciently large quantitatively to fully capture
the value premium (see Table IV), these results strongly supports the conditional CAPM
view that market betas vary over the business cycle.

Please insert Table VII here

C Illiquidity among Micro-Cap Stocks

The results in Table II show that the value premium is larger among micro-cap stocks,
as the spread in average alphas, b+
value -b growth is rises up to 18.9% per year. In addition,
both the human capital CAPM and the conditional CAPM have a hard time explaining
this spread. One possible explanation for these results is that abnormal returns may be
tougher to arbitrage away among micro-cap stocks, as they exhibit high idiosyncratic
variance, low analyst coverage, and low institutional ownership (e.g., Nagel (2005), Wang
and Yu (2012)). Alternatively, the value premium may be driven by dierences in
liquidity. For one, the cross-sectional variation in illiquidity, measured with the Amihud
measure (2002), is extremely strong among micro stocks (see Table I).
To address this issue, Panel A of Table VIII examines the illiquidity of the portfolios
that are mispriced under the CAPM. The results for micro-cap stocks reveal that growth
stocks are more liquid than value stocks. Specifically, 84.5% of portfolios with negative
alphas exhibit lower-than-average illiquidity, while 71.3% of portfolios with positive al-
phas have high illiquidity levels (i.e., quintiles 4 and high). This dierence, which is
not observed in the other size groups, suggests that liquidity partly drives the value
premium of micro-cap stocks.
Following these findings, it is natural to ask whether this premium arises as a com-
pensation for bearing systematic liquidity risk. To address this issue, I measure the
performance of a liquidity CAPM that includes the excess return of the Pastor and
Stambaugh (2003) traded liquidity factor.20 The proportions of mispriced portfolios for
each BM quintile (growth, 2, 3, 4, and value) are reported in Panel B of Table VIII.
Overall, this model oers little improvement over the CAPM. Among micro-cap portfo-
b
lios, b+
growth and value are as high as 53.7% and 92.0%, respectively, versus 57.1% and
20
Its excess return, downloaded from WRDS, is defined as the dierence between the value-weighted
average return on stocks with high sensitivities to liquidity less the value-wieghted average return on
stocks with low sensitivities to liquidity. Since this factor is only computed from 1968 onwards, I estimate
the mispricing parameters between July 1968 and December 2010.

22
97.8% for the CAPM. These results point out to a large disconnect in the cross-section
between portfolios with high (low) levels of illiquidity and those exhibiting high (low)
exposures to marketwide liquidity risk.

Please insert Table VIII here

D Sensitivity Analysis

D.1 Operating and Financial Leverage

To examine whether the main results are sensitive to the proxies used for Operating
and Financial Leverage (OL and FL), I propose alternative point-to-point measures
defined as follows: OL =
= and FT = =
, where is the unit variable cost margin, is total sales, is earnings
before interest and taxes, and is pretax earnings. To compute these measures, we
need to take a stand on the variable versus fixed nature of production costs. Specifically,
I estimate as
where is the total costs of goods sold, and
denote selling, general, and administrative costs. This approach is consistent
with Anderson, Banker, and Janakiraman (2003) who argue that the major part of
is variable. All these items are obtained from Compustat.
Armed with these new measures, I revisit the relation between leverage and the
value premium in Table IX. Overall, the results are consistent with those documented
in Table V. First, we still observe a positive relation between leverage and BM (in Panel
A). Second, the majority of portfolios with negative (positive) CAPM-alphas still exhibit
low (high) levels of both OL and FL (Panel B).

Please insert Table IX here

D.2 Human Capital Mimicking Portfolio

Next, I compare the properties of the estimated mimicking portfolio for aggregate income
growth, obtained under alternative specifications for the choice of base assets. The
first specification replaces the value minus growth portfolios with their respective long
and short positions, while the second specification considers the six Fama-French size-
BM portfolios (in these two cases, we remove the size factor because of multicollinearity).
Next, I modify the selection of industry portfolios as follows. Specification 3 breaks the
durables, non-durables & services portfolio into its three components, while Specification
4 and 5 do the same for the manufacturing, energy & utilities portfolio and the business

23
equipment & telecom portfolio, respectively. Finally, I examine the importance of the
size and momentum factors by removing each of them in Specification 6 and 7.
Overall, Table X shows that the results are robust to changes in the set of base assets.
First, in all specifications, the coecient -statistic associated with the value portfolio
of large firms is strongly positive. The same result holds for the growth portfolio of
small firms. Second, the correlation with income growth and adjusted 2 stay nearly
unchanged compared to the baseline specification shown in the first column. Finally,
the risk-return characteristics of the mimicking portfolio remain almost constant.

Please insert Table X here

Since individuals observe their own income and asset returns simultaneously, Heaton
and Lucas (2000) and Eiling (2012) test the human capital CAPM using the contempo-
raneous income growth, measured as ( + 1 ) (1 + 2 ) Consistent with
their findings, I find that the choice of the timing convention greatly aects the results
obtained at the monthly frequency. Specifically, the last column of Table VIII shows
that the mimicking portfolio bears virtually no relation with , i.e., only one estimated
coecient is significant at the 10%-level, and the adjusted 2 drops to 0.6%. One pos-
sible interpretation for this result is that given the one-month publication lag in labour
income data, information about is not fully incorporated in equity prices at time In
this case, using the lagged contemporaneous growth rate is more appropriate (e.g., Ja-
gannathan, Kubota, and Takehara (1998)). Alternatively, Eling (2012) suggests that
is plagued by measurement errors and should, therefore, be replaced by industry-specific
income growth rates.

V Conclusion

This paper develops a new methodology to evaluate asset pricing models that departs
from previous tests in two important aspects. First, it follows the prescription made
by DT and LNS, and develop a portfolio formation technique that greatly expands the
cross-section of Book-to-Market (BM) portfolios. Second, it combines two mispricing
measures to summarize how well each model is able to price portfolios in the cross-
section.
Applying this new methodology, I examine whether the human capital CAPM and
the conditional CAPM are able to explain the value premium in this large cross-section.
The results reveal that the human capital CAPM does an excellent job for big-cap stocks,

24
but fails to improve performance over the CAPM among micro-cap and small-cap firms.
While the conditional CAPM alone cannot explain the value premium, it is still able
to completely eliminate mispricing among high BM portfolios. Overall, this balanced
assessment helps reconcile the conflicting results obtained by previous empirical studies
on the value premium.
Consistent with the large body of literature that links firms corporate decisions
with asset returns (e.g., Carlson, Fisher, and Giammarino (2004), Gomes and Schmid
(2010)), this paper also suggests that leverage is an important driver of the riskiness
of value stocks. The results documented for small-cap and big-cap stocks reveal that
portfolios with high leverage (i) are more exposed to human capital risk, and (ii) have
market betas that increase during recessions. However, the evidence for micro stocks is
much weaker. Further analysis shows that, in this specific size group, liquidity is a more
important driver of the value premium than leverage.
Although this paper focuses on the value premium, using micro portfolios to expand
the cross-section has many other applications. For instance, it can applied to a wide
range of anomalies, such as the momentum, the profitability, or the accrual eects (e.g.,
Fama and French (2008)).

25
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29
VI Appendix

A Derivation of Expressions (4) and (5)

R0
To derive Equation (4), note that 0
= (1 ) () where () is the distri-
bution of the true alpha under mispricing ( 6= 0) Under the identification assumption,

() = 0 for 0 (A1)

the alpha -statistic, cannot be postive if 0, i.e., ( | 0 ) = 0 for [0,+[

This implies that Z 0
0
= (1 ) () (A2)

By the same token, cannot be negative if 0 implying that

Z +
+
= (1 0 ) () (A3)
0

To obtain Equation (5), note that if the standard deviation, is independent of

we have
() () = ( ) (A4)

where () is the prior distribution of , and ( ) is the joint distribution of and

under mispricing. It implies that
Z 0 Z 0 Z + Z 0
() = ( ) = b (b
)b
(A5)
0

R +
where = 0 () and (b ) denotes the distribution of b under mispricing
Under the identification assumption in Equation (A1), the estimated alpha, b cannot
be positive if 0 Therefore, expressing the estimated alpha, b as the true alpha,
plus noise completes the proof, since
Z Z Z
0 0 +

b (b
)b
= () +
() = (A5)
(1 0 )

where () and
() denote the distribution of and under mispricing, respectively.
The same procedure can be used to derive the expression for +

30
B Estimating the -Statistic Distribution

Here, I provide additional detail on the procedure used to estimate the -statistic distri-
bution in group
() () ( | ) (B1)

where () is the -statistic distribution in the portfolio population, and ( | ) is the

probability that the portfolio belongs to group conditional on I begin with a short
description of the Lindseys method, which provides a very convenient way to estimate
the coecient vector, = [ 0 7 ]0 that characterizes ():

X7
() = exp (B2)
=0

This method consists in estimating a discretized version of () by partitioning the range

of -statistics, = [45 0 +45] into bins, , of equal width, equal to
0.1 ( = 1 ) To compute the vector b I use the orthogonality conditions of the
Poisson Generalized Linear Model (GLM):

b = 0
0 exp( ) (B3)

where is a 8 matrix whose row, is equal to [1 7 ] is the

centerpoint of bin and is the -vector of counts, i.e., = [ ]0 with =
#( ). Computation of b relies on a form of iteratively re-weighted least square
performed by the function glmfit in Matlab.

If each count is
P an independent Poisson observation, i.e., ( ), where =
( ) = exp 7 b
=0 the GLM , is identical to the maximum likelihood
Q
estimate obtained by directly maximizing =1 ( ) (e.g., Efron and Tibshirani (1996))
However, if these assumptions
are not met, the GLM can still be used. In particular,
P
b( ) =exp 7 b
=0 turns out to be an unbiased and consistent estimator of ( )
under many forms of dependence between counts (Efron (2010), ch. 5). However,
this dependence has an impact on the variance of b( ) and, as a result, on the variance
of all the mispricing measures, as shown in Appendix C.

A similar procedure can be used to determine the conditional probability, ( | )

Specifically, to estimate the coecient vector , = [0 3 ]0 of the cubic logistic

31
regression
1
X3 X3
( | ) = 1 + (B4)
=0 =0

I use the Binomial GLM to obtain the following orthogonality conditions:

0 (b
)1 exp( b
)) = 0 (B5)

where is a 4 matrix whose row, is equal to [1 3 ] is the

-vector of fractions, i.e., = [ ]0 with = = #( ) and
(b ) is a diagonal matrix with b( ) = 1+exp(0 b ) on its diagonal Here again,
I use the function glmfit in Matlab to compute b . This yields the following probability
0
estimate, b ( ) = b( | ) =exp( b )(1+exp(0 b)) which can be used along
b
with ( ) in Equation (B1) to obtain the discretized -statistic distribution for group
b ( )

C Standard Deviation of the Mispricing Measures

Next, I derive closed-form expressions of the standard deviation of the mispricing mea-
b
sures, b+
b
b+
and under general forms of cross-correlation between the portfolio
-statistics. As the number of -statistics, grows large, the covariance matrix of the
-vector of counts, can be estimated using the root-mean square approximation pro-
posed by Efron (2010b):

b

c
() 1 b1 b10 + 2 b2 b20
= (b) bb0 + 2 b (C1)
2

where b is the -vector of the estimated (discretized) -statistic distribution, b =

[ b( ) ]0 (b) is a diagonal matrix with b on its diagonal, b1 and b2
are the -vectors of the first and second derivatives of b( ) =exp(0 )b and b 1 b
2
denote the cross-sectional median of the estimated correlation and squared correlation
between the portfolio return residuals.21 If the -statistics are independent, follows a
multinomial distribution, and, as such, its covariance matrix is equal to the first term
in the RHS of Equation (C1). The second term introduces a correlation penalty that is
straightforward to compute, as the dependence pattern across the portfolio -statistics
21
The correlation between residuals can be used to infer the correlation between -statistics because
there is a one-to-one mapping between them. To illustrate, consider two portfolios and that are cor-
rectly priced (i.e., = = 0) As shown by Efron (2008, ch. 8), we have (-stat) 0 (residuals)
where 0 = 1 (1 2 (residuals))(2( + 1)) and is the number of return observations.

32
is captured by the two scalars, b
1 and b
2

Any variation in aects the distribution b through the estimated coecient vector,
b From the Poisson GLM orthogonality conditions in Equation (B3) a given change in

produces a change in b that satisfies 0 = 0 (b)

b =
b This implies

the following relation between and log(b) :

b = 1 0 =
b = (C2)

Next, I extend Efrons approach to approximate the covariance matrix of the -

vector of fractions, The probability that a -statistic from group falls in bin
conditional on ( | ) is equal to ( ) where denotes the total
number of portfolios in group Since ( | ) = (1 ) = = ( )
and are uncorrelated, implying that ( ) = ( | ) Using this result along
with Efrons root-mean square approximation, we have for large :

b b b b b1 b10 b
2 b2 b2
2
c ) = ( )
( 1 0
( ) + b 2
1 + (b)1
2
(C3)
where is the -vector of the (discretized) -statistic distribution for group , b =
b
[ b ( ) ]0 b ( ) = b( ) b ( ) (10 b ) 1 is a -vector of ones, (b ) is a
diagonal matrix with b ( ) on its diagonal, and b1 and b2 are the -vectors of the

first and second derivatives of b ( ) = b( ) (10 b )exp 0 b 1 + exp 0 b

To determine how a change in aects the -vector of conditional probabil-

ity b = [ b ( ) ]0 I start from the Binomial GLM orthogonality conditions in
Equation (B5) A given change in produces a change in b that satisfies 0 =
0 (b b) b = b where (b b) is a diagonal matrix with b ( )b ( )
on its diagonal Therefore, the relation between log(b ) and can be written as

= b
b log(1+( b
))
= ( 1 0
b)1
(b
0
) = (C4)

) is a diagonal matrix with b ( ) on its diagonal.

where (b

b0 and b based
The third step consists in computing the variation in the log of b

33
on Equations (9), (10), and (11):

b = b + b
= +
b 0 = 1 b 0 b
0 (0 )

b = 1 b 2 1 b0 1 b
0 (C5)

where b (0 ) is a -vector with entries equal to b if 0 and zero otherwise,

0 = 10 b (0 ) 1 is a diagonal matrix with b ( )(b ( )(1 b0 )) on its
diagonal, 2 is a diagonal matrix with 0 b 0 (b ( )(1
b0 )) on its diagonal,
0 is the density of the standard normal distribution, is the bins width ( =0.1),
and b0 = b0 (1
b0 )
With Equation (C5) at hand, we can determine the variation in the estimated pro-
b
portion of porfolios with negative mispricing, as a function of both and :

1 b 0 b b b

b = b

b

= b


() 0 0


1 b b
b
= 0 1 0
() 1 0 2 1 (0 ) ( + )

= 0 ( + )
= 0 + 0 (C6)

where b () is a -vector with entries equal to b ( ) if 0 and zero otherwise,

= 10 b () Finally, a standard use of the delta approach provides an estimator of
the variance of b that explicitly accounts for the cross-correlation between portfolio
-statistics:
b2 (b
0
c
) = ()
0
c )
+ ( (C7)

c
where () c ) are taken from Equations (C1) and (C3), respectively.
and (
b
To determine the variation in the average of negative alpha, we can express it
as a function of and :

1 c b (b b b

b = b

b

= b

()
) 0 0
b


h
i
1 c b
b
= 1 0 0
() 1 0 2 1 (0 ) ( + )

= 0 ( + )
= 0 + 0 (C8)

c () is a -vector with entries equal to b ( ) if 0 and zero otherwise

where

34

c () Using Equation (C8), we can compute the estimated variance
and and = 10
b
of the mispricing level, as

b2 (b
0
c
) = ()
0
c )0
+ ( (C9)

The same procedure can be applied to estimate the standard deviation of b+ and b+
.
To check the accuracy of these formulas, I reproduce the results of the simulation
analysis performed by BSW. With 1 = 005 and = 898 they report a-90% confi-
b+ equal to [15%,31.6%] (see Panel D of Table A.II in their appendix).
dence interval for
Based on the same parameters, I find that b(b + ) is equal to 5.2%, yielding a confidence
interval of [13.5%,30.6%] that is very much in line with the one above.

35
 Table I
Descriptive Statistics of the Book-to-Market Micro Portfolios

Panel A shows, for each size group (micro-cap, small-cap, big-cap), the total number of Book-to-
Market (BM) portfolios along with the cross-sectional median and the 25-75% quantiles (in brack-
ets) of the (annualized) mean and standard deviation, skewness, and kurtosis of size-adjusted
portfolio returns. Panel B reports the cross-sectional median and the 25-75% quantiles (in brack-
ets) of the portfolio size, BM, operating leverage, financial leverage, and illiquidity. Finally, Panel
C uses the Fama-French model to determine the median and the 25-75% quantiles (in brackets)
of the adjusted 2 and (annualized) residual standard deviation of size-adjusted returns for:
(i) the cross-section of micro portfolios; (ii) the cross-section of individual stocks; (iii) quintile
BM portfolios. All statistics are computed using monthly observations between July 1963 and
December 2010.

Portfolio Size-Adjusted Returns

Nb. Port. Nb. Obs. Mean (Ann.) Std (Ann.) Skewness Kurtosis
Micro 3,256 360[240,408] 2.7[-2.8,6.5] 19.3[17.8,21.3] .26[.12,.39] 3.6[3.2,3.9]
Small 1,060 390[186,468] 0.5[-3.6,3.3] 15.5[13.8,17.8] .17[.00,.35] 4.4[3.8,5.1]
Big 1,061 420[150,510] 2.1[0.1,4.0] 13.2[11.8,15.5] .32[.12,.50] 5.1[4.4,6.1]

Portfolio Characteristics
Size ($ Mio.) Book/Market Operating L. Financial L. Illiquidity
Micro 30[17,55] 0.74[0.38,1.33] 0.28[0.22,0.34] 0.45[0.40,0.52] 4.44[2.02,9.45]
Small 237[108,422] 0.56[0.31,0.92] 0.33[0.24,0.41] 0.46[0.40,0.52] 0.14[0.05,0.35]
Big 2398[969,4467] 0.51[0.29,0.86] 0.39[0.30,0.51] 0.50[0.45,0.56] 0.01[0.00,0.06]

Factor Structure of Size-Adjusted Returns

R2 (%)Fama-French Model Residual StdFama-French Model (Ann.)
Micro Port. Stocks Quintile Port. Micro Port. Stocks Quintile Port.
Micro 4.1[1.5,7.4] 3.6[1,5,7.2] 14.8[7.6,42.4] 18.8[17.3,20.6] 54.8[44.0,66.2] 5.1[4.2,5.2]
Small 11.2[4.2,21.1] 5.2[2.3,9.9] 60.0[1.5,64.1] 14.5[12.8,16.7] 40.0[32.0,51.1] 4.1[3.3,4.3]
Big 17.1[10.0,27.9] 7.1[3.5,13.2] 67.1[27.4,67.3] 11.8[10.6,13.6] 31.1[24.9,40.2] 4.9[3.3,4.9]

36
 Table II
The Value Premium

This table shows the performance of the CAPM in the cross-section of Book-to-Market (BM)
micro portfolios. For each size group (micro-cap, small-cap, big-cap), I sort each portfolio in
BM quintiles (growth, 2, 3, 4, and value). Then, for each quintile, I estimate the two mispricing
measures: (i) the proportion of mispriced portfolios (Mispricing-Proportion); (ii) the average
(annualized) CAPM-alpha that these mispriced portfolios generate (Mispricing-Alpha). If the
estimated proportion is statistically not dierent from zero (at 5%), the average alpha is not
estimated ("-"). The figures in parentheses show the standard deviation of the estimated pro-
portions. The figures in brackets show the estimated cross-sectional volatility in CAPM-alpha
among mispriced portfolios.

Micro-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 57.1 (2.9) 20.8 (2.0) 0.0 0.0 0.0 15.6
+ 0.0 4.8 (1.8) 44.1 (2.6) 89.5 (2.0) 97.8 (2.1) 47.3
MispricingAlpha (Ann.) -10.0 [3.9] -6.7 [2.5] -8.4
+ 5.4 [1.9] 5.9 [2.4] 6.9 [2.6] 8.9 [3.0] 6.8

Small-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 68.2 (7.1) 32.0 (4.5) 4.5 (2.7) 0.0 0.0 20.9
+ 0.0 0.0 17.8 (3.4) 61.1 (4.3) 72.5 (4.6) 30.3
MispricingAlpha (Ann.) -10.5 [4.3] -6.1 [2.4] -8.3
+ 4.1 [1.7] 4.0 [1.7] 5.2 [2.2] 4.4

Big-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 0.0 0.0 0.0 0.0 0.0 0.0
+ 0.0 0.6 (0.6) 9.8 (4.3) 48.9 (6.1) 86.2 (9.8) 29.2
MispricingAlpha (Ann.)
+ 2.9 [1.2] 3.2 [1.3] 4.2 [1.6] 3.4

37
 Table III
Performance of the Dierent Asset Pricing Models

The performance of the human capital CAPM, the conditional CAPM, and a combination of
these two models in the cross-section of Book-to-Market (BM) micro portfolios is reported in
Panels A, B, and C, respectively. For each size group (micro-cap, small-cap, big-cap), I sort
each portfolio in Book-to-Market (BM) quintiles (growth, 2, 3, 4, and value). Then, for each
quintile, I estimate the two mispricing measures: (i) the proportion of mispriced portfolios
(Mispricing-Proportion); (ii) the average (annualized) alpha that these mispriced portfolios gen-
erate (Mispricing-Alpha). The figures in parentheses show the standard deviation of the esti-
mated proportions. If the estimated proportion is statistically not dierent from zero (at 5%), the
average alpha is not estimated ("-"). The figures in brackets show the estimated cross-sectional
volatility in alpha among mispriced portfolios.

Panel A Human Capital CAPM

Micro-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 59.8 (2.8) 24.1 (2.0) 0.0 0.0 0.0 16.8
+ 0.0 2.3 (1.6) 43.5 (2.6) 87.8 (2.0) 95.9 (2.1) 45.9
MispricingAlpha (Ann.) -10.4 [4.1] -7.1 [2.7] -8.7
+ 5.4 [1.6] 6.4 [2.6] 7.6 [2.8] 10.0 [3.1] 8.0

Small-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 73.6 (5.4) 32.4 (4.1) 5.2 (3.0) 0.0 0.0 22.2
+ 0.0 0.0 14.3 (3.5) 65.5 (4.3) 75.7 (4.4) 31.1
MispricingAlpha (Ann.) -10.6 [4.1] -6.3 [2.4] -8.4
+ 4.3 [1.8] 4.4 [1.9] 5.5 [2.3] 4.7

Big-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 0.0 0.0 0.0 0.0 0.0 0.0
+ 0.0 0.0 4.1 (6.9) 23.5 (8.0) 36.9 (10.4) 12.9
MispricingAlpha (Ann.)
+ 2.8 [1.1] 3.3 [1.4] 3.1

38
 Table III
Performance of the Dierent Asset Pricing Models (Continued)

Panel B Conditional CAPM

Micro-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 51.9 (2.9) 18.2 (1.9) 0.0 0.0 0.0 14.0
+ 0.0 3.8 (1.7) 43.7 (2.6) 84.6 (2.0) 94.2 (2.1) 45.2
MispricingAlpha (Ann.) -9.7 [3.9] -6.4 [2.4] -8.1
+ 5.3 [1.8] 5.9 [2.4] 6.8 [2.6] 8.7 [2.9] 6.7

Small-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 60.6 (5.4) 28.4 (3.7) 5.9 (2.8) 0.0 0.0 19.0
+ 0.0 0.0 9.6 (2.5) 43.2 (4.4) 54.1 (4.5) 21.4
MispricingAlpha (Ann.) -10.1 [4.1] -5.8 [2.3] -2.9 [1.0] -6.3
+ 5.6 [2.1] 3.8 [1.7] 4.6 [1.9] 4.7

Big-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 0.0 0.0 0.0 0.0 0.0 0.0
+ 0.0 2.2 (2.0) 9.6 (4.8) 31.9 (7.0) 71.2 (10.6) 23.0
MispricingAlpha (Ann.)
+ 2.8 [1.3] 3.5 [1.4] 3.1

Panel C Human Capital & Conditional CAPM

Micro-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 55.2 (2.9) 21.7 (1.9) 0.0 0.0 0.0 15.4
+ 0.0 2.0 (1.6) 43.5 (2.6) 86.3 (2.1) 95.7 (2.2) 45.5
MispricingAlpha (Ann.) -10.1 [4.1] -6.9 [2.6] -8.5
+ 5.3 [1.5] 6.3 [2.5] 7.6 [2.8] 9.8 [3.1] 7.9

Small-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 61.9 (5.2) 31.1 (3.9) 6.3 (2.9) 0.0 0.0 19.9
+ 0.0 0.0 10.5 (2.9) 50.5 (4.3) 62.5 (4.7) 24.7
MispricingAlpha (Ann.) -10.0 [3.9] -6.1 [2.3] -3.3 [1.0] -6.4
+ 4.9 [2.1] 4.1 [1.8] 5.2 [2.2] 4.7

Big-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 0.0 0.0 0.0 0.0 0.0 0.0
+ 0.0 0.0 2.8 (8.3) 12.6 (9.2) 11.9 (9.8) 5.5
MispricingAlpha (Ann.)
+ 39
 Table IV
Monthly Volatility in Conditional Market Betas

For each size group (micro-cap, small-cap, big-cap), I sort each portfolio in BM quintiles (growth,
2, 3, 4, and value). Then, for each quintile, I estimate the average monthly beta volatility
among the portfolios that exhibit time-varying market betas (i.e., portfolios with 6= 0 and
6= 0). The figures in brackets show the estimated cross-sectional volatility in beta volatility
among the portfolios that exhibit time-varying market betas.

Growth 2 3 4 Value Avg.

Micro 0.22 [0.07] 0.18 [0.06] 0.17 [0.05] 0.13 [0.04] 0.14 [0.05] 0.17
Small 0.23 [0.07] 0.17 [0.05] 0.14 [0.04] 0.13 [0.04] 0.17 [0.05] 0.17
Big 0.23 [0.07] 0.17 [0.05] 0.13 [0.04] 0.12 [0.03] 0.17 [0.05] 0.16

40
 Table V
Leverage and Book-to-Market

Panel A examines whether the Book-to-Market (BM) of micro portfolios is related to their
Operating Leverage (OL) and Financial Leverage (FL). For each size group (micro-cap, small-
cap, big-cap) and each leverage measure, I sort portfolios into leverage quintiles (low, 2, 3, 4,
and high) and BM quintiles (growth, 2, 3, 4, and value) formed independently. Then, for each
BM quintile, I measure the distribution of micro portfolios across the dierent leverage quintiles.
Panel B examines the relation between the two leverage measures and the value premium. For
each size group, I sort portfolios into OL and FL quintiles formed independently, and estimate,
for each of these 25 groups, the proportions of mispriced portfolios (i.e. portfolios with negative
and positive CAPM-alphas). Finally, I express these proportions as a fraction of the total
proportion of mispriced portfolios shown in Table II to make them sum up to 100%.

Panel A Relation Leverage and Book-to-Market

Micro-Cap Portfolios
BM BM
OL \ G. 2 3 4 V. FL \ G. 2 3 4 V.
Low 61.4 31.0 5.4 1.7 0.3 Low 31.3 36.6 21.8 8.7 1.5
2 30.8 41.6 22.1 4.8 0.8 2 8.0 22.7 36.4 29.3 3.5
3 7.1 21.5 43.5 22.9 5.1 3 9.9 16.1 28.0 34.1 11.9
4 0.6 5.5 23.2 46.5 24.1 4 14.6 15.8 13.2 24.9 31.4
High 0.0 0.3 5.8 24.1 69.7 High 36.2 8.8 0.6 2.9 51.5

Small-Cap Portfolios
BM BM
OL \ G. 2 3 4 V. FL \ G. 2 3 4 V.
Low 72.0 26.9 0.9 0.0 0.0 Low 51.9 42.0 6.1 0.0 0.0
2 27.5 51.9 18.9 1.4 0.5 2 21.4 43.4 33.5 1.9 0.0
3 0.5 21.2 62.7 13.2 1.9 3 15.7 12.7 51.9 19.8 0.0
4 0.0 0.0 17.5 70.7 11.8 4 6.2 1.9 8.5 67.0 16.5
High 0.0 0.3 5.8 24.1 69.7 High 4.8 0.0 0.0 11.3 83.5

Big-Cap Portfolios
OL \BM G. 2 3 4 V. FL \
BM G. 2 3 4 V.
Low 74.4 24.5 0.9 0.0 0.0 Low 40.9 52.4 6.6 0.0 0.0
2 25.1 51.9 19.8 3.3 0.0 2 28.1 28.8 42.5 0.9 0.0
3 0.5 23.6 63.7 10.8 1.4 3 13.3 17.0 34.4 34.4 0.9
4 0.0 0.0 15.6 67.4 16.9 4 6.7 1.9 13.2 49.5 28.6
High 0.0 0.0 0.0 18.4 81.7 High 11.0 0.0 15.1 15.1 70.4

41
 Table V
Leverage and Book-to-Market (Continued)

Panel B Relation between Leverage and CAPM-Mispricing

Micro-Cap Portfolios
Negative Mispricing (CAPM- 0) Positive Mispricing (CAPM- 0)
OL OL
FL \ Low 2 3 4 High Total FL \ Low 2 3 4 High Total
Low 13.1 0.7 0.0 0.0 0.0 13.8 Low 1.8 2.6 1.8 1.3 0.4 8.0
2 5.9 6.2 0.5 0.0 0.0 12.6 2 0.1 1.6 8.9 7.8 2.7 21.1
3 5.1 7.1 0.7 0.0 0.0 12.8 3 0.0 1.1 6.2 10.9 6.2 24.5
4 7.3 10.0 4.1 0.2 0.0 21.6 4 0.0 0.0 2.8 10.1 12.3 25.2
High 12.1 21.0 5.4 0.6 0.0 39.2 High 0.0 0.0 0.2 3.7 17.3 21.3
Total 43.5 45.0 10.6 0.8 0.0 100.0 Total 1.9 5.4 19.8 33.8 39.0 100.0

Small-Cap Portfolios
Negative Mispricing (CAPM- 0) Positive Mispricing (CAPM- 0)
OL OL
FL \ Low 2 3 4 High Total FL \ Low 2 3 4 High Total
Low 25.9 11.3 1.5 0.0 0.0 38.7 Low 0.0 0.8 0.0 0.0 0.0 0.8
2 7.8 20.1 8.0 0.0 0.0 35.9 2 0.0 0.9 0.6 0.0 0.0 1.5
3 5.2 7.9 3.1 0.0 0.0 16.2 3 0.0 0.8 5.5 9.1 0.0 15.4
4 3.9 1.1 0.3 0.0 0.0 5.2 4 0.0 0.6 4.6 20.1 15.9 41.2
High 3.4 0.6 0.0 0.0 0.0 4.0 High 0.0 0.0 0.0 3.1 38.0 41.1
Total 46.3 40.9 12.8 0.0 0.0 100.0 Total 0.0 3.2 10.7 32.3 53.9 100.0

Large-Cap Portfolios
Negative Mispricing (CAPM- 0) Positive Mispricing (CAPM- 0)
\OL Low 2 3 4 High Total \OL Low 2 3 4 High Total
FL FL
Low Low 0.0 0.0 0.0 0.0 0.0 0.0
2 2 0.0 1.4 0.0 0.7 0.0 2.4
3 3 0.0 3.7 2.3 7.8 0.8 14.5
4 4 0.0 1.1 4.4 13.1 19.8 38.4
High High 0.0 0.9 2.9 8.0 33.3 45.1
Total Total 0.0 7.0 9.6 29.6 53.8 100.0

42
 Table VI
Leverage and Human Capital Betas

For each size group (micro-cap, small-cap, big-cap) and each leverage measure (Operating Lever-
age (OL) and Financial Leverage (FL)), I sort micro portfolios in leverage quintiles (low, 2, 3,
4, and high). Then, for each quintile, I estimate the proportion of portfolios with negative and
positive human capital betas (Sensitivity-Proportion (%)). The figures in parentheses show the
standard deviation of the estimated proportions.

Micro-Cap Portfolios
Low 2 3 4 High Avg.
Operating Leverage
SensitivityProportion (%) 0.0 0.0 11.2 (1.8) 17.3 (2.7) 34.6 (4.1) 12.6
+ 0.0 1.6 (1.8) 1.2 (0.9) 0.0 0.0 0.6
Financial Leverage
SensitivityProportion (%) 1.3 (1.2) 8.9 (1.8) 9.4 (2.1) 20.3 (2.6) 22.9 (2.8) 12.6
+ 1.2 (0.9) 0.8 (0.8) 0.0 0.2 (0.2) 0.8 (0.5) 0.6

Small-Cap Portfolios
Low 2 3 4 High Avg.
Operating Leverage
SensitivityProportion (%) 0.0 1.0 (2.8) 0.0 7.9 (10.5) 20.4 (10.6) 5.9
+ 0.0 3.5 (3.1) 0.0 0.0 0.0 0.7
Financial Leverage
SensitivityProportion (%) 0.0 0.0 0.0 13.4 (10.6) 15.8 (9.4) 5.9
+ 1.2 (2.4) 2.3 (3.0) 0.0 0.0 0.0 0.7

Big-Cap Portfolios
Low 2 3 4 High Avg.
Operating Leverage
SensitivityProportion (%) 33.7 (6.8) 30.9 (6.1) 5.9 (4.4) 0.0 0.0 14.3
+ 0.7 (0.7) 0.7 (0.8) 0.0 2.3 (4.7) 66.2 (9.3) 14.1
Financial Leverage
SensitivityProportion (%) 41.9 (7.5) 21.8 (4.5) 6.7 (3.5) 0.2 (0.5) 0.0 14.3
+ 0.0 1.7 (1.5) 4.5 (3.1) 30.3 (5.5) 33.5 (6.1) 14.1

43
 Table VII
Leverage and Conditional Market Betas

For each size group (micro-cap, small-cap, big-cap) and each leverage measure (Operating Lever-
age (OL) and Financial Leverage (FL)), I sort micro portfolios in leverage quintiles (low, 2, 3, 4,
and high). Then, for each quintile, I estimate the proportion of portfolios having market betas
that are negatively and positively related to (i) the dividend yield (Dividend Yield-Proportion
(%)); and (ii) the term spread (Term Spread-Proportion (%)). The figures in parentheses show
the standard deviation of the estimated proportions.

Micro-Cap Portfolios
Low 2 3 4 High Avg.
Operating Leverage
Dividend YieldProportion (%) 26.0 (2.5) 16.6 (1.8) 6.8 (1.3) 0.3 (0.4) 0.0 9.9
+ 1.2 (0.5) 3.8 (1.0) 17.6 (1.6) 18.7 (1.8) 24.0 (2.3) 12.9
Term SpreadProportion(%) 16.9 (1.8) 27.7 (2.6) 17.3 (1.9) 4.4 (1.1) 0.0 13.3
+ 1.6 (0.8) 0.3 (0.3) 6.1 (1.4) 15.8 (2.0) 9.0 (2.0) 6.5
Financial Leverage
Dividend YieldProportion (%) 17.0 (1.9) 10.5 (1.6) 6.5 (1.2) 4.1 (1.0) 11.7 (1.6) 9.9
+ 7.1 (1.2) 9.5 (1.3) 11.7 (1.8) 15.8 (1.6) 20.6 (2.0) 12.9
Term SpreadProportion(%) 8.3 (1.4) 14.1 (1.7) 15.1 (1.7) 10.7 (1.7) 18.3 (2.0) 13.3
+ 6.0 (1.6) 4.2 (1.3) 7.5 (1.7) 8.9 (1.5) 6.2 (1.4) 6.5

Small-Cap Portfolios
Low 2 3 4 High Avg.
Operating Leverage
Dividend YieldProportion (%) 52.0 (5.0) 17.8 (3.0) 4.4 (1.4) 0.0 0.0 14.9
+ 0.0 8.3 (2.0) 50.8 (3.7) 63.0 (3.9) 68.5 (4.1) 38.1
Term SpreadProportion(%) 17.3 (3.0) 28.7 (3.6) 2.0 (1.4) 0.0 0.0 9.7
+ 5.9 (2.8) 5.2 (1.8) 28.0 (3.7) 65.2 (3.9) 90.0 (4.0) 38.9
Financial Leverage
Dividend YieldProportion (%) 38.6 (3.8) 22.8 (2.9) 10.0 (1.9) 2.8 (0.6) 0.0 14.8
+ 1.8 (1.3) 21.2 (2.7) 41.4 (3.2) 66.6 (3.4) 59.5 (4.1) 38.1
Term SpreadProportion(%) 20.7 (3.1) 18.7 (3.0) 7.1 (1.9) 0.5 (0.2) 1.3 (0.5) 9.6
+ 6.8 (2.4) 8.3 (2.6) 30.7 (3.1) 62.8 (3.5) 85.8 (3.9) 38.9

44
 Table VII
Leverage and Conditional Market Betas (Continued)

Big-Cap Portfolios
Low 2 3 4 High Avg.
Operating Leverage
Dividend YieldProportion (%) 28.8 (5.1) 8.3 (2.3) 11.9 (2.7) 0.0 0.2 (0.2) 9.8
+ 12.8 (2.1) 40.9 (3.8) 39.4 (3.6) 59.7 (4.5) 82.1 (4.2) 46.3
Term SpreadProportion(%) 56.8 (6.5) 24.9 (3.8) 7.1 (2.8) 0.0 0.0 17.8
+ 0.0 8.5 (2.5) 18.4 (3.6) 59.7 (4.9) 91.7 (5.9) 35.6
Financial Leverage
Dividend YieldProportion (%) 18.7 (3.4) 21.3 (3.9) 6.2 (2.0) 0.3 (0.2) 2.5 (1.5) 9.8
+ 24.2 (3.0) 21.2 (2.6) 43.1 (3.5) 61.8 (3.9) 81.6 (5.1) 46.3
Term SpreadProportion(%) 35.6 (4.4) 28.6 (4.3) 12.1 (2.6) 5.1 7.4 (1.6) 17.8
+ 4.9 (2.1) 0.0 29.7 (3.3) 65.5 (4.2) 78.1 (6.7) 35.6

45
 Table VIII
Iliquidity and the Value Premium

Panel A examines the relation between illiquidity (ILLIQ) and the value premium. For each size
group (micro-cap, small-cap, big-cap), I sort micro portfolios in ILLIQ quintiles, and estimate, for
each quintile, the proportions of mispriced portfolios (i.e. portfolios with negative and positive
CAPM-alphas). Finally, I express these proportions as a fraction of the total proportion of
mispriced portfolios shown in Table II to make them sum up to 100%. Panel B reports the
performance of a liquidity CAPM in the cross-section of Book-to-Market (BM) micro portfolios.
The traded liquidity factor is from Pastor and Stambaugh (2003). For each size group, I sort
each portfolio in BM quintiles (growth, 2, 3, 4, and value). Then, for each quintile, I estimate
the proportion of mispriced portfolios (Mispricing-Proportion). The figures in parentheses show
the standard deviation of the estimated proportions.

Panel A Relation between Illiquidity and CAPM-Mispricing

Micro-Cap Portfolios
Negative Mispricing (CAPM- 0) Positive Mispricing (CAPM- 0)
ILLIQ Low 2 3 4 High Total ILLIQ Low 2 3 4 High Total
48.3 36.2 12.5 2.8 0.0 100.0 1.7 6.9 20.1 31.6 39.7 100.0

Small-Cap Portfolios
Negative Mispricing (CAPM- 0) Positive Mispricing (CAPM- 0)
ILLIQ Low 2 3 4 High Total ILLIQ Low 2 3 4 High Total
28.3 28.3 26.6 13.6 3.4 100.0 10.4 9.1 14.5 23.5 42.4 100.0

Big-Cap Portfolios
Negative Mispricing (CAPM- 0) Positive Mispricing (CAPM- 0)
ILLIQ Low 2 3 4 High Total ILLIQ Low 2 3 4 High Total
0.0 12.6 22.7 31.6 33.1 100.0

Panel B Liquidity CAPM

Micro-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 53.7 (2.8) 19.7 (1.9) 0.0 0.0 0.0 14.7
+ 0.0 3.9 (1.8) 40.2 (2.6) 83.7 (2.1) 92.0 (2.1) 44.0

Small-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 70.2 (5.3) 27.8 (4.0) 4.5 (2.8) 0.0 0.0 20.5
+ 0.0 0.0 12.8 (3.0) 52.9 (4.2) 61.4 (4.9) 25.4

Big-Cap Portfolios
Growth 2 3 4 Value Avg.
MispricingProportion (%) 0.0 0.0 0.0 0.0 0.0 0.0
+ 0.0 2.2 (1.6) 13.0 (4.8) 48.6 (6.6) 82.6 (9.8) 29.3

46
 Table IX
Alternative Specifications for Operating and Financial Leverage

Panel A examines whether the Book-to-Market (BM) of micro portfolios is related to their
Operating Leverage (OL) and Financial Leverage (FL). For each size group (micro-cap, small-
cap, big-cap) and each leverage measure, I sort portfolios into leverage quintiles (low, 2, 3, 4,
and high) and BM quintiles (growth, 2, 3, 4, and value) formed independently. Then, for each
BM quintile, I measure the distribution of micro portfolios across the dierent leverage quintiles.
Panel B examines the relation between the two leverage measures and the value premium. For
each size group, I sort portfolios into OL and FL quintiles formed independently, and estimate,
for each of these 25 groups, the proportions of mispriced portfolios (i.e. portfolios with negative
and positive CAPM-alphas). Finally, I express these proportions as a fraction of the total
proportion of mispriced portfolios shown in Table II to make them sum up to 100%.

Panel A Relation between Leverage and Book-to-Market

Micro-Cap Portfolios
BM BM
OL \ G. 2 3 4 V. FL \ G. 2 3 4 V.
Low 38.3 37.8 20.6 3.2 0.0 Low 37.8 35.9 24.6 6.0 0.0
2 26.5 32.3 30.1 11.1 0.1 2 20.7 29.8 31.2 21.2 1.1
3 21.8 19.2 27.8 30.6 0.6 3 19.7 20.1 26.5 33.2 4.3
4 9.8 8.9 17.8 41.6 21.8 4 17.1 11.8 14.6 34.0 26.4
High 3.5 1.8 3.7 13.5 77.4 High 4.7 2.4 3.2 5.7 68.2

Small-Cap Portfolios
BM BM
OL \ G. 2 3 4 V. FL \ G. 2 3 4 V.
Low 40.3 37.7 20.2 1.4 0.0 Low 33.6 34.0 28.3 3.8 0.0
2 25.6 26.9 34.9 12.7 0.0 2 19.9 33.0 32.5 14.1 0.5
3 16.1 23.6 24.1 33.5 2.8 3 25.6 15.1 17.5 34.4 7.6
4 15.1 9.0 16.0 34.4 25.6 4 13.3 12.7 14.6 31.6 28.0
High 2.8 2.8 4.7 17.9 71.6 High 7.6 5.2 7.1 16.0 64.0

Big-Cap Portfolios
OL \BM G. 2 3 4 V. FL \
BM G. 2 3 4 V.
Low 46.5 45.8 0.8 0.0 0.0 Low 46.0 37.7 16.0 0.0 0.0
2 24.2 28.3 44.8 2.8 0.0 2 23.7 30.2 36.8 9.4 0.0
3 20.8 18.4 28.3 31.6 0.9 3 14.7 17.0 22.2 41.5 4.7
4 8.5 6.6 11.8 51.4 21.6 4 10.9 10.4 13.2 31.6 33.8
High 0.0 0.9 7.5 14.2 77.5 High 4.7 4.7 11.8 17.4 61.5

47
 Table IX
Alternative Specifications for Operating and Financial Leverage
(Continued)

Panel B Relation between Leverage and CAPM-Mispricing

Micro-Cap Portfolios
Negative Mispricing (CAPM- 0) Positive Mispricing (CAPM- 0)
OL OL
FL \ Low 2 3 4 High Total FL \ Low 2 3 4 High Total
Low 20.7 8.0 3.7 2.1 1.5 36.0 Low 0.4 2.3 2.6 1.4 0.1 6.8
2 12.4 8.5 4.1 0.3 0.2 25.5 2 1.6 4.0 5.0 4.5 0.6 15.8
3 8.6 6.6 3.8 0.0 0.4 19.5 3 1.1 3.8 6.7 6.7 1.9 20.2
4 5.9 4.4 5.1 1.0 0.0 16.4 4 0.3 2.0 5.1 11.5 8.4 27.1
High 0.9 0.3 1.3 0.1 0.0 2.6 High 0.1 0.0 0.2 4.6 25.1 30.1
Total 48.5 27.8 18.0 3.6 2.1 100.0 Total 3.5 12.0 19.7 28.7 36.1 100.0

Small-Cap Portfolios
Negative Mispricing (CAPM- 0) Positive Mispricing (CAPM- 0)
OL OL
FL \ Low 2 3 4 High Total FL \ Low 2 3 4 High Total
Low 1714 9.6 4.0 4.2 0.5 35.5 Low 0.0 0.0 0.0 0.2 0.0 0.3
2 16.4 8.0 3.0 0.9 0.9 29.2 2 0.0 3.9 1.8 2.7 0.0 8.3
3 10.1 6.2 2.3 4.1 0.7 23.4 3 0.2 1.9 9.5 8.4 2.1 21.9
4 3.0 2.5 2.0 1.0 0.0 3.3 4 0.3 2.0 6.2 17.2 10.0 35.6
High 2.0 0.0 0.1 1.1 0.0 0.0 High 0.0 0.0 0.2 6.0 27.7 33.8
Total 48.6 26.4 11.4 11.4 2.3 100.0 Total 0.5 7.6 17.7 34.5 39.7 100.0

Big-Cap Portfolios
Negative Mispricing (CAPM- 0) Positive Mispricing (CAPM- 0)
OL OL
FL \ Low 2 3 4 High Total FL \ Low 2 3 4 High Total
Low Low 0.0 0.0 0.0 0.0 0.0 0.0
2 2 0.0 0.2 1.5 0.1 0.2 2.1
3 3 0.0 1.2 5.9 10.6 1.9 19.7
4 4 0.0 0.0 1.7 16.6 13.1 31.4
High High 0.0 0.0 1.0 5.3 40.5 46.8
Total Total 0.0 1.5 10.2 32.6 55.7 100.0

48
 Table X
Alternative Specifications for the Human Capital Mimicking Portfolio

This table compares the properties of the estimated mimicking portfolio for aggregate income
growth, , obtained under alternative specifications for the choice of base assets. Baseline de-
notes the baseline specification used in the paper. The first specification replaces the value minus
growth portfolios with their respective long and short positions, while the second specification
considers the six Fama-French size-BM portfolios. Specifications 3, 4, and 5 break the dier-
ent industry portfolios into their individual components. Specification 6 and 7 remove the size
and momentum factors, respectively. Finally, Baseline Cont. keeps the baseline specification,
but replace with contemporaneous aggregate income growth, . The results show the coe-
cient -statistics associated with each base asset, the correlation between the mimicking portfolio
and income growth along with the adjusted 2 , and the annualized excess mean and standard
deviation of the mimimicking portfolio.

Dependent Variable: Monthly Aggregate Income Growth

Regressors Baseline 1 2 3 4 5 6 7 Baseline Cont.
Value-Growth Large 4.48 4.02 4.11 4.50 4.56 3.65 2.24
Value-Growth Small -3.09 -3.26 -2.95 -3.12 -3.02 -2.96 -1.49
Value Large 4.36 3.99
Neutral-Large 0.40
Growth Large 0.26 -0.10
Value Small -2.33 0.32
Neutral-Small -2.23
Growth Small 3.20 3.50

Dur., Non-Dur. & Ser. 1.80 0.76 1.36 0.47 2.05 1.77 1.38 -0.57
Durables 1.13
Non-Durables 2.10
Services 0.46
Manuf., Energy & Util. 1.70 1.80 2.17 1.63 0.38 1.78 1.91 -0.38
Manufacturing 2.10
Energy 0.22
Utilities 2.00
Bus. Equip. & Telecom 1.80 1.46 1.53 1.63 1.84 1.81 1.45 -0.14
Business Equipment 1.74
Telecom 1.56

Market -2.50 -3.00 -2.60 -2.74 -2.56 -2.47 -2.56 -2.45 0.31
Size -0.19 -0.28 -0.15 -0.58 0.20 1.24
Momentum 3.61 3.46 3.50 3.65 3.62 3.64 3.63 0.87

Correlation 0.22 0.23 0.25 0.23 0.22 0.22 0.22 0.18 0.14
Adjusted R2 (%) 3.5 3.8 4.3 3.6 3.3 3.4 3.6 2.0 0.6
Average Return (Ann.) 0.28 0.26 0.26 0.30 0.29 0.27 0.29 0.16 -0.09
Std. Deviation (Ann.) 0.26 0.28 0.30 0.28 0.27 0.27 0.27 0.22 0.17

49
 Figure 1
Portfolio Formation Technique

This example illustrates the portfolio formation technique used to create a large cross-section of
Book-to-Market (BM) micro portfolios. At the start of each year, I first sort stocks according
to their BM. Then, for each stock, I form an equally-weighted "surrogate" portfolio that
includes the stock itself, as well as -1 additional stocks with similar BM. For instance, the
surrogate of stock includes stock , stock , and stock , while the surrogate of stock
includes stock , stock , and stock . Second, each year-1 surrogate is chained with the year-2
surrogate having the nearest standardized BM value. For instance, if we combine the surrogates
of stocks and , we obtain a micro portfolio with high BM denoted by to . This
formation technique yields a total of micro portfolios, where is equal to max(M1 2 ),
and 1 , 2 denote the total number of stocks existing at the start of year 1 and 2, respectively.

Y E A R 1 ( M 1 E x is t in g S t o c k s )

S to ck s w ith h i g h B M
S to c k j

1 0 +1 .. .S t o c k b S t o c k k .. .
B M V alu e
( s ta n d a r d iz e d ) S u r r o g a te j

R et u r n so f P o rt fo li o b m hig h ( Ye a r 1 ):

m o n t h 1 =(1 / N )( R st o c k b ,1 +. .. +R st o c k k ,1 )
. ..
m o n th 1 2 = (1 /N )(R s t oc k b ,1 2 +. ..+ R st o c k k ,1 2 )

C h a in i n g
R e tu r n s
Y E A R 2 ( M 2 E x is t in g S t o c k s )
S t o c k s w i th h i g h B M
S to c k p

1 0 +1 ... S t o ck a S t o ck q ...
B M V a l u e
(s ta n d a rd i z e d ) S u r ro g a te p

R e tu r n s o fP o r tfo lio b m h ig h (Ye a r 2) :

m o n t h 1 = (1 / N )(R s t oc k a ,1 +. ..+ R st o c k q, 1 )
.. .
m o n th 12 = (1 / N )(R s t o c k a ,1 2 + . ..+ R st o c k q, 1 2 )

50
 Figure 2
Detecting Mispricing from the Data

This figure shows the probability of detecting positive alpha (i.e., mispricing) from the data
for individual stocks (dashed line) and micro portfolios with equal to 10 stocks (solid line)
and 20 stocks (dotted line), respectively. For a given level of annual alpha, , I assume that
the estimated alpha t-statistic, z, follows a normal ( 1), where = (12)b b is
, and
the monthly standard deviation of the estimated CAPM-alpha, proxied by the cross-sectional
median across all stocks (micro portfolios) in the sample. Consistent with the methodology to
be presented in Section II.B, the probability of detecting mispricing is equal to prob(z 0 ),
where 0 = [05 05].

100

90

80
Probability of Detecting Mispricing (Power)

70

60

50

40

30

20

10

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Annual Alpha (Mispricing)

51
 Figure 3
Human Capital Mimicking Portfolio

At the end of each year starting in 1980, I use monthly data up to that point in time to regress
aggregate income growth on the excess return of the base portfolios. Panel A plots the evolution
of the correlation between income growth and the excess return of the mimicking portfolio. Panel
B shows the time-variation in the coecient -statistic associated with the value minus growth
portfolio of large stocks (solid line) and small stocks (dashed line).
0.4 5

3
0.3
2

t-statistic of the slope coefficient

1
Correlation

0.2 0

-1

-2
0.1
-3

-4

0 -5
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
End of the year End of the year

(A) Correlation with Income Growth (B) Exposure to Value-Growth Portfolios

52
 Figure 4
Stock Market Return Predictability

At the end of each year starting in 1980, I use the entire return history up to that point in time to
regress the market excess return on the lagged values of the dividend yield and the term spread
(plus a constant). Panel A plots the evolution of the coecient -statistic associated with the
dividend yield (solid line) and the term spread (dashed line). Panel B shows the time-variation
12
in the monthly volatility of the market risk premium, computed as b 0 b
b , where b is the
vector of estimated coecients and b is the covariance matrix of the predictors.
5 1.2

1.1

1
4
0.9

0.8

Monthly volatility(in percent)

t-statistic (slope coefficient)

3
0.7

0.6

0.5
2

0.4

0.3
1
0.2

0.1

0 0
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
End of the year End of the year

(A) Exposure to Dividend Yield Term Spread (B) Volatility of the Market Risk Premium

53
 Figure 5
Time-variation in the Value Premium (Continued)

100 100
90 90
80 80
Mispriced portfolios

Mispriced portfolios
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
End of the year End of the year

-18 18
-16 16
-14 14
Annual CAPM Alphas

Annual CAPM Alphas

-12 12
-10 10
-8 8
-6 6
-4 4
-2 2
0 0
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
End of the year End of the year

(A) Large-Growth (B) Large-Value

54
 Figure 5
Time-variation in the Value Premium

At the end of each year starting in 1980, I use the entire return history up to that point in time to
estimate the mispricing parameters in the growth and value terciles, respectively. For each size
group (micro-cap, small-cap, large-cap), the left panel shows the time-variation in the proportion
of portfolios with negative alphas in the growth tercile, , along with the average level

of CAPM-alphas these portfolios generate, . The right panel shows the time-variation
in the proportion of portfolios with positive alphas in the value tercile, + , along with the
+
average level of CAPM-alphas these portfolios generate, .

100 100
90 90
80 80
Mispriced portfolios

Mispriced portfolios
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
End of the year End of the year

-18 18
-16 16
-14 14
Annual CAPM Alphas

Annual CAPM Alphas

-12 12
-10 10
-8 8
-6 6
-4 4
-2 2
0 0
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
End of the year End of the year

(A) Micro-Cap Growth (B) Micro-Cap Value

100 100
90 90
80 80
Mispriced portfolios

Mispriced portfolios

70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
End of the year End of the year

-18 18
-16 16
-14 14
Annual CAPM Alphas

Annual CAPM Alphas

-12 12
-10 10
-8 8
-6 6
-4 4
-2 2
0 0
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
End of the year End of the year

(C) Small-Cap Growth (D) Small-Cap Value

55