Size and Value in China

  • Jianan Liu, Rob Stambaugh, and Yu Yuan
  • Journal of Financial Economics
  • A version of this paper can be found here

What are the research questions?

China represents the world’s second largest stock market and a growing component of the world’s GDP. China also operates under peculiar political and economic environments relative to the market economies of the Western world. Because China is so unique, a plausible research hypothesis is that traditional asset pricing models, such as the Fama-French 3-factor model, may not be appropriate for this unique economic environment. The authors specifically address the following questions:
  1. Are size and value important factors in China?
  2. Does the Fama-French model capture these factors, effectively?
  3. Are other factors useful in pricing Chinese stocks?

What are the Academic Insights?

  1.  YES.  Both size and value are important for understanding the expected returns of Chinese stocks.
  2. NO.  The Fama French 3-factor model needs to be augmented in two ways: 1) eliminate the smallest 30% of listed stocks (often reverse merger “shell” companies) and 2) use earnings/price as opposed to book/market (better able to explain the cross-section).
  3. YES.  Sentiment seems to be a factor that helps explain the expected average returns of Chinese stocks ( Sentiment is measured via an “abnormal” turnover variable).

Why does it matter?

This paper highlights the need to think critically regarding one’s choice of an asset pricing model in different markets. Once again, highlighting that asset pricing is more of an art than a science. Bottom line? A one-size-fits-all model may not be appropriate in all situations and with respect to the Chinese stock market, this certainly seems to be the case. For example, the authors highlight the issue with replicating the Fama French size factor:

Unlike small listed stocks in the US, China’s tight IPO constraints cause returns on the smallest stocks in China to be significantly contaminated by fluctuations in the value of becoming corporate shells in reverse mergers…Eliminating these stocks yields factors that perform substantially better than using all listed stocks to construct factors…

The paper is also important because it serves as a quasi “out-of-sample” experiment. The paper’s core results reiterates that size and value seem to be associated with higher expected returns. In recent memory, where mega-cap everything has beaten small-cap everything, investors have a hard time believing the research. This piece simply states that large-cap growth stocks probably aren’t the answer if one’s goal is to earn high expected returns.

The most important charts from the paper

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.


We construct size and value factors in China. The size factor excludes the smallest 30% of firms, which are companies valued significantly as potential shells in reverse mergers that circumvent tight IPO constraints. The value factor is based on the earnings-price ratio, which subsumes the book-to-market ratio in capturing all Chinese value effects. Our three-factor model strongly dominates a model formed by just replicating the Fama and French (1993) procedure in China. Unlike that model, which leaves a 17% annual alpha on the earnings-price factor, our model explains most reported Chinese anomalies, including profitability and volatility anomalies.

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