Penetrating the Book-to-Market
Black Box: The R&D Effect
Baruch Lev and Theodore Sougiannis*
The book-to-market (BM) phenomenon looms large among
capital market enigmas. Empirical studies have consistently
demonstrated the existence of a positive association between
the BM ratio and subsequent stock returns.
Fama and French
(1992a, p. 428), confirming this relation, concluded that
`although the size effect has attracted more attention, book-to-
market equity has a consistently stronger role in average returns.'
Attempts to explain the book-to-market findings generally
followed one of three routes: (i) Risk premium: The higher returns
to large BM stocks are said to compensate for higher risk, such as
the risk of financial distress (Fama and French, 1993 and 1995).
(ii) Mispricing. The association between BM and subsequent
returns is believed to be due to systematic mispricing of stocks,
such as the incorrect extrapolation by investors of past growth of
`glamour companies' (Lakonishok et al., 1994), or to errors in
market expectations of future earnings (Frankel and Lee, 1995).
(iii) Selection Bias. The book-to-market phenomenon is due to
Journal of Business Finance & Accounting, 26(3) & (4), April/May 1999, 0306-686X
ß Blackwell Publishers Ltd. 1999, 108 Cowley Road, Oxford OX4 1JF, UK
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* The authors are from New York University and the University of Illinois at Urbana-
Champaign. The comments and suggestions of workshop participants at U.C. Berkeley,
University of Illinois, University of Tel-Aviv, the fourth conference on Financial
Economics and Accounting, the third International Conference on Contemporary
Accounting Issues, and especially Yakov Amihud, William Beaver, Shmuel Kandel, Josef
Lakonishok, Hayne Leland, Joshua Livnat, David Modest, Stephen Penman, Siew Hongh
Teoh, Brett Trueman, Paul Zarowin, and the anonymous referee are gratefully
acknowledged. (Paper received March 1998, revised and accepted August 1998)
Address for correspondence: Theodore Sougiannis, Department of Accountancy,
University of Illinois at Urbana-Champaign, 1206 South Sixth Street, Champaign, IL