Factor investing in A-share markets? This paper1 shows that the two classic Fama-French factors, size and value, are also powerful predictors of stock returns in China. To get the most out of these factors, the authors propose to tweak the definitions a bit.
For the size factor they exclude the 30% smallest firms, which they justify by arguing that these companies are valued significantly as potential shells in reverse mergers that circumvent tight IPO constraints. Their preferred value factor for China is the earnings-price ratio, which they find subsumes the book-to-market ratio that is typically used in academia.
The study shows that a three-factor model constructed in this way strongly dominates the standard Fama-French approach in China. As practitioners we prefer to use a diversified mix of value factors that work consistently across different markets, rather than trying to identify the one best metric.
The issue of reverse mergers, or backdoor listings, is one of the reasons why for our quantitative strategies we conduct more thorough fundamental screening of stocks listed in China to define a clean investable universe.
1Liu, Stambaugh & Yuan, “Size and Value in China”, NBER Working Paper No. w24458, 2018.
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