What is 'High Minus Low - HML'
High minus low (HML), also referred to as a value premium, is one of three factors in the Fama and French asset pricing model. HML accounts for the spread in returns between value and growth stocks and argues that companies with high book-to-market ratios, also known as value stocks, outperform those with lower book-to-market values, known as growth stocks.
BREAKING DOWN 'High Minus Low - HML'Used to evaluate profit margins for a security over the short- and long-term, the HML provides an indication of the anticipated performance of the security in the future. The formula, high minus low, is used to calculate the associated range. HML is one of three factors in the original Fama and French’s Three Factor model, which is often used to evaluate a portfolio manager's returns.
Fama and French’s Three Factor Model
Founded in 1992 by Eugene Fama and Kenneth French, the Fama and French’s Three Factor model uses three factors, including HML, to attempt to explain excess returns in a manager's portfolio. This model builds off of the one factor model associated with the Capital Asset Pricing Model (CAPM), with a factor referred to as beta, by adding the factors of size, also referred to as small minus big (SMB), and value, as defined by HML.
Beyond beta, Fama and French found that small company stocks often gain higher returns that those of larger companies, while value stocks gain higher returns than those associated with growth stocks. The model continues based on the assumption that higher compensation is necessary for riskier investments, which results in higher earnings potential. By examining a portfolio’s return based on the three factors, it is possible to separate the skill of the fund manager from higher returns based solely on the composition of the portfolio.
Specifically, HML shows whether a manager is relying on the value premium by investing in stocks with high book-to-market ratios to earn an abnormal return. If the manager is buying only value stocks, the model regression shows a positive relation to the HML factor, which explains that the portfolios returns are accredited only to the value premium. Since the model can explain more of the portfolio's return, the original excess return of the manager decreases.
Fama and French’s Five Factor Model
As of 2014, Fama and French adapted their model to include five factors. Along with the original three factors, the new model adds the concept that companies reporting higher future earnings have higher returns in the stock market, a factor referred to as profitability. The fifth factor, referred to as investment, relates the concept of internal investment and returns, suggesting that companies directing profit towards major growth projects are likely to experience losses in the stock market.