On Selection Biases in Book-to-Market Based Tests of Asset Pricing Models

Many studies have documented portfolio strategies that provide returns in excess of those expected, given the level of risk of the portfolio. Variables that seem to have predictive power for equity returns include the market capitalization of the firm's equity and the ratio of the firm's book equity to market equity (BE/ME). Firms with low market capitalization and high book-tomarket values seem to earn high returns. With respect to the book-to-market anomaly, it has been argued that the apparent superior performance is due to a subtle selection bias in a typical data source used to implement the tests of asset pricing models, the COMPUSTAT data. We use a sample of COMPUSTAT data that is free from this bias to investigate whether the previous evidence on the book-to-market anomaly is an artifact of this selection bias. The postulated selection bias does not seem to be important for samples restricted to NYSE/AMEX firms. There is some difference when NASDAQ firms are included in the standard COMPUSTAT sample. This may be due to a truly stronger BE/ME effect or to a more severe selection bias in that sample. Our data do not allow us to disentangle these two possible explanations.