The Productivity Premium in Equity Returns

37 Pages Posted: 18 Jun 2007  

David P. Brown

University of Wisconsin - Madison - Department of Finance, Investment and Banking

Bradford Rowe

University of Wisconsin - Madison

Date Written: June 13, 2007

Abstract

A productive firm has a high return on invested capital, and is likely to have a low capital to enterprise value ratio and a low book to market ratio. Similarly, unproductive firms tend to be value firms. This is evidence of an efficient market. However, given the well-known value premium in equity returns and given the negative correlation between book-to-market ratios and productivity in the cross section of firms, we expect productive firms to offer lower returns than unproductive firms. Therefore it is surprising that productivity is a positive predictor of returns. We conclude that investors have historically made systematic mistakes by failing to fully incorporate measures of firm productivity in stock selection. These errors are one source of the value premium in equity returns. If they continue, portfolio managers of all styles - value, growth and balanced - may increase alpha by tilting toward productive firms.

Keywords: Equity returns, stock returns, book-to-market ratio, productivity, profitability, return on invested capital, ROI, average returns

JEL Classification: G11, G12, G14

Suggested Citation

Brown, David P. and Rowe, Bradford, The Productivity Premium in Equity Returns (June 13, 2007). Available at SSRN: https://ssrn.com/abstract=993467 or http://dx.doi.org/10.2139/ssrn.993467

David P. Brown (Contact Author)

University of Wisconsin - Madison - Department of Finance, Investment and Banking ( email )

975 University Avenue
Madison, WI 53706
United States
608-265-5281 (Phone)
608-265-4195 (Fax)

Bradford Rowe

University of Wisconsin - Madison ( email )

716 Langdon Street
Madison, WI 53706-1481
United States

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