37 Pages Posted: 18 Jun 2007
Date Written: June 13, 2007
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: Suggested Citation
By Lu Zhang