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Average returns on value and growth portfolios are broken into dividends and three sources of capital gain: (1) growth in book equity, primarily from earnings retention, (2) convergence in price-to-book ratios (P/Bs) from mean reversion in profitability and expected returns, and (3) upward drift in P/B during 1927–2006. The capital gains of value stocks trace mostly to convergence: P/B rises as some value companies become more profitable and their stocks move to lower-expected-return groups. Growth in book equity is trivial to negative for value portfolios but is a large positive factor in the capital gains of growth stocks. For growth stocks, convergence is negative: P/B falls because growth companies do not always remain highly profitable with low expected stock returns. Relative to convergence, drift is a minor factor in average returns.

About the Author(s)

Eugene F. Fama PhD

Eugene F. Fama is Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business. His efficient markets hypothesis, drawn from his 1970 Journal of Finance paper, 'Efficient Capital Markets: A Review of Theory and Empirical Work,' has gained widespread acclaim and application in the finance industry. Professor Fama has published nearly 100 academic research papers on finance and has written two popular textbooks, The Theory of Finance and Foundations of Finance. He was the recipient of the inaugural Onassis Prize in finance, the inaugural Morgan Stanley — American Finance Association Award for Excellence in Finance, and the CFA Institute Nicholas Molodovsky Award. Professor Fama holds a BA from Tufts University and an MBA and a PhD from the University of Chicago Booth School of Business.

Kenneth French
Kenneth R. French

Kenneth R. French is Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College, Hanover, New Hampshire.