Expected Returns: An Investor's Guide to Harvesting Market Rewards

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Value-oriented equity selection

• Value stocks with high book-to-market ratios and earnings yields (i.e., low prices relative to their book values and earnings) have outperformed growth stocks and the market both in the U.S. and globally over many decades (but can underperform sharply over short windows).

• The strategy of sector neutrality (picking stocks that are cheap vs. industry peers) has given a better risk–reward tradeoff than the traditional approach to value investing which uses all stocks and allows industry bets.

• Style timing based on the current extent of the value opportunity or on other indicators appears only mildly helpful.

• The main behavioral explanation for value stocks’ long-run outperformance is excessive extrapolation by investors of multi-year growth rates. In reality, earnings growth mean-reverts faster than the market expects, making growth stocks more likely to disappoint. Value stocks also can be dull or worse (beaten-up stocks in depressed companies that are uncomfortable to hold).

• Various alternative rational explanations have been proposed, but relatively complex stories are needed to support them. It is not obvious from data that value stocks are riskier than growth stocks (since value stocks have lower market betas and similar performance in recessions), but some serious thinkers have found greater risk in value stocks. Notably, value stocks often underperform when liquidity dries up.

• Value strategies analogous to value-oriented stock selection ...