Asset Growth Dynamics and Valuation-ratio Based Anomalies

Stock returns are positively related to the ratio of a firm's book value of common equity to its market value. The well-known effect is pervasive in stock markets around the world. Investment strategies based on the phenomenon provide substantial profits, around 8% over the first year of holding and up to 30% over a three-year horizon. This has challenged the notion of market efficiency in traditional finance theory and has been under debate among financial economists for more than two decades. The current literature has provided various different and seemingly opposing arguments but individually supportive evidence to this phenomenon. We provide and examine a unified explanation, specifically a mechanism involving extrapolative corporate growth expectation and style investing focusing on growth, to address the main driving force of the book-to-market effect and simultaneously reconcile and synthesize the set of empirical findings being recently documented. We expect to document that (1) the book- to-market effect or the class of positive relations between stock returns and similar valuation ratios is strong (weak) when total asset growth subsequently reverses (persists); (2) firm attributes that have been shown to be related to the book-to-market equity or related valuation ratio and systematic risks essentially contain information about future asset growth (3) limits to arbitrage are endogenously associated with uncertainty in growth dynamics; and (4) the effect is stronger when growth is ex-ante predicted to subsequently reverse more