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.